Introduction: Resolving Cryptocurrency-Related Tax Delinquency under the CRA's Voluntary Disclosures Program (VDP)
Our knowledgeable Canadian crypto-tax lawyers have assisted numerous Canadian cryptocurrency traders, cryptocurrency investors, and cryptocurrency miners with correcting their tax affairs under the Canada Revenue Agency's Voluntary Disclosures Program (also known as the VDP).
One instance involved a client who was one of the earliest to purchase and mine Bitcoin. This taxpayer began mining Bitcoin with a $1,500 laptop shortly after the Bitcoin network's creation, back when a Bitcoin miner didn't need to expend the equivalent of a small nation's GDP to cover the electricity costs. In addition to acquiring Bitcoin by mining, this taxpayer also consistently purchased Bitcoin with fiat. In 2017, when the Bitcoin network underwent two hard forks, the taxpayer received Bitcoin Cash (BCH) and Bitcoin Gold (BTG) worth hundreds of thousands of dollars. The taxpayer promptly traded the BCH and BTG units for additional Bitcoin. Throughout the years, this taxpayer also received cryptocurrency airdrops worth thousands of dollars. By the time that this taxpayer approached our expert Canadian tax lawyers for crypto-tax advice, the taxpayer had amassed an untaxed Bitcoin portfolio worth almost $100 million.
The problem, however, was that our client had failed to report millions of dollars in cryptocurrency-related income and holdings to the Canada Revenue Agency. Part of the reason was that, back then, the CRA had provided only sparse guidance to the general public about cryptocurrency transactions. For example, the CRA's 2013 publication, entitled "What you should know about digital currency?", simply likened cryptocurrency transactions to barter transactions without much elaboration on the tax consequences. As a result, our client had no idea how to calculate cryptocurrency-related income, whether to report that income as business income or as capital gains, whether the Bitcoin holdings should be reported on a T1135 form, or how to report the Bitcoin forks or the cryptocurrency airdrops for Canadian tax purposes.
Despite needing to contend with several complicated crypto-tax issues, our top Canadian crypto-tax lawyers expertly and swiftly analyzed our client's cryptocurrency transactions, provided a tax-law opinion about the Canadian tax implications, and prepared and filed a VDP application on our client's behalf—thereby saving our client from civil tax liability in the form of gross-negligence penalties and from criminal tax liability for crypto tax evasion.
This article provides an overview of the various crypto-tax issues that were raised by this client's situation and resolved by the analysis of our skilled Canadian crypto-tax lawyers. This article concludes by offering pro tax tips from our esteemed Canadian crypto-tax lawyers.
The Characterization Issue: Is Bitcoin a Capital Property? Or Is it Inventory?
The characterization issue is one of the Canadian crypto-tax issues that our client's situation raised. Canada's Income Tax Act recognizes only two broad sorts of property for tax purposes:
- capital property, which creates a capital gain or loss upon disposition; and
- inventory, which figures into the computation of business income.
The type of income that the property generates upon sale—that is, capital gains or business income—determines whether that property is a capital property or inventory. In other words, you start by determining the nature of the income, and then you characterize the property, not the other way around. Hence, your profits from a transaction involving Bitcoin or any other cryptocurrency will be treated as either (i) business income or (ii) a capital gain, and, if they are characterized as business income, your cryptocurrency units constitute inventory.
The income/capital distinction also comes with important tax implications. Business income is fully taxable while only a portion of a capital gain is taxable. In particular, for the first $250,000, only one-half of the capital gain is taxable, and for any amount over $250,000, two-thirds of the capital gain is taxable.
Bitcoin and cryptocurrency transactions often straddle the line between income and capital. Canadian courts have turned out a large body of jurisprudence wrestling with the ambiguity between investing, which produces a capital gain or loss, and trading, which results in business income or expenses.
