Introduction — Taxation of Trading Stocks and Cryptocurrency
Taxpayers, particularly those with valuable inventory or capital assets, can be crippled through the actions of opportunistic thieves and fraudsters. As the use of technology continues to proliferate, intangible assets are increasingly also subject to these same risks. Bloomberg recently reported that theft by hackers of cryptocurrencies, such as Bitcoin and Ether, has become an annual USD $200 million business. The tax implications of such an unfortunate occurrence are understandably often an afterthought, however obtaining the best tax result can help lessen the blow. There are no special provisions in the Income Tax Act that deal specifically with losses suffered through theft or fraud. Any available tax deductions are subject to the general principles relating to the taxation of income from business or property and income earned on account of capital. CRA has published policy to explain how these principles apply to losses from theft or fraud. Our Canadian tax lawyers are experts on the Income Tax Act and can help you obtain tax relief if you are the victim of Bitcoin or other theft, fraud or embezzlement.
Loss of Business Inventory or Cash through Theft — CRA Policy and Case Law
Courts have long held that losses suffered as a result of theft, fraud or embezzlement are generally deductible in accordance with the general limitation contained in paragraph 18(1)(a) of the Income Tax Act, namely that deductions are available to the extent they are incurred to earn income from a business. Much of CRA policy and case law concerning this topic focuses on the connection between the theft or embezzlement and the operations of the business. CRA’s Income Tax Folio S3-F9-C1, Lottery Winnings, Miscellaneous Receipts, and Income (and Losses) from Crime, contains CRA’s published position on the tax treatment of losses of trading assets, such as inventory or cash, that occur as a result of theft or embezzlement. Under paragraph 1.33 of S3-F9-C1, CRA writes that losses that arise from theft or embezzlement are generally deductible so long as:
- such losses are an inherent risk of carrying on the business; and
- the loss is reasonably incidental to the normal income-earning activities of the business.
This policy does not allow for a loss of inventory or cash to be deducted twice and it only allows for out-of-pocket losses to be deducted: unrealized profits due to the theft or embezzlement are not deductible. In addition, proceeds from an insurance policy or any amounts otherwise recovered will serve to limit the deduction or result in an income inclusion in the year they are paid or receivable. S3-F9-C1 acknowledges that thefts by strangers or employees are inherent risks of business and that losses occurring as a result thereof are normally deductible. Losses of inventory or capital that occur through the theft or embezzlement of a partner, proprietor or substantial shareholder are generally not deductible and may be characterized as withdrawals of capital or losses sustained outside the normal income-earning activities of a business. However, in Parkland Operations Ltd. v. The Queen ,  1 CTC 23, the Federal Court Trial Division allowed a corporation from which two officers had misappropriated funds totaling $563,396, to deduct the misappropriated funds. Key to the decision of the Court was that the funds had been embezzled from the corporation’s operating funds, which the Court held “indeed constitute a part of the company's normal revenue receiving activities”.
Deductions made necessary due to theft and embezzlement by senior employees is to be determined on a case by case basis and CRA’s position is that losses are less likely to be allowed if a senior employee has significant shareholdings in the business or otherwise exerts a significant amount of control over the business. The case law in this area of the law is heavily fact-driven and whether or not a given instance of theft or fraud can be a deductible expense can turn on the perceived importance of a single factor. In all cases, the innocent taxpayer must make all reasonable efforts to obtain restitution for the stolen or embezzled cash or inventory. If your business has been the victim of theft or embezzlement, speak with our team of Toronto tax lawyers to obtain all tax deductions to which you are entitled.
Expenses paid to fraudsters for the purpose of earning income may also be deductible, although they are subject to both the existence of a business as well as the general rule contained in section 67 of the Tax Act that deductions for expenses incurred will only be allowed to the extent they are reasonable. In Hammill v The Queen, 2004 TCC 595, a taxpayer purchased various gems for the purpose of re-sale at a profit, only to be targeted by fraudsters who conned him out of $1.6 million as well as the gems. In Hammill, the fraudsters held themselves out as experts and brokers in the sale of valuable gems. They fabricated several offers, each of which required the payment of various upfront fees and deposits by the taxpayer, for the purchase of the taxpayer’s gems. All of the “deals” fell through and the fraudsters, despite being arrested by the RCMP, were released on bail and quickly disappeared. The taxpayer claimed a deduction for the lost gems in addition to deductions for the approximately $1.6 million he paid to the fraudsters on account of the fake deals. CRA allowed the deduction for the lost inventory, but issued a tax reassessment to deny amounts paid to the fraudsters as part of the fabricated transactions. While the Tax Court expressed sympathy to the taxpayer, it held that all expenses were not deductible, both because the Court was not convinced that a business existed and in any event because the expenses were unreasonable. Important to the Court’s decision was that the taxpayer took no steps to ascertain the legitimacy of the fraudsters’ operation, which was objectively suspicious and promised absurdly high profits, as well as the fact that there was no business structure to speak of. All agreements were shoddily drafted, even incomprehensible, in the Court’s opinion and in many cases the taxpayer had paid far more than the already ridiculous amounts requested by the fraudsters. The taxpayer in Hammill did not attempt to collect deposits paid as part of the sales that fell apart, nor did he ever question why he, the seller, was required to put down deposits. The Tax Court concluded that the expenses “were not made or incurred by the taxpayer for the purpose of gaining or producing income from a business or property and the Court is satisfied that these expenses were not reasonable under the circumstances”. If the matter had been in issue, the Court implied that it would have also denied the deduction taken for the value of the lost gems. The decision of the Tax Court was affirmed by the Federal Court of Appeal in Hammill v. Canada, 2005 FCA 252, with the Court commenting that the existence of a fraud “from beginning to end... precludes the existence of a business”.
