Introduction - Binance Announces it Will Proactively Withdraw from the Canadian Cryptocurrency Market
On May 12, 2023, Binance, the world's largest cryptocurrency exchange by volume of trades, announced it would be withdrawing its services offered to Canadian cryptocurrency traders and investors. As a consequence, any existing Canadian users of Binance will be required to close any open positions by September 30, 2023, and from October 1, 2023, onward, Canadian customers will be restricted to liquidating any remaining cryptocurrency holdings held through the exchange.
Binance's withdrawal from the Canadian market has come at a tumultuous time for Canadian cryptocurrency traders and investors. The collapse of FTX Trading Ltd., previously the third-largest cryptocurrency exchange in the world, vexed cryptocurrency users and fuelled one of the worst cryptocurrency market downturns since the technology achieved widespread popularity in the mid-2010s. But while Binance's withdrawal may be surprising to many Canadian cryptocurrency investors, it is hardly unprecedented.
In the wake of the FTX collapse, government regulatory bodies worldwide began taking increasingly aggressive moves toward preventing similar disasters. In 2021, the Ontario Securities Commission ("OSC") moved to expand compliance obligations for "crypto asset trading platforms" by mandating that platforms voluntarily register with the OSC and agree to regulatory undertakings, or face penalties for non-compliance.
The OSC's prosecution of other cryptocurrency exchanges for non-compliance including Bybit and KuCoin, and Binance's seeming disinterest in complying with Ontario securities laws, promoted it to cease operating in Ontario by the early months of 2022. Binance's withdrawal from Canada all-together follows a similar push by the Canadian Securities Administrators (the "CSA"), the informal governing conglomerate formed by Canada's provincial and territorial securities regulators, to impose uniform regulatory obligations on all crypto trading platforms operating across Canada. CSA Staff Notice 21-332, "Crypto Asset Trading Platforms: Pre-Registration Undertakings", released on February 22, 2023, has signalled that CSA members will continue imposing registration requirements on crypto trading platforms operating in Canada, including additional requirements concerning custody and segregation of crypto assets for Canadian clients to protect those assets from another disaster similar to the FTX collapse.
The departure of Binance invites income-tax considerations for Canadian cryptocurrency traders and investors who have used the exchange to present. It also highlights important income-tax considerations for all Canadian cryptocurrency traders and investors who may or may not have held an account with Binance, but otherwise held an account with another regulated or unregulated cryptocurrency exchange.
This article will discuss the immediate income-tax implications of Binance's withdrawal from Canada, in addition to the importance of maintaining off-exchange cryptocurrency trading and investing records to protect yourself against a potential cryptocurrency tax audit. This article will conclude by offering pro crypto tax tips to Canadian taxpayers engaging in cryptocurrency transactions using a regulated or unregulated crypto exchange, and how you should prepare your own books and records, and will then answer some frequently asked questions.
The Canadian Income-Tax Considerations of Closing or Switching Cryptocurrency Exchange Accounts
Under the Canadian Income Tax Act, a disposition of property may trigger an income tax liability. For the purposes of the Income Tax Act, "property" may include intangible property, such as cryptocurrency tokens and non-fungible tokens ("NFTs"). The definition of a disposition for purposes of the Income Tax Act is similarly broad, and it captures most circumstances where a person relinquishes ownership of property. A disposition for tax purposes can occur regardless of whether a person disposed of property voluntarily or involuntarily, and regardless of whether that person receives compensation for any disposition. Thus, a disposition may include, among other transactions: (1) a sale of property; (2) the expropriation or confiscation of property; (3) the exchange of one property for another property such as one token for a different token; and (4)the theft, loss or abandonment of a property.
