January 13, 2018
By Dale Barrett
Managing Partner Barrett Tax Law
1-866-278-8424 416-907-8429
So, after investing in Bitcoin and Ethereum, the North Koreans hacked one of your cryptocurrency exchanges and you lost a Bitcoin after it had hit $20,000 USD (and you bought the Bitcoin for $1.00). Now what? Nobody can help you get it back, and now it's time to deal with the Canada Revenue Agency (the “CRA”)!
Taxation of Cryptocurrency Profits
Cryptocurrency is not really a currency, as far as the CRA is concerned. According to the CRA Views 2013-0514701I7 document, cryptocurrency is characterized as a commodity.
“Virtual currencies, such as Bitcoins, are not considered to be a currency issued by a government of a country, such as American dollars. As such, they are generally treated as a commodity for purposes of the Income Tax Act. Therefore, using Bitcoins to purchase goods or services would be treated as a form of barter transaction.”(i)
Interestingly enough, the Income Tax Act (the “Act”) defines foreign currency as "currency of a country other than Canada"(ii) which would seem to exclude Bitcoin. However, the CRA expressed the opinion that for purposes of the T1135 form, digital currency such as Bitcoin and interest in a foreign partnership that holds such currency may both be “specified foreign property” if situated, deposited and held outside Canada.(iii)
This means that gains derived from the purchase and sale of cryptocurrency are currently taxed like gains from the sale of any other commodity, and trades are taxed like other barter transactions.(iv) That is to say, that these gains may be subject to either capital gains treatment, or in the case of more active or professional traders (or a more aggressive CRA auditor) they may be subject to regular income tax. Which tax applies is dependent upon the facts, although; the CRA is likely to aggressively attempt to tax these gains as income transactions rather than capital gains, resulting in twice the amount of tax payable compared to a Capital Gain, and putting the onus on the taxpayer to disprove the CRA’s position.
"Where a person trades or sells Bitcoins like a commodity (i.e., speculating on the changes in the value of Bitcoins), the resulting gain or loss may be on account of income or capital. Determining whether such a transaction is on account of income or capital can only be made following an assessment of all the facts relating to the particular taxpayer’s circumstances.” Paragraphs 9 to 32 of Interpretation Bulletin IT-479R, “Transactions in securities”, provides general comments for purposes of determining whether transactions are income or capital in nature.
“The determination of the income tax consequences relating to the treatment of gains and losses arising from the purchase and sale of Bitcoins would be generally the same as for transactions involving other types of commodities.”(v)
In order to determine if one’s cryptocurrency transactions will be taxed as income or capital transactions, Courts have, in the case of other commodities, applied the "course of conduct" and "intention” tests.(vi)
Course of Conduct Test
If the “whole course of conduct” in respect of one’s cryptocurrency transactions indicate that:
a) the taxpayer’s transactions are performed in a way capable of producing gains and with the object of producing gains, and b) the taxpayer is performing the transactions in the same way as a trader or securities dealer would be performing the transactions,
the resulting gains would likely be taxed as business income.
This is akin to the aggressive way in which the CRA often approaches serial sales of a real estate property (even principal residences) by real estate professionals: If a regular person buys and sells their principal residence, regardless of how much they earn from the sale of their residence, the resulting capital gain is shielded from taxation by the “principal residence exemption”. However, when a realtor repeatedly buys and sells their residence, due to the fact that the realtor is a professional in the area and performs the transactions in their professional capacity and with specialized knowledge, there is an assumption by the CRA that the whole course of conduct indicates that the gains are business income and that the transactions were intended to produce such gains. I regularly see the CRA attempt to tax such transactions as business income.
“The presumption that gains from security transactions are on income account will also be taken by the Department in any situation where it is apparent that the taxpayer has used special information not available to the public to realize a quick profit.”(vii)
Similarly, while a recreational gambler does not have to pay taxes in Canada on their winnings, as lottery winnings are generally non-taxable, a professional (or very regular) gambler’s winnings may be taxed if the CRA determines that they are in the “business” of gambling.