The taxpayer's motive or intent at the time of acquiring the cryptocurrency is the most important criterion that courts consider when determining whether the transaction produced a capital gain or business income. Still, to discern a taxpayer's intention, courts will focus on the objective factors surrounding both the purchase and the sale of the cryptocurrency. Applied to cryptocurrency transactions, these factors may include:
- transaction frequency—e.g., a history of extensive buying and selling of cryptocurrency or of a quick turnover of cryptocurrency units might suggest a business;
- length of ownership—e.g., brief periods of holding the cryptocurrency indicate business dealings, not capital investing;
- knowledge of cryptocurrency markets—e.g., increased knowledge of or experience with cryptocurrency markets favours a business characterization;
- relationship to the taxpayer's other work—e.g., if cryptocurrency transactions (or similar dealings) form a part of a taxpayer's employment other business, it points toward business;
- time spent—e.g., a greater likelihood of characterization as a business if a substantial part of the taxpayer's time is spent studying cryptocurrency markets and investigating potential purchases;
- financing—e.g., leveraged cryptocurrency transactions indicate a business; and
- advertising—e.g., increased likelihood of business characterization if the taxpayer has advertised or otherwise made it known that he deals in cryptocurrency.
In our experience, most Canadians who invest or trade cryptocurrency don't even know that this analysis exist, and they thereby incorrectly report their crypto-related income, leaving themselves vulnerable to a CRA crypto-tax audit. To ensure that your tax returns are accurate, speak to one of our savvy Canadian crypto-tax lawyers today.
Canadian Tax Implications of Bitcoin Mining
Our client had also spent several years mining Bitcoin. Bitcoin mining (and cryptocurrency mining in general) can match at least three distinct tax characterizations, each of which comes with its own set of Canadian tax implications. Moreover, the mining itself and the disposition of the cryptocurrency acquired through mining are two separate activities, and they each invoke different Canadian tax rules.
A taxpayer might engage in cryptocurrency mining purely as a hobby or personal activity without any commercial intent. (Granted, crypto mining as a hobby is far less likely nowadays because of its prohibitive costs.) Hobby mining doesn't qualify as a "source of income" for Canadian tax purposes. Therefore, when a hobbyist miner obtains cryptocurrency through mining, the miner need not report the value of those mined crypto units as income. Instead, the income inclusion (or loss realization) happens when the taxpayer disposes of the mined crypto units. Because the crypto-mining hobbyist did not acquire the units with the intent to trade, the disposition results in a capital gain or capital loss (as opposed to business income or a business loss).
A second alternative views cryptocurrency mining as akin to acquiring inventory—namely, inventory in a cryptocurrency-trading business. On this interpretation, the crypto mining is not itself the taxpayer's source of income; it's simply an aspect of the taxpayer's source of income. The taxpayer's source of income consists of selling and trading the cryptocurrency units that the taxpayer acquired by mining. Thus, just as a gold miner doesn't recognize an income inclusion upon unearthing gold deposits, a cryptocurrency trader doesn't recognize taxable income when acquiring cryptocurrency through mining. Instead, the income inclusion (or loss realization) occurs when the cryptocurrency trader disposes of the mined crypto units. But unlike the crypto-mining hobbyist, who reports the resulting gain or loss on capital account, the commercial cryptocurrency miner must report the resulting gain or loss on income account—that is, as business income or as a business loss.
A third alternative treats cryptocurrency mining as akin to providing a service. Through cryptocurrency mining, the taxpayer expends computing power to validate blockchain transactions and thereby provides a service to users collectively. In exchange, the cryptocurrency miner receives compensation in the form of the mining reward. Under this interpretation, the cryptocurrency mining is itself a source of income. As a result, when the cryptocurrency miner receives mining rewards, those receipts are fully taxable as the miner's business income under subsection 9(1) of Canada's Income Tax Act. Thus, when calculating taxable income, the Canadian cryptocurrency miner must include the fair-market value of the cryptocurrency that the miner received as a mining reward—specifically, the value, expressed in Canadian dollars, as of the time that the miner received the cryptocurrency. In addition, because the crypto miner has reported the value of the mining-reward cryptocurrency as taxable income, subsection 52(1) of the Income Tax Act allows the crypto miner to increase the tax cost of that cryptocurrency accordingly. The increased tax cost prevents double tax when the crypto miner ultimately disposes of the cryptocurrency that the miner obtained as a mining reward.
