Introduction — Taxation of Trading Stocks and Cryptocurrency
The new year often has taxpayers reflecting on their investment activities of the year past and this January is no different, especially with the recent plunge in prices of cryptocurrencies. In addition to traditional investments like stocks and bonds, cryptocurrencies such as Bitcoin, Dash, Ether, Litecoin, Ethereum and Ripple have become extremely popular investments in recent years due to their overall surge in value. With many holders deciding to sell their cryptocurrency in order to crystallize accrued increases in value, our Toronto tax law firm frequently receives questions with respect to how these gains should be reported for Canadian tax purposes. Because capital gains are only half taxable, it is perhaps not surprising that Bitcoin investors are steadfast in their belief that when they eventually sell, their gains will be taxed on account of capital and not as inventory of a business or an adventure or concern in the nature of trade, which are fully taxable. This article will summarize some of the principals that can be drawn from Canadian tax law jurisprudence concerning the characterization of trading gains and discuss how these principles apply to cryptocurrency. However, there is no magic formula and each situation is dependent on its own facts. If you are unsure about how to report your Bitcoin and cryptocurrency gains, speak with one of our top Toronto tax lawyers to gain clarity on your reporting obligations.
Fully Taxable Income or Capital Gains— Factors Considered by the Courts
The Federal Court of Appeal’s decision in Vancouver Art Metal Works Ltd. v. Canada, 2 FC 179, is heavily cited by the Tax Court of Canada when the distinction between income earned on account of capital and income earned through a business or trade arises. In Metal Works, the Federal Court of Appeal recognized that such a determination is heavily fact-dependent and cited five factors that can helpinform the analysis:
- the frequency of the transactions;
- the duration of the holdings;
- the intention to acquire the securities for resale at a profit;
- the nature and quantity of the securities; and
- the time spent on the activity.
CRA has published materials that mirror many of these factors. Generally speaking, a portfolio that features a significant number of transactions and short holding periods, coupled with fairly active involvement by its owner can be indicative of a trade or business in buying and selling securities. The intention to resell at a profit and the specific securities involved are also extremely relevant, as is knowledge and education related to securities. When a taxpayerbelieves that a given disposition should be on account of capital and not income, the implication is that such a taxpayer is arguing that they disposed of a capital asset. Capital assets are defined by their ability to generate income through their use or simple ownership thereof, not by their ability to be sold at a profit at a later date. Therefore, securities that do not provide passive returns, such as dividend or coupon payments, are generally viewed as being less capital in nature than, for instance, Canadian bank stocks.
Courts have increasingly focused on the subjective intention of the taxpayer in question, whether it be to acquire securities and sell at a profit or to hold as an investment, as the most important of the above noted factors from Metal Works, with the other factors serving as a way to objectively verify the taxpayer’s statedintention. For example, Mittal v The Queen, 2012 TCC 417, is an example of a Tax Court stock trading case in which the taxpayer’s stated intention in trading was verifiable from the objective evidence. The taxpayer’s stated intention in Mittal was to actively trade and earn gains on the sale of shares, with the plan of trading full-time upon retirement. The taxpayer had filed to claim significant business losses from his trading activities, only to have CRA issue him a tax assessment to reassess the losses as on account of capital. The Tax Court found as a fact that the taxpayer, who kept very detailed time logs of his trading activities, spent an average of 25 hours per week on his trading activities, substantially all of which involved short-term periods of ownership. 19 of the 27 stocks traded by the taxpayer during the year in question were non-dividend bearing, which the Court also found relevant. The Tax Court held that the taxpayer in Mittal was clearly “playing the market” and that his actions represented a “classic example of someone engaged in an adventure in the nature of trade”. In Wong v. The Queen, 2013 TCC 130, the taxpayer’s stated intention was to earn capital gains from his securities trading to gain access to available capital losses from an earlier year. However, in applying the Metal Works factors, the Tax Court found that the taxpayer had engaged in over 600 securities transactions over a five-year period, with each security typically held for a brief period of time. The Court had no difficulty in concluding that the taxpayer’s trading operations represented a “classic example of someone engaged in an adventure in the nature of trade”, citing Mittal. It should also be noted that the taxpayer in Wong did not do himself any favours by stating that his principal intention in trading was to earn capital gains from the disposition of shares: such an intention, while shared by anyone who invests in the stock market, is entirely consistent with carrying on business as a trader.