A disposition involving cryptocurrency tokens may include a sale of cryptocurrency tokens for fiat currency (i.e. Canadian or U.S. dollars), and may also include a conversion of one particular type of cryptocurrency tokens for another type. For example, while the purchase of Bitcoin ("BTC") for Canadian dollars represents a pure acquisition of property and would typically not form a taxable event, trading BTC units for Ethereum ("ETH") units is an exchange of property and would typically qualify as a taxable disposition. So, with respect to the closure of Binance, simply closing a cryptocurrency exchange account or migrating cryptocurrency assets from one exchange or wallet to another will generally not trigger tax consequences. However, if that transfer involves liquidating any tokens within the account, such as closing of a position, or exchanging tokens for other cryptocurrency units to transfer those assets held with an exchange, then the resulting profit will generally be taxable.
Whether any resulting profit is fully-taxable business income from the sale of inventory, or half-taxable capital gains from the sale of capital property, is a complicated legal tax determination that flows from the taxpayer's motive or intent at the time the cryptocurrency units were acquired. Broadly speaking, characterizing proceeds from a transaction as on capital account are more favourable than on income account where a transaction is profitable, because only half of a taxpayer's capital gains form taxable income. However, a loss is better characterized as on income account than on capital account, because losses on income account are deductible against any sources of income, while losses on capital account may only offset taxable capital gains. The Tax Court of Canada and Canada Revenue Agency have set out a complex series of objective factors that will be considered to arrive at the appropriate characterization of profits as on capital account or on income account, including the following:
- Transaction frequency - for instance, a trend of selling frequent cryptocurrency buying and selling or a high rate of cryptocurrency unit turnover may point to a business;
- Duration of ownership - for instance, keeping cryptocurrencies for short periods of time indicates commercial activities rather than capital investments;
- Understanding of cryptocurrency marketplaces - more knowledge or expertise with cryptocurrency markets favours a business categorization;
- Relationship to the taxpayer's other employment; for instance, if cryptocurrency trades (or similar activities) are a component of the taxpayer's employment or other business, it indicates toward business;
- Time invested - for instance, there is a higher change that the taxpayer will be classified as operating a business if a significant portion of that taxpayer's time is spent researching potential acquisitions, analyzing cryptocurrency markets, or actively managing a cryptocurrency portfolio;
- Financial support - for instance, leveraged cryptocurrency transactions signify a business; and
- Advertising - for instance, there is a greater chance that the taxpayer's cryptocurrency company would be characterized as a business if the taxpayer had advertised it as a business.
These are the predominant considerations when closure of a cryptocurrency exchange account results in a disposition. An inter-account transfer alone will not constitute a disposition for tax purposes, because a transfer alone does not result in that taxpayer relinquishing ownership of an underlying cryptocurrency token. Where the tokens simply flow between accounts controlled by the same taxpayer, that is not a taxable event. So where possible, to avoid triggering Canadian tax obligations, it is best to arrange for a direct transfer of cryptocurrency tokens out of an account subject to closure and without liquidating those assets for fiat or other types of cryptocurrency.
The Dangers of Cryptocurrency Account Closure for Proper Record-Keeping
Maintaining independent cryptocurrency trading and investing records off-exchange is vital any cryptocurrency trader or investor. The closure of a cryptocurrency exchange can result in losing access to your complete cryptocurrency trading history. Maintaining your own audit trail of purchases and dispositions helps to ensure that you not only report income earned from your cryptocurrency trading and investing activities properly, but that you and your experienced Canadian crypto tax lawyer are ready to respond successfully to any cryptocurrency tax audit launched by the Canada Revenue Agency ("CRA").
It is your legal responsibility to ensure you maintain adequate records of your trading and investing activities. Under section 230 of the Canadian Income Tax Act, any taxpayer who owes and pays income tax is obligated to maintain sufficient books and records that enable any person to determine and verify that income tax payable. Those records must be maintained at a place of residence or business in Canada for a period of at least six years after the end of the last tax year to which those documents relate. This limitation period is deceptive, however, because the profit you earn from a disposition of cryptocurrency units is determined in part by the cost of acquiring that property. Your records concerning the purchase of cryptocurrency units will be as, if not more, relevant in the year that you sell your holdings, which could be many years after the date of purchase. Failing to maintain records is also in of itself an offence under section 238 of the Canadian Income Tax Act, and a non-compliant taxpayer may face on a successful conviction a fine of up to $25,000 and imprisonment of up to 12 months. So practically speaking, records should be maintained for much longer than six years.
