Introduction: Massive Crypto Crashes Have Impacted Investors Worldwide
The cryptocurrency derivatives exchange FTX Trading Ltd., a company once valued at over USD $32 billion, announced on Friday November 11, 2022, that it had filed for Chapter 11 bankruptcy protection in the United States. This marked the collapse of FTX.
FTX's collapse followed only a week after Binance, FTX's largest competitor in the cryptocurrency exchange field and an investor in FTX itself, announced that it would be liquidating a substantial portion of its holdings in FTX native cryptocurrency tokens, FTT, triggering widespread investor concern and speculation over the financial stability of FTX.
The collapse of FTX, also now known as the FTX crash, was combined with a leaked balance sheet showing that a majority of FTT in circulation was owned by Alameda Research, a quantitative cryptocurrency trading firm related to FTX and its CEO, Samuel Bankman-Fried, triggering concerns over FTX's true solvency. After a failed bailout by Binance, one of cryptocurrency's most recognizable public forces has completely collapsed, to the surprise of cryptocurrency investors worldwide.
With the collapse of FTX, many cryptocurrency traders with holdings on FTX have lost access to their assets. The FTX collapse has chipped away at investor confidence throughout the cryptocurrency market, resulting in a substantial downturn in value across nearly all cryptocurrency assets. And because of the FTX crash, many Canadian cryptocurrency investors have seen a substantial loss in the value of their portfolios. For those Canadian taxpayers invested in cryptocurrency who intend to continue their trading or investing activities, caution is required when disposing of any assets.
A savvy Canadian cryptocurrency trader should now learn from the FTX collapse to turn his or her mind to realizing the losses now in an effort to maximize their potential future tax savings on a true disposition of their investment. The "stop-loss" rules of the Canadian Income Tax Act exist to stop exactly such a benefit for Canadian taxpayers, and in particular the "superficial loss" rules for individual taxpayers.
Understanding these rules is crucial to avoiding losing your tax savings on losses from your cryptocurrency investments, as well as identifying how you may still benefit from market fluctuations such as that which has followed the collapse of FTX. If you are a Canadian cryptocurrency investor looking to learn from the FTX crash and evaluate how best to maximize your tax savings and to plan for the future, speak to one of our expert cryptocurrency tax lawyers in Canada to better understand your filing position and opportunities.
Accrued Losses and Triggering "Superficial Loss" Rules Under the Canadian Income Tax Act
The Canadian Income Tax Act includes several provisions to prevent Canadian taxpayers from realizing "superficial losses" on property. The purpose of these provisions is to prevent a Canadian taxpayer from artificially realizing an accrued capital loss by disposing of a property and immediately after re-acquiring the property to crystallize the taxpayer's loss. Section 54 of the Canadian Income Tax Act defines a "superficial loss" as a loss from disposition of a particular capital property, where:
- During the period beginning 30 days before, and 30 days after, the disposition, the taxpayer, or an "affiliated" person (which includes among other relationships spouses and common-law partners, and controlled corporations, but not parents and children) acquires a substituted property that is the same property or "identical" to the previously owned property; and
- At the end of that 61-day period, the taxpayer or affiliated person owns or had a right to acquire the substituted property.
Under subparagraph 40(2)(g)(i) of the Canadian Income Tax Act, a taxpayer's loss from the disposition of a property to the extent that it is a superficial loss, is deemed to be nil. Thus, a taxpayer is prevented from deducting that loss until that taxpayer has disposed of that property with a final intent. Further, where a taxpayer acquires an "identical" substituted property, the rules apply all the same. The CRA has taken the position that an "identical" property for purposes of section 54 of the Canadian Income Tax Act defining a superficial loss includes "properties which are the same in all material respects, so that a prospective buyer would not prefer one as opposed to another." Determining a Canadian taxpayer's preference is a fact-driven analysis, that will depend on many details concerning the taxpayer's intentions.
Subsection 18(14) provides a similar superficial loss rule in the context of certain businesses. Specifically, where a Canadian taxpayer disposes of a property in an inventory of a business that is "an adventure or concern in the nature of trade". Similarly, to section 54, subsection 18(14) applies where during the period beginning 30 days before, and 30 days after, the disposition, the taxpayer or an affiliated person acquires the same or an identical property and at the end of that 61-day period the taxpayer or affiliated person owns or has right to the substituted property. And just as with subparagraph 40(2)(g)(i), subsection 18(15) deems the loss on disposition, to the extent the loss was a superficial loss, to be nil.