The most important lesson from this discussion is that the Canadian income-tax implications will depend on each taxpayer's specific circumstances. Cryptocurrency mining invokes a complicated tax analysis with several possible interpretations. Canadian taxpayers who mine cryptocurrency should therefore educate themselves about their income-tax obligations by seeking tax guidance from a skilled Canadian crypto-tax lawyer.
Canadian Income-Tax Implications of Receiving New Cryptocurrency under a Hard Fork: Tax-Free Windfall or Income from a Source?
In 2017, when the Bitcoin network underwent two hard forks, our client received Bitcoin Cash (BCH) and Bitcoin Gold (BTG) worth hundreds of thousands of dollars. This raised questions about our client's Canadian tax obligations with respect to receiving those forked coins.
Two Canadian tax principles bear on the tax-law analysis of the Bitcoin hard forks. The first principle is that a receipt is taxable only if it's "income from a source." This is why the winnings of an amateur gambler aren't taxed. Casual gambling doesn't produce a source of income because it's a personal endeavour and doesn't serve as a reliable means of generating profit. Yet if the gambling stems from another business or if the gambler earns a livelihood from a skill-based game, then the gambling qualifies as a source of business income—and the taxpayer's winnings will be taxed as such.
The second tax principle relates to characterizing the income stemming from a property or asset. In particular, depending on how it's used, a property can generate business income, investment income, or a capital gain. If the property itself generates income, that income is either business income or investment income. The correct income-tax characterization depends on the level of activity associated with producing that income: an active venture suggests a business and thus business income; a passive undertaking implies an investment and thus investment income. If, however, the income comes from disposing of the property, the resulting profit is either business income or a capital gain. In this case, the appropriate income-tax characterization depends on whether the taxpayer acquired the property with the intent to trade.
So, how do these Canadian tax principles bear on Canadian taxpayers who received Bitcoin Cash and Bitcoin Gold as a result of the hard fork? Well, the first principle raises the question of whether the receipt of forked coins constitutes a source of income. The second principle affects those Canadian taxpayers for whom the receipt of forked coins was indeed a source of income. For them, the issue is how to properly report that income.
A receipt is non-taxable unless it stems from a source of income. A source of income possesses one or more of the following characteristics: it produces a yield that recurs on a periodic basis; it requires organized effort, activity, or pursuit on the taxpayer's part; it involves a marketplace exchange; it gives the taxpayer an enforceable claim to receive payment; and, in the case of a source of business or investment income, it stems from the taxpayer's pursuit of profit.
Thus, the receipt of forked coins doesn't constitute a source of income unless the recipient can alter the protocol underlying the cryptocurrency network and thereby institute the hard fork. In the context of cryptocurrency, a "fork" refers to a change to the protocol underlying the cryptocurrency network. A hard fork (or chain split) alters the protocol code to create a new version of the blockchain alongside the old version, thereby producing a new token that operates under the rules of the amended protocol while the original token continues to operate under the existing protocol. Most cryptocurrency users don't wield the power to alter the network protocols underlying the cryptocurrency that they own. As such, they have no say in whether a hard fork occurs.
For example, take the two Bitcoin hard forks under which Bitcoin users received Bitcoin Cash (BCH) and Bitcoin Gold (BTG). The decision to institute the two hard forks rested with the developers of the Bitcoin network. Most Bitcoin owners had no influence over the issuance of the two forked coins, and they received the Bitcoin Cash units or Bitcoin Gold units without any action on their part. They received the forked coins so long as their cryptocurrency wallets contained Bitcoin units at the relevant time. In addition, the two Bitcoin hard forks didn't exhibit the characteristics of an income source for many of the taxpayers who received the forked BCH and BTG units. The forks didn't recur on a periodic basis; they required no organized effort, activity, or pursuit on the part of most taxpayers involved; they stemmed from an alteration to the Bitcoin protocol, not a marketplace exchange; and the recipients of the forked coins arguably had no enforceable claim to receive them because they provided no consideration for them. So, it's possible that, for many Canadian taxpayers who received Bitcoin Cash and Bitcoin Gold as a result of the hard forks, their receipt of these units was a tax-free windfall.