The CRA maintains extensive powers to investigate and tax audit taxpayers concerning their tax affairs, and to inspect the records that section 230 requires a taxpayer to maintain. Section 231.1 of the Canadian Income Tax Act affords CRA auditors and investigators the power to enter a taxpayer's place of business without a warrant to inspect that taxpayer's books and record, and to examine a taxpayer's inventory and property to verify the accuracy of those books and records. A warrant will still be required where an auditor or inspector seeks to search a taxpayer's home, but the conditions to obtain such a warrant are exceptionally low. Further, section 231.2 of the Canadian Income Tax Act grants the CRA powers to compel any person to provide documents or information required as part of a tax investigation. This power is exceptionally broad, and allows the CRA to compel that not only the taxpayer produce documents, but also allows the CRA to compel third parties like banks and cryptocurrency exchanges, but also including the taxpayer's accountant, to cooperate. Failure to cooperate when appropriately compelled to by the CRA is an offence under the Income Tax Act, and carries with it the potential for fines and imprisonment on a successful conviction.
A cryptocurrency tax audit initiated by the CRA typically involves issuance of a letter to a taxpayer with notice that an audit has been launched. This letter may include a comprehensive cryptocurrency audit questionnaire, which may include topics such as:
- a taxpayer's timeline of owing or using cryptocurrency;
- the types of cryptocurrencies purchased or sold;
- whether the taxpayer has used or uses third-party exchange wallets, such as Binance;
- the taxpayer's source of funds used to finance cryptocurrency purchases;
- whether the taxpayer has organized record-keeping practices for cryptocurrency transactions;
- whether the taxpayer has engaged in any blockchain or cryptocurrency liquidity mining or yield farming activities, proof-of-stake or proof-of-work validation activities;
- transaction record-keeping practices of the taxpayer;
- the taxpayer's frequency of cryptocurrency transactions; and
- the taxpayer's time spent studying cryptocurrency markets.
It is vital that any Canadian cryptocurrency trader or investor maintain off-exchange books and records, to provide a layer of protection against any CRA cryptocurrency tax audit. Losing records as a consequence of a cryptocurrency exchange shutdown will not prevent the CRA from moving forward with a cryptocurrency tax audit or issuing any tax reassessments. Under subsection 152(7) of the Canadian Income Tax Act, the CRA is not bound in any case by the information provided by a taxpayer when issuing an assessment or reassessment of that taxpayer's income. The CRA is entitled to consider sources other than the taxpayer's books and records when assessing a taxpayer, including external and third-party sources of information and its own assumptions, and is entitled to employ various indirect-income-verification tests in order to assess a Canadian taxpayer where books and records are unreliable or non-existent.
For example, the CRA may conduct a bank deposit analysis of a taxpayer to indirectly verify that taxpayer's income. A bank deposit analysis involves a review of third-party records like bank statements and credit card statements as provided by the taxpayer's bank, to determine whether the inflow and outflow from those accounts matches reported income. Where there is a serious discrepancy between a taxpayer's financial affairs and spending habits when compared with reported income, the CRA may employ a net worth analysis to estimate and assess a taxpayer unreported income. Under the net worth tax audit methodology, where any increase in wealth over that period cannot be explained by the income reported by the taxpayer, the CRA will assume that the difference is unreported income of the taxpayer. And once the CRA issues an assessment or a reassessment of a taxpayer, under subsection 152(8) of the Canadian Income Tax Act, that assessment remains valid until it is successfully vacated or varied on objection by the taxpayer. A taxpayer is typically left to challenge the assumptions and calculations of the CRA on a line-by-line and item-by-item basis, and to perform an assessment of their own assets and liabilities over the tax audit period to refute the CRA's assumptions. This is exceptionally hard in the case of cryptocurrency trading and investing activities where transaction records are poorly maintained. Rebutting any such reassessment will extensive forensic analysis work to show inflows and outflows of cryptocurrency units from wallets per transaction to rebut the CRA's adoption of an IIV method in favour of some more reasonable audit method.