Subsection 248(1) of the Canadian Income Tax Act defines a "business" to include "an adventure or concern in the nature of trade". Thus, every adventure or concern in trade is necessarily a business, but the inverse is not always true. A business will generally exist where a Canadian taxpayer carries out a trade or profession consistently, for the purpose of earning a profit. An "adventure or concern in the nature of trade" tends to involve an isolated transaction or transactions, where the Canadian taxpayer purchases a property with the intention of selling it at a profit. Whether a Canadian taxpayer is engaged in a full-fledged business, or an adventure or concern in trade, will similarly be a very fact-driven analysis.
There are, generally speaking, no superficial loss rules that apply to income losses. Thus, absent the application of these superficial loss rules, or the superficial loss rules that may elsewhere apply under the Canadian Income Tax Act, a taxpayer is not stopped from crystalizing a loss on non-capital property. A cryptocurrency trader engaged in a pure trading business could potentially dispose of and repurchase inventory without triggering superficial loss rules while crystallizing operating losses from that trading business. Whether this crystallization is possible will entirely depend on the characterization of a cryptocurrency trader's activities as either a business, or as an investment, where the cryptocurrency disposed of may be treated as a capital asset. In such cases, the disposition will trigger superficial loss rules, to the taxpayer's detriment. This may be the case where a Canadian taxpayer holds cryptocurrency tokens as long-term investments or has instead bought in to cryptocurrency hedge funds and investment portfolios rather than actively trading cryptocurrency assets.
Taxation of Dispositions of Cryptocurrency Tokens as a Business or as a Capital Investment
Under the Canadian Income Tax Act, the type of income earned determines the nature of the asset disposed of. So, the analysis begins by characterizing the type of income earned or loss accrued. No Canadian court has provided clear guidance on taxation of cryptocurrencies, and the CRA has failed to provide any coherent guidance of its own on the characterization of cryptocurrency for Canadian tax purposes. The body of Canadian case law concerning the characterization of business and investment income, and capital gains, does however provide some principled guidance for evaluating the characterization of a Canadian taxpayer's cryptocurrency transactions. Although the courts have not viewed any single factor as determinative, relevant factors for determining the character of a sale of property as capital, or as part of a business, include:
- The nature of the property sold.
- The length of period of ownership by the taxpayer.
- The frequency or number of other similar transactions by the taxpayer.
- The work expended on or in connection with the property realized.
- The circumstances that were responsible for the sale; and
- Particularly important for cryptocurrency holders, the taxpayer's motive for both acquiring the property and for making the sale.
Thus, many factual elements surrounding a Canadian taxpayer's acquisition and disposition of a cryptocurrency token will influence how that crypto transaction will be taxed. Your motivations for participating in and dealing in various cryptocurrencies and cryptocurrency investment vehicles, and your motivations for selling your holdings will all be relevant to evaluating whether those proceeds on disposition will be taxable as capital gains or as business income.
Pro Tax Tip - Do Not Become Complacent. Keep Good Records and Get a Written Legal Opinion for Your Filing Position.
A Canadian taxpayer should always act conservatively when faced with the potential application of superficial loss rules under the Canadian Income Tax Act. This is especially the case where you adopt the position that your losses were from a business, and not the disposition of capital property. A business loss is far more powerful than a capital loss. While only one-half of capital losses are deductible, one may fully deduct losses and expenses associated with business or investment activity.
Prudence and due diligence thus are the greatest weapons you have against a reassessment by CRA following a tax audit. While you may hold the view that your transactions characterize your proceeds and losses as from a business, it is always possible that the CRA and Canadian courts will adopt a different view and challenging those positions can be a very costly endeavor.
Keeping accurate records of your cryptocurrency trading activity is therefore crucial to avoiding the worst of tax enforcement measures. You should never rely on cryptocurrency exchanges themselves to hold onto your records, and you should always maintain your own trading records. The FTX crash, among other prior cryptocurrency exchanges like QuadrigaCX, is the perfect example of what can happen if you fail to do your own due diligence. That is, you may be left scrambling to produce evidence necessary to fight an unfair CRA audit or reassessment, and the burden will be on you to disprove their assumptions.