This analysis isn't universal, however. For instance, the receipt of forked coins likely constitutes taxable income for Canadian taxpayers who develop cryptocurrency platforms, initiate hard forks, and thereby reap new cryptocurrency units. In those cases, for the cryptocurrency developer, the hard fork certainly exhibits some characteristics of an income source. It requires organized effort, activity, or pursuit on the developer's part. And, as something under the crypto developer's control, the hard fork can conceivably recur on a periodic basis. So, a hard fork is very likely a source of taxable business income for Canadian cryptocurrency developers who receive forked coins by their own doing. The income-tax result is that the Canadian cryptocurrency developer must report the value of the forked coin as income for the year in which the developer received it.
This illustrates that every situation calls for a tax-law analysis that takes account of the taxpayer's specific circumstances. The tax implications will turn on each taxpayer's specific set of facts. This means that Canadian cryptocurrency investors and should learn their tax obligations by seeking tax guidance from an experienced Canadian crypto-tax lawyer.
Canadian Income-Tax Implications of Receiving & Disposing of Cryptocurrency Airdrops
Our expert Canadian crypto-tax lawyers were also required to analyze the Canadian tax treatment of our client's cryptocurrency airdrops. Our client's cryptocurrency airdrops gave rise to a similar tax-law analysis as that invoked by our client's Bitcoin hard forks.
As mentioned above, a receipt is non-taxable unless it comes from a source of income. A source of income possesses one or more of the following characteristics: it produces a yield that recurs on a periodic basis; it requires organized effort, activity, or pursuit on the taxpayer's part; it involves a marketplace exchange; it gives the taxpayer an enforceable claim to receive payment; and, in the case of a source of business or investment income, it stems from the taxpayer's pursuit of profit.
It therefore appears that receiving airdropped tokens doesn't usually count as a source of income unless the airdrop relates to a business run by the recipient. For example, a cryptocurrency airdrop might generate income for a social-media influencer who receives the tokens in exchange for promotional services, such as posting or tweeting about a new cryptocurrency platform or the issuing company. In this scenario, the airdrop acts as a source of income for the recipient because it involves organized effort, activity, or pursuit. As someone capable of promoting the new cryptocurrency, a social-media influencer might regularly receive airdrops from emerging platforms. Thus, in this case, a cryptocurrency airdrop is likely to be considered taxable business income. Consequently, the recipient must report the value of the airdropped tokens as income for the year they were received. However, the income amount might be minimal, as airdrops often involve small quantities of virtual currencies with little to no market value at the time of receipt.
This tax treatment won't apply universally, however. In particular, it probably doesn't apply to most airdrop recipients, who received the airdropped cryptocurrency tokens unprompted, for no consideration whatsoever. Indeed, cryptocurrency airdrops don't exhibit the characteristics of an income source for most the taxpayers who receive them. In most cases, the airdrops don't recur on a periodic basis; they require no organized effort, activity, or pursuit on the recipient's part; and the recipients of the airdrop arguably had no enforceable claim to receive the airdropped token because the recipients don't provide any consideration for them. So, it's possible that, for many Canadian taxpayers who received cryptocurrency by means of airdrops, their receipt of the airdropped tokens was a tax-free windfall.
Canadian taxpayers must ultimately recognize that no single tax-law analysis applies to every situation. The income-tax implications vary based on each taxpayer's unique circumstances. Therefore, to understand their tax obligations, Canadian taxpayers who trade, invest in, or develop cryptocurrency, or who've received cryptocurrency airdrops should seek tax advice from a knowledgeable Canadian crypto-tax lawyer
The T1135-Filing Requirement under Section 233.3 of the Income Tax Act: Is Bitcoin a "Specified Foreign Property"?
Our client's massive Bitcoin holdings also required our Certified Specialist in Taxation Canadian crypto-tax lawyer to determine whether our client had an obligation to file T1135 forms. If so, then our client's VDP application would need to include T1135 forms. Otherwise, our client faced steep penalties if he had failed to file T1135 forms when required to do so. A simple failure to file can result in a penalty of up to $2,500 plus interest. If the failure to file constitutes gross negligence, the maximum penalty can reach $12,000. An additional 5% penalty may apply if your T1135 form is over 24-months late, and if your T1135 form includes a false statement or omits information, the penalty is the greater of $24,000 and 5% of the unreported amount.
