Introduction: Cryptocurrency-Trading Businesses in Canada
Canadian cryptocurrency-trading businesses face unique
challenges. The mostly unregulated market brings higher risk of
fraud and cyber-crime. The volatile markets may bleed profits. And
some cryptocurrency traders don’t even realize that they’re
carrying on a business, misreporting their profits as capital
gains.
This article aims to educate cryptocurrency traders on a
fundamental income-tax issue: calculating the costs of their
cryptocurrency inventory for tax purposes. This article first
discusses how Canada’s tax system distinguishes a
cryptocurrency-trading business, for which cryptocurrency is
inventory, from a cryptocurrency investor, for whom cryptocurrency
is a capital property. It then analyzes how a
cryptocurrency-trading business should compute and claim its
inventory costs for income-tax purposes. It concludes by offering
pro tax tips for Canadian cryptocurrency-trading businesses.
Is Your Cryptocurrency Inventory? Trading vs. Investing
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, one
starts by determining the nature of the income and then
characterizes the property, not the other way around. Hence, your
profits from a cryptocurrency transaction 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. The full amount of business or property income is
taxable, while only one-half of a capital gain is taxable. On the
flip side, while only one-half of capital losses are deductible,
one may fully deduct losses and expenses associated with business
or investment activity.
Some cryptocurrency transactions straddle the line between
income and capital. Canadian courts have indeed churned out a large
body of case law wrestling with the ambiguity between investing,
which produces a capital gain or loss, and trading, which results
in business income or expenses. Courts assess a wide range of
factors when deciding whether to characterize a transaction’s
gains or losses as on an account of capital or income. 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.
Ultimately, 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. In other
words, courts will determine a taxpayer’s intent by evaluating
the factors listed above.
Computing & Claiming Costs of Cryptocurrency Inventory for
Income-Tax Purposes
Subsection 9(1) of Canada’s Income Tax Act codifies
the deductibility of inventory costs by defining a taxpayer’s
business income as the taxpayer’s “profit from that
business.” When evaluating how a taxpayer went about computing
profit, a court may ask whether a particular deduction agrees with
generally accepted accounting principles (GAAP). But for income-tax
purposes, the determination of a taxpayer’s profit is
ultimately a legal question. In other words, while accounting
principles and commercial practices may influence a court’s
determination of whether a deduction was proper, those norms
don’t comprise the operative legal criteria. In many cases, the
Income Tax Act expressly ousts the use of otherwise
acceptable accounting practices. So too have the courts.
That said, on the issue of computing inventory costs,
Canada’s income-tax law mainly defers to commercial practice
and generally accepted accounting principles (GAAP). For instance,
commercial practice stipulates the use of accrual accounting for
most businesses-especially those with high inventory turnover. As
such, cryptocurrency-trading business will recognize inventory
costs on an accrual basis, which means that the business
doesn’t deduct the cost of cryptocurrency as an expense for the
fiscal period in which the cryptocurrency was purchased. Instead,
the business recognizes the inventory cost as an expense for the
fiscal period in which the cryptocurrency was sold (i.e., cost of
goods sold). For any cryptocurrency remaining on hand at the end of
the fiscal period, the inventory at cost is recorded as an asset on
the balance sheet for that period.
Cryptocurrency-trading businesses typically feature substantial
inventory turnover. Thus, it’s neither possible nor desirable
to keep a running tally of the cost of goods sold on a daily basis.
So, the only feasible way of determining the cost of goods sold is
to (i) determine the sum of the value of inventory on hand at the
beginning of the tax year and the cost of the inventory purchased
during the year and then (ii) subtract the value of the inventory
on hand at the end of the year.
This accounting exercise gives us the following formula:
Cost of Goods Sold = Opening Inventory + Acquisitions – Closing
Inventory
If inventory costs remain stable, the formula presents little
trouble. If prices fluctuate, problems arise. For example: At the
beginning of the year, a cryptocurrency-trading business has on
hand 10,000 units of a particular coin with a current price of
$1.00 per coin. At the end of the year, the business has on hand
10,000 units of the same coin with a current price of $4.00 per
coin. During the year, the business traded 100,000 cryptocurrency
units in the same coin, the price of which steadily increased as
the business bought and sold cryptocurrency units each month.
It’s impossible to say whether the 10,000 units in closing
inventory are the same units as those in the opening inventory, or
whether some or none from the opening inventory remain.
Hence, the computation of cost of goods sold involves two steps:
The first is valuation, the second tracing.
Inventory Valuation
Valuation refers to the method by which you assign an overall
cost (or value) to the opening inventory and the closing inventory.
Canada’s Income Tax Act permits two general methods of
valuing inventory:
- valuation at the lower of cost and fair market value for each
item of inventory; or - valuation of the entire inventory at fair market value.
A taxpayer may choose between these two methods and must use it
consistently thereafter. (If the taxpayer wishes to switch, the
Canada Revenue Agency must first give its permission.) Moreover,
the Income Tax Act requires that the value of a
business’s opening inventory equal the value of the
business’s closing inventory from the immediately preceding
year. So, the value of a taxpayer’s closing inventory
determines the value of the taxpayer’s opening inventory for
the following year.
Inventory Tracing
Tracing refers to the method by which you determine which goods
comprise the closing inventory and how much those goods cost.
Canada’s income-tax law permits two methods of tracing: (1)
averaging and (2) first in, first out (FIFO).
Averaging assumes that the cost of each unit in closing inventory
and of goods sold during the year equals the average cost of all
units in opening inventory and of all units purchased during the
year. FIFO allocates the most recent costs to closing inventory and
the oldest costs to goods sold during the year. The assumption is
that the goods sold were those first purchased-hence, first in,
first out.