So professional cryptocurrency traders can expect that their profits will be taxed as business income. But for the rest of us, the courts and the CRA will examine a variety of factors in making this determination. Such factors include the frequency of the transactions, period of ownership, knowledge of the cryptocurrency market, the amount of time spent on performing the transactions, and others.
The more frequently the trades are made, the less time the cryptocurrencies are held, the higher percentage of one’s time that is dedicated to making the trades, and the greater the taxpayer’s expertise and knowledge in the cryptocurrency world, the more likely it is that the CRA will find that the gains are on account of income rather than capital.(viii)
If it walks like a professional trader, and quacks like a professional trader, the more likely it is that the CRA will characterize one as a professional trader and thus apply business income tax.
What is also troubling is that section 248(1) of the Act (ix) indicates that “an adventure or concern in the nature of trade” is also a “business”, and that income derived from such adventure or concern in the nature of trade can be taxed as business income. So even though, one may not be a professional trader or have tremendous cryptocurrency expertise, and even though one may have held their Bitcoin for many years and does not trade frequently, if the “course of conduct” or the “intention” of the taxpayer suggest that the transaction is “an adventure or concern in the nature of trade”, an isolated transaction may be subject to full taxation as business income rather than capital gains.
The Intention Test
Except for those most sentimental items like a wedding band or family heirloom, anybody, even the extremely wealthy, may be inclined to sell something under attractive circumstances – even if they never intended to sell. So, if one bought a painting for $100 because it perfectly matched one’s décor, and not because it was thought to be a good investment, it is foreseeable that if a buyer offered $10,000 for the painting, the owner would sell. And if one’s crappy old car became valuable because Britney Spears autographed it, even a billionaire (except a Britney collector) would likely sell. This type of sale would likely not be characterized as an “adventure or concern in the nature of trade” – even though unknown to the taxpayer at the time of purchase, the latent intention to sell existed.
But if the CRA can establish or infer (they don’t have to prove anything… the taxpayer has the burden of disproving the CRA’s inference and any resulting tax assessment), that the taxpayer's intention [with respect to the property] was to sell the property at the first suitable opportunity , it can lead to a tax assessment in respect of “an adventure or concern in the nature of trade” and thus twice the tax would be payable vs. that which would apply to a capital gain. And conversely (since the government wrote the Income Tax Act a great deal is in their favour), the failure of the CRA to demonstrate this intention to sell doesn’t necessarily preclude taxation of the gains as business income if the “course of conduct” test indicates business income.
Cryptocurrency Theft
Cryptocurrency security is a major issue -- there are computer viruses and other kinds of hacker attacks that are constantly scanning computers connected to the Internet, many with the intent of draining a bitcoin wallet. Some viruses even attack Android phones in order to drain Vitcoin wallets.
According to many leading experts in South Korea and around the world, North Korea has been regularly linked to theft of cryptocurrency. As the various sanctions in place against North Korea are increasingly suffocating the nation, their funding has become sparse. Seoul believes that the North Korean establishment has been hacking croptocurrency exchanges, primarily in South Korea, for the purpose of providing alternate sources of funding for their faltering economy.(x) The US government has echoed this sentiment, accusing North Korea of perpetrating the WannaCry ransomwhare cyberattack in order to compensate for the devastating effects resulting from the increased sanctions.(xi)
On December 7, 2017, it was reported that hackers stole $75 million (4,700 coins) of Bitcoin by exploiting a compromised company computer at NiceHash, described as the largest marketplace for mining digital currencies.(xii)
But what happens when your cryptocurrency is stolen in the course of one of these hacks? Crypto exchanges and wallets are not covered by the types of CDIC insurance which would protect one’s assets in a Canadian bank. In the course of a bank failure in Canada, one’s deposits are insured by the CDIC for up to $100,000. But in the course of the failure of a crypto exchange such as the South Korean Yapian Youbit cryptocurrency exchange which lost 17% of its assets in the course of a hack by North Korean cyberspies, investors were left in the cold. As the exchange filed for bankruptcy, its customers were supposed to receive 75% of their assets.(xiii) And in 2014 when the Mt. Gox Bitcoin exchange (the largest exchange at that point) was subject to a “$460 Million Disaster” (xiv), investors were left in the cold. This is the most famous example of an exchange hack, and the founders of that exchange have also been accused of wrongdoing, and the matter is now before Japanese courts.