Stolen Capital Assets — Capital Loss Available
If a loss is realized by a taxpayer through the theft or embezzlement of a capital asset, CRA’s position in S3-F9-C1 is that the amount of the loss is calculated according to the general rule contained in section 40 of Income Tax Act, which is that loss is equal to proceeds of disposition realized on the stolen or embezzled capital asset less its adjusted cost base. This general rule is subject to various limitations, exclusion and other property-specific rules. It is important to note that section 54 of the Tax Act defines “proceeds of disposition” to include compensation for capital assets unlawfully taken and proceeds from an insurance policy on the stolen or embezzled capital asset. Where proceeds of disposition are payable on the theft or embezzlement of a capital asset, the date of disposition is to be determined according to the rules contained in subsection 44(2) of the Income Tax Act. Where no proceeds of disposition are payable or recoverable, the date of disposition will be the date on which the loss of the capital asset was discovered. Proper documentation is essential to successfully claiming significant capital losses. Our team of Toronto tax lawyers can advise you on the documentation that is required in order to help you withstand a CRA tax audit.
Theft by Hackers — Bitcoin and Cryptocurrency
Cryptocurrencies such as Bitcoin, Ethereum, Dash and Ripple are digital in nature and heavily dependent on the integrity of their respective block chains. While generally considered extremely secure, cryptocurrencies are subject to risk of theft from hackers and Bloomberg recently reported that in less than a decade, hackers have stolen USD $1.2 billion worth of Bitcoin and Ether, with the fair market value of such thefts likely much higher due to the general increase in cryptocurrency values during 2017.
While the concept of cryptocurrency theft is an unexplored phenomenon in Canadian tax law, the principles concerning losses suffered as a result of theft contained in CRA’s S3-F9-C1appear to be applicable to hacked cryptocurrency. A determination of whether stolen cryptocurrency represents inventory of a trading business or a capital asset requires a complicated analysis that is beyond the scope of this article, however a discussion of this important distinction can be found here. Regardless of whether the stolen cryptocurrency is characterized as inventory of a business or as a capital asset, in the absence of being insured or restitution having been obtained, the available deduction from business income or resulting capital loss will likely be equal to its book value or adjusted cost base. For recent purchasers of crypto-currency, this could mean the availability of a significant deduction or capital loss due to the current high values of cryptocurrency. For taxpayers who have held long-term positions in Bitcoin and accrued substantial gains, only to have it stolen by hacker or fraudster, relief will be limited to the amount originally spent by the taxpayer on the stolen Bitcoin, subject to any insurance proceeds or success in collecting amounts in satisfaction of the theft. This interpretation is dependent on CRA’s current published position regarding the characterization of cryptocurrencies, namely that they are commodities. If CRA changes course and elects to treat cryptocurrencies like any other currency, then a cryptocurrency business likely needs to have been in place in order to obtain tax relief for losses suffered as a result of cryptocurrency theft. Speak with one of our tax lawyers about your cryptocurrency operation to help you determine your reporting obligations under the Income Tax Act.
Conclusion —Deduction or Capital Loss Available on Theft of Assets
All taxpayers face the risk that cash, inventory or capital assets can be stolen at any time by a thief or fraudster. Deductions from income from a business or property are potentially available on the theft of inventory or cash, while a capital loss may be incurred if a capital asset is stolen. If cryptocurrency such as Bitcoin is stolen by hackers, tax relief may also be available. In all cases, organized books and records are a necessity. If you have suffered losses as the result of theft or crime, speak with one of top Toronto tax lawyers to achieve an optimal tax result in order to make the best of a bad situation.