A third tracing GAAP method-last in, first out
(LIFO)-also exists. LIFO makes the opposite assumption as that made
by FIFO, and it thus allocates the oldest costs to closing
inventory and the most recent costs to goods sold during the year.
Canadian courts have rejected its legitimacy, however. Thus,
Canadian cryptocurrency-trading businesses cannot use LIFO for
income-tax purposes. This is an example of Canada’s income-tax
law expressly ousting the use of otherwise acceptable accounting
practices.
Pro Tax Tips: Record-Keeping, Cryptocurrency Tax Audits,
Voluntary Disclosures Program & Solicitor-Client Privilege
A cryptocurrency-trading business that lacks proper records will
fare poorly during a CRA cryptocurrency tax audit. If selected for
a cryptocurrency tax audit by the Canada Revenue Agency, a
Canadian cryptocurrency trader will typically receive a 13-page
cryptocurrency-audit questionnaire, which includes over 50
questions on a range of topics, such as:
- The timeline of owing or using cryptocurrency;
- The source of the cryptocurrencies purchased;
- The use of third-party exchange wallets;
- The source of funds used to purchase cryptocurrency;
- Transaction record-keeping practices of the taxpayer;
- Participation in initial coin offerings (ICOs);
- Whether any cryptocurrency holdings generate passive income for
the taxpayer (e.g., Node, Masternodes, Supernodes, etc.); - Participation in cryptocurrency mining (including questions
about the sort of mining hardware used and energy expenses related
to mining); - Acceptance of cryptocurrency as payment for goods or
services; - The frequency of cryptocurrency transactions; and
- The time spent studying cryptocurrency markets.
The taxpayer must also turn over bank-account statements and any
other records allowing the Canada Revenue Agency’s tax auditor
to verify the taxpayer’s answers.
Cryptocurrency traders must therefore keep records of their
cryptocurrency transactions. If you use a cryptocurrency exchange,
you should periodically export your transaction information to
avoid losing it. (Many cryptocurrency traders found themselves
suddenly without any records when the Canadian cryptocurrency
exchange QuadrigaCX imploded.) You should also maintain the
following records about your cryptocurrency transactions:
- The date of each transaction;
- Any receipts for purchasing or transferring
cryptocurrency; - The value of the cryptocurrency in Canadian dollars at the time
of the transaction; - The digital-wallet records and cryptocurrency addresses;
- A description of the transaction and of the other party (e.g.,
the other party’s cryptocurrency address); - The exchange records;
- Records relating to any accounting and legal costs; and
- Records relating to any software costs for managing your tax
affairs.
If you mine cryptocurrency, you should keep the following
records in addition to your cryptocurrency-transaction records:
- Receipts for purchasing cryptocurrency-mining hardware;
- Receipts for expenses associated with your
cryptocurrency-mining operation (e.g., power costs, mining-pool
fees, maintenance costs); - Records about your cryptocurrency-mining operation (e.g.,
hardware specifications, hardware operation time); and - The mining pool details and records.
Our Certified Specialist Canadian tax lawyer can provide advice
about record-keeping and proper reporting of your cryptocurrency
profits to ensure that CRA doesn’t fault you for
misrepresenting the information in your tax returns. You may, for
example, benefit from a tax memorandum examining whether your
cryptocurrency profits should be reported as capital gains or as
business income or as a blend of both. It is also important to
remember that an intermediate transaction-e.g., purchasing Bitcoin for the sole purpose of acquiring a
trading pair-may itself give rise to a taxable transaction.
Since forming an international coalition aimed at cryptocurrency
transactions, the Canada Revenue Agency, the Internal Revenue
Service, and other tax administrators have fine-tuned the
strategies allowing them to identify cryptocurrency users for tax
audit or prosecute them for tax evasion. The advances and
cooperative efforts of tax authorities signal the end of the
anonymity that cryptocurrency users thought they once enjoyed. This
should definitely concern Canadian taxpayers with unreported
profits from cryptocurrency transactions. If you filed tax returns
that omitted or underreported your cryptocurrency profits, you risk
facing not only civil monetary penalties, such as gross-negligence
penalties, but also criminal liability for tax evasion.
You may qualify for relief under the CRA’s Voluntary Disclosures Program (VDP). If your
VDP application qualifies, the CRA will renounce criminal
prosecution and waive gross-negligence penalties (and may reduce
interest). A voluntary-disclosure application is time-sensitive,
however. The CRA’s Voluntary Disclosures Program will reject an
application-and thus deny any relief-unless the application is
“voluntary.” This essentially means that the VDP must
receive your voluntary-disclosure application before the CRA
contacts you about the non-compliance you sought to disclose. Our
experienced Canadian tax lawyers have dealt with many Canadian
taxpayers involved with cryptocurrency and can carefully plan and
promptly prepare your voluntary-disclosure application. A properly
prepared disclosure application not only increases the odds that
the CRA will accept your disclosure but also lays the groundwork
for a judicial-review application to the Federal Court should the
CRA unfairly deny your disclosure.
To determine whether you qualify for the Voluntary Disclosures
Program, schedule a confidential and privileged consultation with
one of our expert Canadian tax lawyers. The Canada Revenue Agency
cannot compel the production of information protected by
solicitor-client privilege. In other words, solicitor-client
privilege prevents the CRA from learning about the legal advice
that you received from your tax lawyer. Your communications with an
accountant, however, remain unprotected unless the accountant has
been retained on your behalf by a Canadian tax lawyer. So, if you
seek tax advice but want to keep that information away from the
CRA, you should approach a Canadian tax lawyer first. If an
accountant is needed, your Canadian tax lawyer will retain the
accountant on your behalf and extend the privilege.
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.