Most recently, an exchange called NiceHash was hacked and lost 65 million dollars of depositors' bitcoins. The exchange is liquidating and the losses will be "mutualized," which is a euphemism for depositors losing the majority of their cash and getting a fraction of their balance back.
Cryptocurrency Loss
Bitcoin itself is anonymous to an extent -- however unless you are sophisticated at moving money between different wallets and even different cryptocurrencies, it is likely that a sophisticated entity like the CRA and IRS could trace your bitcoin transactions on the blockchain if they were sufficiently motivated.
And due to the decentralized nature of cryptocurrency, investors are required to keep their own records and remember the passwords to their “wallets”, which can reside online, on PCs, or on a dedicated hardware device. The downside is that if one loses their PIN or password or if they send cryptocurency to an incorrect “address”, due to the fact that there is no central bank or authority behind the currency, one can actually “lose” their cryptocurrency forever without the ability to get it back. It just disappears into the ether. It’s not like losing your PIN to your bank card. There is nobody to help get your wallet password back.
This is because the Bitcoin transaction network is not owned by any one party. Rather it lives on a decentralized network of computers owned by private companies and individuals located around the world act to verify Bitcoin transactions. And with many of the security measures in place to safeguard cryptocurrency, the more times one attempts to guess their lost password, the more difficult it becomes to actually succeed. When a password goes missing, people are forced to try to “steal” their own Bitcoin back by trying to “hack” their own wallet.
As one individual who lost $30,000 of Bitcoin noted, “This decentralized nature of the bitcoin network is not without consequences—the main one being that if you screw up, it’s your own damn problem.”(xv)
An alternative to bitcoin wallets is bitcoin exchanges -- the best known of these is a company called Coinbase. None of the exchanges have robust oversight or regulation, their actual capital positions are opaque, and a series of hacker break-ins have made off with hundreds of millions of dollars worth of Bitcoin. Interestingly enough, the IRS has been particularly interested in Coinbase and has petitioned it before the US District Court for the Northern District of California a special type of summons which would force Coinbase to disclose information regarding all US persons that conducted virtual currency exchanges using Bitcoin.(xvi)
Tax Treatment of Disposing Cryptocurrency (to a Thief or because of Taxpayer Error)
When one disposes of their cryptocurrency for cash, the value of which exceeds the amount paid by the taxpayer for the cryptocurrency (their Adjusted Cost Base or “ACB”), a gain results. As discussed earlier, this gain can be on account of income or capital, and the taxpayer must report the gain and is taxed according to its characterization.
If a taxpayer unrelated to me disposes of their cryptocurrency to me as a gift (I accept these types of gifts gladly!), there is no tax implication to me or to the generous taxpayer. These gifts are tax-free. (Please send your extra BTC to me at 1DyafFKuEwMZgGgnuTSRgn7kJBre6q99i6). If the taxpayer disposes of their cryptocurrency as a gift to a family member however, they are deemed to be transacting at fair market value. And whether or not the donor receives any compensation from their family member, they are deemed to have received cash equal to the value of the cryptocurrency at the date of the gift, and will be taxed on any resulting gain (either capital gains or business income tax as the circumstances will dictate).
And, if the taxpayer disposes of their cryptocurrency to a charity, they may receive from the charity a tax receipt, the value of which is equal to the value of the cryptocurrency at the date of donation.