As well, you may benefit from obtaining a tax memorandum on the proper characterization of your proceeds and losses from cryptocurrency dispositions. Obtaining a tax memorandum is a substantial piece of evidence demonstrating that you performed your due diligence when determining your correct Canadian income tax filing position if you are ever faced with a CRA audit on your cryptocurrency dispositions. Further, where your cryptocurrency holdings are characterizable as capital assets, there may still be ways to crystallize your losses. The disposition of one cryptocurrency and immediate acquisition of another (like Bitcoin for Ethereum) may avoid triggering the superficial loss rules where the two do not qualify as identical properties. This presents a very powerful crypto tax planning opportunity for cryptocurrency investors, but this analysis will depend heavily on the facts and surrounding circumstances of the investor. Our specialist Canadian cryptocurrency tax lawyers can provide more formative advice on how best to maintain your records, and provide you with legally-justified opinions on the proper reporting position of your cryptocurrency dispositions to protect against CRA overreach denying you legitimate business losses.
FTX Meaning: What is FTX in crypto?
FTX was a crypto exchange based out of the Bahamas that specialized in leveraged products and derivatives. The FTX crypto exchange promoted coins and tokens liquidation and transactions by allowing users to connect with their crypto wallets, exchange cryptocurrencies and NFTS, trade and more. It also encouraged collectibles transactions. US residents were not permitted to trade on its platform because of existing crypto regulations, however, other users around the world were able to use this platform until investigations begun and bankruptcy was filed by the company leading to the FTX crash.
What does FTX stand for?
FTX stands for Futures Exchange, the full name of the cryptocurrency exchange company that has since experienced a collapse, providing another example of the implications of when cryptocurrencies crash.
What was the FTX Crash?
In November of 2022, the world's then-second-largest cryptocurrency derivatives exchange FTX Trading Ltd. filed for Chapter 11 bankruptcy in the United States. The collapse of FTX was triggered following the sudden liquidation of FTX's native cryptocurrency token FTT by Binance, FTX's largest competitor, and sealed by a failed effort by Binance to buy out FTX after entering a freefall. The market crisis resulting from the FTX crash resulted in a widespread sinkage of cryptocurrency token values, impacting nearly all cryptocurrency investors and portfolios.
What is a "Superficial Loss"
Under the various provisions of the Income Tax Act, a "superficial loss" occurs where a Canadian taxpayer disposes of qualifying property, and during the period beginning 30 days before and 30 days after the disposition, the taxpayer or an affiliated person acquires a property that is the same or "identical" to the property disposed of. If the taxpayer or affiliated person owns the property at the end of the 61-day period, the taxpayer's loss from the disposition to the extent it is deemed superficial, will be deemed to be nil. The purpose of the superficial loss provisions of the Canadian Income Tax Act are to prevent a Canadian taxpayer from artificially realizing an accrued loss for tax planning purposes, where there is no true sense of finality to the disposition.
What Does it Mean to "Crystallize" My Tax Losses?
A gain or loss on property for tax purposes is realized when the property is disposed of. A taxpayer, in theory, could dispose of and immediately re-acquire that asset when its value is low to ensure access to those loses for tax planning purposes. There are many nuanced rules under the Canadian Income Tax Act, however, to prevent inappropriate tax planning by triggering "superficial losses". Any effort to crystallize your losses should be vetted and supervised by an expert Canadian tax lawyer to ensure these rules do not apply to deny you those losses.
An expert Canadian crypto tax lawyer can also help to determine what tax planning opportunities exist to crystallize your losses where your cryptocurrency holdings qualify as capital assets, such as swapping your cryptocurrency holdings for other cryptocurrencies that do not qualify as identical properties plus planning the reacquisition of the same cryptocurrencies after running out the superficial loss limitation period.
How are Business Losses and Capital Losses from Cryptocurrency Transactions Treated Differently for Superficial Loss Rules?
A Canadian taxpayer who holds cryptocurrency tokens as a long-term investment may receive proceeds of disposition as a capital gain, or from a business or as an adventure or concern in trade which is instead an income transaction and not a capital gain. In these cases, the superficial loss rules of the Canadian Income Tax Act will prevent that Canadian taxpayer from disposing of and reacquiring cryptocurrency tokens to crystallize accumulated losses. What we can learn from the collapse of FTX is that, If a Canadian taxpayer is engaged in an active trading business, the superficial loss rules may not apply to a disposition and reacquisition, allowing that Canadian taxpayer to crystallize operating losses for tax planning purposes.
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.