Small Number of Transactions — Adventure or Concern in the Nature of Trade
The fewer transactions in which a taxpayer takes part, the more likely the activity is going to be viewed as on account of capital and not inventory. However, even this factor is not determinative: there are cases where the courts have held that even a single isolated transaction can constitute an adventure or concern in the nature of trade. In MNR v Taylor,  CTC 189, a taxpayer purchased foreign lead with the goal of profiting from the inadequate domestic supply of lead in Canada. The taxpayer realized a substantial gain on the disposition of the lead, approximately $83,000 in 1956, which he claimed as a capital gain, which were tax-free under the old Tax Act. The Exchequer Court of Canada held that the taxpayer, in recognizing the deficiency in the market and purchasing a commodity in order to make a profit therefrom, acted exactly as a professional trader in lead would have in the circumstances and was therefore engaged in an adventure or concern in the nature of trade, regardless of the fact that it was an isolated transaction. Failing to properly report your trading activities can result in significant penalties and interest. Avoid an expensive tax assessment by getting the opinion of one of top Toronto tax lawyers.
Capital Gains Election for Disposition of Canadian Securities
Subsection 39(4) of the Income Tax Act contains an election that allows taxpayers to permanently elect to treat dispositions of “Canadian Securities”, a defined term, as on account of capital. The effect of the election is to deem every Canadian security owned by the taxpayer in the year of election and all subsequent years to be a capital property, with capital gains and losses realizable on their eventual disposition. Once made, the election is effective indefinitely. Although subsection 220(3.1) of the Income Tax Act grants CRA the discretion to allow for certain elections to be revoked, CRA’s position is that an election made under subsection 39(4) cannot be revoked or cancelled because it is not one of the “prescribed elections” listed in Income Tax Regulation 600. Subsection 39(5) of the Tax Act prevents certain taxpayers from making the election, such as traders or dealers in securities, financial institutions, corporations with a principal business of lending money and purchasing debt obligations and non-residents. It is also important to note that the 39(4) election only applies with respect to dispositions of a “Canadian security”, which is defined to include shares of a Canadian resident corporation, units in a mutual fund trust or a bond, debenture, bill, note, hypothecary claim or similar obligation issued by a resident Canadian. Income Tax Regulation 6200 further restricts this definition as it lists a variety of “prescribed securities, shares and debt obligations” that are carved out of the definition of Canadian security for purposes of the 39(4) election.
Bitcoin and Cryptocurrency Taxation – Capital Gains or Business Income?
Although cryptocurrency trading cannot be directly compared to trading in stocks, bonds and other securities, the above discussion of historical Canadian tax law casesoffer some guidance on the factors that are likely to be considered by CRA and the courts in determining whether gains earned from selling BTC, Ethereum, Ripple or Dash are capital gains or income from a trading business or adventure or concern in the nature of trade. Because cryptocurrency does not fall within the definition of Canadian security, dispositions thereof are not eligible for the subsection 39(4) election.
The Courts are clear that this is a fact-driven exercise and that a given case can turn on the perceived significance of even a single factor. For instance, investing cash in a limited number of cryptocurrencies consisting ofa small number of transactions, combined with a lengthy period of ownership, is more suggestive of the gains being characterized as capital gains and not fully taxable income. However, the exact same initial investment combined with a very brief period of ownership, perhaps a purchase of Bitcoin in mid-October of 2017 and a subsequent sale when it reached its current historical high in December, looks more like an adventure or concern in the nature of trade. The Taylor case is clear that even a single isolated transaction can result in fully taxable income. It is also important to point out that most if not all cryptocurrencies do not have the potential to earn passive income, such as dividends or interest payments, like stocks or bonds and prima facie do not resemble typical capital assets. While not determinative on its own, this generally means that the only way to earn income from many cryptocurrencies is to sell it at a profit, which is simply one factor that may favour a taxable income characterization in a given case. Other activities such as cryptocurrency mining or holding Dash Master Nodes to earn a return are also significant factors to be considered.
Tax Tip — Consult a Tax Lawyer: Stock and Cryptocurrency Trading Taxation
Attempting to predict how CRA and the Canadian courts will characterize income earned through the trading of securities and commodities has the potential to be a difficult exercise. The rise of Bitcoin and other cryptocurrencies further complicates the analysis. The characterization of income earned through the disposition of securities is heavily fact-driven and each case requires a comprehensive analysis of the facts. Principles from Canadian tax case law concerning securities tradingappear generally applicable to the buying and selling of cryptocurrency, however caution should be exercised since cryptocurrencies do not resemble typical capital assets. Advance tax planning is key to maximizing your chances of a successful capital gains claim. Our team of experienced Toronto tax lawyers can research your specific circumstances and provide you with tax planning advice or with a reasonable filing position so you can withstand a vigorous CRA tax audit.