But, the question of the day is how the CRA will treat the (involuntary) disposition of cryptocurrency to a thief (ie. in the course of a hack on a cryptocurrency exchange). What kind of a loss can the taxpayer claim? Will it be a capital loss or a business loss? And what is the value of the loss? Is it the ACB of the commodity or will it be the fair market value at the time of loss (ie. when you involuntary dispose of a Bitcoin valued at $20,000 which cost $1.00 to acquire with zero proceeds of disposition, is the loss $19,999.00 (ie the value on the day of loss less the ACB) Or is the loss $1.00?)
Under the Act, the theft (or loss because of taxpayer loss of their PIN / digital wallet password) of property constitutes an involuntary “disposition” of said property. It may be treated like expropriation (also an involuntary disposition) but without consideration, if that is the case.
Whether the loss occurs through self-inflicted error or through the actions of a hacker, two factors will be determinative of the tax treatment: firstly, whether the cryptocurrency is a foreign currency or a commodity, and secondly, whether the losses have the character of a business loss or a capital loss. And if it is a capital loss, it must be determined if the loss is a business investment loss (See Income Tax Folio S4-F8-C1, Business Investment Losses).
Cryptocurrency (Commodity) Loss as a Business Loss
According to Income Tax Folio S3-F9-C1, Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime, a loss of “trading assets” is deductible in computing income from a business provided that:
a) such losses are an inherent risk of carrying on the business; and b) the loss is reasonably incidental to the normal income-earning activities of the business.
So, if the characterization of one’s trading of cryptocurrency is on account of business activity rather than an investment (capital), then it could be argued that the loss of currency through theft / hacking is an inherent risk of carrying on the business, and it may be possible to deduct the losses when computing business income. Then the question becomes, what value may be deducted? Would it be the FMV at the time of theft or the cost to the taxpayer?
Section 1.33 of Tax Folio S3-F9-C1 provides some guidance:
“In all cases, if the cost of an asset or property is expensed on some other basis, that amount may not be deducted a second time if the asset or property is stolen. Only out-of-pocket losses are eligible for deduction; profits lost or foregone as a result of theft or embezzlement are not deductible.”(xvii)
So, given that the difference between the FMV and the ACB of the commodity at the time of theft equates to the profit that would have been achieved if the cryptocurrency was actually sold at the same point in time at FMV, this lost profit would not be deductible, and as long as the ACB was not already deducted, the deduction should be limited to the ACB.
And, in the case of the stolen Bitcoin, when 1 Bitcoin with current value of $20,000 is stolen, the deduction is limited to $1.00 (the purchase price).
But if the characterization of one’s trading of cryptocurrency is on account of capital, rather than business income, the rules are different.
Cryptocurrency (Commodity) Loss as a Capital Loss
In general, a taxpayer can deduct their loss plus costs to discharge a third party liability caused by the theft, less any insurance or restitution received.(xviii) And when a taxpayer suffers the loss of a capital asset as a result of a theft, the “proceeds of disposition” are determined by referencing section 54 ITA which tells us that in the case of a theft, the “proceeds of disposition” would equal the “compensation for property unlawfully taken”.
Therefore, if no insurance or restitution is received, the proceeds of disposition are zero, which is usually the case, unless there is some sort of compensation from the cryptoexchange,as occurred in the bankruptcy of South Korean Yapian Youbit cryptocurrency exchange.
So in the case that one’s Bitcoin loss can be considered to be of a capital nature, the quantum of the capital loss becomes:
Loss = (0 + compensation received) – (ACB + (costs to discharge a 3rd party liability resulting from the theft)).
So in the case of no compensation and no costs to discharge a 3rd party liability, the capital loss to be claimed in respect of the stolen Bitcoin is $1.00.
Cryptocurrency: Commodity vs. Currency
The principles governing taxation of commodity trading rather than forex trading currently seem to apply to cryptocurrency trading.
While the CRA has only issued some very basic commentary and guidance about Bitcoin and cryptocurrency, and while it appears that in Canada, transactions involving cryptocurrency are currently treated as commodity trading or barter, it is not 100% certain at this point whether the treatment of cryptocurrency as a commodity will continue into the future.