A Canadian-resident taxpayer must file a T1135 form for each taxation year in which (1) the taxpayer held "specified foreign property"; and (2) the taxpayer's aggregate tax cost for the "specified foreign property" exceeded $100,000 (in Canadian currency). If these conditions apply, the taxpayer's Canadian income-tax return must include a T1135 form (Foreign Income Verification Statement), and the T1135 form must list all "specified foreign property" that the taxpayer held during that year.
The definition of "specified foreign property" in Canada's Income Tax Act will typically encompass cryptocurrency, non-fungible tokens (NFTs), and other blockchain-based assets. In particular, "specified foreign property" includes (among other things) "funds or intangible property situated, deposited or held outside Canada." Cryptocurrency, NFTs, and other blockchain-based assets are certainly "intangible property." And because they exist on decentralized digital platforms, they're arguably not "situated, deposited, or held" inside any particular country—much less inside Canada. They must therefore be "situated, deposited or held outside Canada." As such, cryptocurrency, NFTs, and other blockchain-based assets will generally require the filing of a T1135 form for each year in which their total tax cost exceeds $100,000.
Yet "specified foreign property" excludes "property that is used or held exclusively in the course of carrying on an active business." For example, a business's offshore inventory will qualify for this business-use exemption. And if the business is a cryptocurrency-trading business, then the same is true for the cryptocurrency serving as the business's inventory.
As a result, the aforementioned capital/income test determined whether our client's Bitcoin was reportable on the T1135 form. If our client's Bitcoin qualified as inventory, the Bitcoin was excluded from the definition of "specified foreign property," and our client didn't need to report them on a T1135 form—even though their tax cost exceeded $100,000. But if our client's Bitcoin was capital property, then our client needed to file client's T1135 forms reporting the Bitcoin holdings, which meant that our client's voluntary-disclosure application needed to include those T1135 forms.
Pro Tax Tips: The CRA's Voluntary Disclosures Program (VDP) & The Importance of Tax-Law Advice on Proper Cryptocurrency Tax Reporting
After analyzing these complicated crypto-tax issues and determining how Canada's tax legislation applied to our client's circumstances, our expert Canadian crypto-tax lawyers prepared a voluntary-disclosure application on our client's behalf and filed it with the CRA's Voluntary Disclosures Program (VDP). In particular, we prepared our client's VDP application so that it not only increased the odds that the Canada Revenue Agency would grant tax amnesty but laid the groundwork for a judicial-review application to the Federal Court if the CRA were to unfairly deny our client's VDP application.
Under the Canada Revenue Agency's Voluntary Disclosures Program, qualifying taxpayers can avoid criminal charges for tax evasion and sidestep civil tax liability in the form of gross-negligence penalties. But the CRA will grant this relief only if the taxpayer's VDP application is "voluntary," meaning you submitted your application before the Canada Revenue Agency discovered the non-compliance that you sought to disclose.
Ultimately, the Canada Revenue Agency's Voluntary Disclosures Program accepted our client's VDP application under the VDP's General Program, which meant that our client had received the maximum interest-and-penalty relief available under the VDP. Our prudent Canadian crypto-tax lawyers had therefore saved our client millions of dollars in civil gross-negligence penalties and saved our client from criminal tax-evasion charges.
One of the reasons for our client's tax problems was that the CRA had provided very little guidance to the general public about cryptocurrency transactions or their tax implications. Even today, the Canada Revenue Agency's publications on cryptocurrency mining and cryptocurrency transactions fail to notify Canadian taxpayers about the numerous, complicated tax issues that cryptocurrency invokes.
Moreover, Canadian taxpayers must understand that they generally cannot rely on the CRA for advice on reporting their cryptocurrency transactions. The Canada Revenue Agency is an administrative body, and its task is to enforce Canada's crypto tax laws, but it has no jurisdiction to interpret or create the law. (Those jobs belong to the judiciary and the legislature, respectively.) Nor does the CRA have any jurisdiction (or competence) to give a legal opinion to Canadian taxpayers. This is especially true when it comes to the tax implications of emerging cryptocurrency-related technology, like DeFi arrangements and other blockchain-based assets. Furthermore, the Canada Revenue Agency is not in any way bound by its own publications. If the CRA decides to audit your tax return, the tax auditor can ignore the CRA's own previously released guidelines. The doctrine of estoppel does not preclude the CRA from issuing an assessment that is inconsistent with a previously released publication. See: Stickel v MNR, [1973] CTC 202, 73 DTC 5178 (FCA); aff'd. [1974] CTC 416, 74 DTC 6268 (SCC). The interpretation of tax legislation is left to the Tax Court of Canada, the Federal Court of Appeal, and the Supreme Court of Canada.
Therefore, Canadian taxpayers who trade, invest in, mine, or stake cryptocurrency, non-fungible tokens (NFTs), or other DeFi and blockchain-based assets should seek tax-law advice from an expert Canadian crypto-tax lawyer. Because of the distinctive and novel features of various DeFi arrangements and blockchain-based assets, Canadian taxpayers who've entered DeFi arrangements or dealt in blockchain-based assets should instruct their Canadian crypto-tax lawyer to prepare a confidential and privileged tax-law memorandum examining their GST/HST obligations under Canada's Excise Tax Act and their income-tax obligations under Canada's Income Tax Act.
Moreover, solicitor-client privilege precludes the Canada Revenue Agency from learning about the confidential legal advice that you receive from our Canadian crypto-tax lawyers. As a privileged document, the tax-law memorandum will also remain beyond the reach of the Canada Revenue Agency because the CRA cannot compel the production of a document protected by solicitor-client privilege. Yet the existence of the memorandum will prove your diligence and serve to counter the CRA's attempts to justify imposing gross-negligence penalties.
Frequently Asked Questions
I've heard about a tax form called the T1135 Foreign Income Verification Statement. Do I need to report my cryptocurrency on this form?
It depends. A Canadian-resident taxpayer must file a T1135 form for each taxation year in which (1) the taxpayer held "specified foreign property"; and (2) the taxpayer's aggregate tax cost for the "specified foreign property" exceeded $100,000 (in Canadian currency).
The definition of "specified foreign property" in Canada's Income Tax Act will typically include cryptocurrency, but only if the cryptocurrency isn't "property that is used or held exclusively in the course of carrying on an active business." So, if you run a cryptocurrency-trading business, your cryptocurrency qualifies as inventory and is excluded from the definition of "specified foreign property," which means that you don't need to report them on a T1135 form—even if your crypto's tax cost exceeds $100,000. But if your cryptocurrency is capital property, and if your tax cost exceeds $100,000, then you need to file a T1135 form reporting your crypto holdings. The income/capital test calls for a rigorous legal analysis, and in our experience, most Canadians who invest or trade cryptocurrency don't even know that this analysis exists. To ensure that your tax returns are accurate, speak to one of our savvy Canadian crypto-tax lawyers today.
I see that the Canada Revenue Agency released a few publications about cryptocurrency transactions and cryptocurrency mining. Will these publications tell me everything that I need to know about how to report my crypto-mining transactions for Canadian tax purposes? Can I rely on these publications?
No. This CRA publications vastly oversimplify the Canadian income-tax implications of cryptocurrency mining and cryptocurrency transactions. In fact, it is our view that the CRA analysis of the taxation of crypto mining is incorrect. Furthermore, the CRA is not in any way bound by its own publications. If the CRA decides to audit your tax return, the CRA tax auditor can ignore the Canada Revenue Agency's own previously released guidelines. The legal doctrine of estoppel does not preclude the CRA from issuing a tax assessment or tax reassessment that's inconsistent with a previously released cryptocurrency-information publication. For advice about your cryptocurrency-related tax obligations, consult one of our knowledgeable Canadian crypto-tax lawyers today. Moreover, if you've entered any complex DeFi arrangements or dealt in any unique blockchain-based assets, you should consider instructing your Canadian crypto-tax lawyer to prepare a confidential and privileged tax-law memorandum examining your GST/HST obligations under Canada's Excise Tax Act and your income-tax obligations under Canada's Income Tax Act.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.