The Income Tax Act specifically defines foreign currency as “currency of a country other than Canada” (xix). However, in the event that a foreign country or nation were to adopt Bitcoin as its official currency, it is forseeable that the CRA would apply the provisions currently in place for gains/losses on foreign currency. To date, however, no country has adopted Bitcoin or any other cryptocurrency as their official currency.
At the moment, it is the CRAs policy that “Where it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of goods abroad, or the rendering of services abroad, and such goods or services are used in the business operations of the taxpayer, such gain or loss is brought into income account. If, on the other hand, it can be determined that a gain or loss on foreign exchange arose as a direct consequence of the purchase or sale of capital assets, this gain or loss is either a capital gain or capital loss, as the case may be.” (xx)
So, if cryptcurrency transactions were to ever be taxed under the forex provisions, the gains would be treated as business income unless, for example, during a transaction for the sale a particular cryptocurrency for Canadian dollars, one could demonstrate that there were intermediary transactions which were merely a consequence of the sale of capital assets, and which in turn caused a gain or a loss. And with a forex loss, subsection 39(2) of the ITA provides that, for individuals, only the amount in excess of $200 is treated as a capital gain or loss.
While taxpayers currently have some guidance with respect to cryptocurrency transactions, the guidance is very basic and the CRA has been vague. They have indicated that cryptocurrency is “generally [emphasis added] treated as a commodity for purposes of the Income Tax Act.” The key word being “generally”, which opens to door for exceptions – both now and in the future.
So until Parliament decides that cryptocurrency is actually a (foreign) “currency” or that cruptocurrency transactions equate to forex transactions, it appears as though the involuntary disposition through theft or loss must be treated akin to the involuntary disposition of any other commodity and taxed similarly. So if you are hacked and you don’t have insurance, you are out of luck.
Dale Barrett is the bestselling tax author of Tax Survival for Canadians and the managing partner of Barrett Tax Law. He is also the General Editor of the Income Tax and Family Law Handbook published by LexisNexis.
Dale provides a broad range of tax advice to individuals and businesses, including many involved in the trading, mining, and investing in Bitcoin and other cryptocurrency.
For more information on Dale Barrett and Barrett Tax Law, please visit www.barretttaxlaw.com, email us at clientcare@barretttaxlaw.com or call 1-866-278-8424 in North America or 416-907-8429 elsewhere. You may qualify for a free consultation.
Footnotes
i) CRA Views 2013-0514701I7 “Bitcoins” – December 23, 2013 ii) Income Tax Act at subsection 248(1) iii) CRA document no. 2014-0561061E5, April 16, 2015. iv) IT-490 “Barter Transactions” v) CRA Views 2013-0514701I7 “Bitcoins” – December 23, 2013 vi) IT-479R “Transactions in Securities” vii) Ibid, Section 17 viii) Ibid ix) Income Tax Act at subsection 248(1) x) https://www.cnet.com/news/north-korean-hackers-breaching-servers-to-steal-cryptocurrencies/ xi) https://www.cnet.com/news/us-accuses-north-korea-of-carrying-out-wannacry-cyberattack/ xii) http://money.cnn.com/2017/12/07/technology/nicehash-bitcoin-theft-hacking/index.html?iid=EL xiii) https://www.cnbc.com/2017/12/19/yapian-youbit-exchange-files-bankruptcy.html xiv) https://www.wired.com/2014/03/bitcoin-exchange/ xv) https://www.wired.com/story/i-forgot-my-pin-an-epic-tale-of-losing-dollar30000-in-bitcoin/ xvi) https://www.natlawreview.com/article/court-enforces-partially-irs-john-doe-summons-served-virtual-currency-exchanger xvii) Income Tax Folio S3-F9-C1, Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime xviii) Income Tax Folio S3-F9-C1, Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime ss1.38-1.41 xix) Income Tax Act at subsection 248(1) xx) Archived IT-95R – Foreign Exchange gains and losses, published December 16, 1980 xxi) CRA Views 2013-0514701I7 “Bitcoins” – December 23, 2013