Pro Tax Tip: The Quality of Records That You Maintain Will Help to Determine Whether the Outcome of a Cryptocurrency Tax Audit is Positive or Negative
A cryptocurrency user's lack of records ultimately benefits the CRA, because it might justify the CRA's use of an indirect-income-verification audit method that would significantly over-estimate unreported taxable income. To successfully avoid the negative results of a cryptocurrency tax audit by the CRA, a cryptocurrency trader or investor should assemble and maintain extensive records of transactions off-exchange so as to avoid losing any records in the event of an exchange shutdown. Good cryptocurrency transaction records should maintain the following information for each transaction:
- the date of the transaction;
- the transaction ID (i.e., TxID or Tx Hash);
- any receipts for purchasing or transferring cryptocurrency (i.e. fiat currency, other cryptocurrencies);
- the value of the cryptocurrency in Canadian dollars at the time of the transaction;
- the digital-wallet records and cryptocurrency addresses for each cryptocurrency transferred;
- a description of the transaction and of the other party (e.g., the other party's cryptocurrency address);
- any exchange records for the transaction, if applicable;
- records relating to any accounting and legal costs; and
- records relating to any software costs for managing your tax affairs.
Cryptocurrency exchange records should be periodically exported and backed up using cloud services or other reliable methods of data storage to avoid inadvertently losing those records forever. Further, where you are engaging in extensive cryptocurrency trading or investing activities, you should obtain a form a legal opinion concerning your appropriate Canadian tax filing position. Should the CRA audit your cryptocurrency trading or investment activities and challenge your filing position, there is always the risk that the CRA will pursue gross negligence penalties for any unreported income it reassesses. Under subsection 163(2), a taxpayer who knowingly or under circumstances amounting to gross negligence make a false statement or omission on a tax return may be liable for the greater of: (1) $100; and (2) 50% of the total amount of tax that would otherwise be payable by the taxpayer. Obtaining a written legal opinion in the form of a tax memorandum from a top Canadian crypto tax lawyer, exploring whether your cryptocurrency trading or investing profits are classified as on income account or capital account, or both as the circumstances may show, demonstrates your due diligence and tremendously reduces the risk that additional tax penalties for non-compliance will be levied.
What Happened to Binance in Canada in May 2023?
On May 12, 2023, Binance announced it would be withdrawing its services offered to Canadian cryptocurrency traders and investors. Binance had previously ceased operating in Ontario in early 2022, following moves by the Ontario Securities Commission ("OSC") to expland compliance obligations for crypto asset trading platforms in the province. extensive cryptocurrency exchange collapses like that of Celsius or FTX Trading Ltd. further prompted the Canadian Securities Associations ("CSA") to adopt additional compliance obligations for crypto exchanges in February 2023. In response to increasing regulation, existing Canadian users of Binance are required to close any open positions by September 30, 2023, and from October 1, 2023, onward, Canadian customers will be restricted to liquidating holdings exclusively and cannot otherwise acquire new cryptocurrency units through the exchange.
What Records Should I Maintain as a Cryptocurrency Trader or Investor?
Under section 230 of the Canadian Income Tax Act, you are required to maintain books, records, and supporting documents for at least six years after the end of the last tax year to which those documents relate. Good cryptocurrency transaction records should maintain the following information for each transaction: (1) the date of the transaction; (2) the transaction ID (i.e., TxID or Tx Hash); (3) any receipts for purchasing or transferring cryptocurrency (i.e. fiat currency, other cryptocurrencies); (4) the value of the cryptocurrency in Canadian dollars at the time of the transaction; (5) the digital-wallet records and cryptocurrency addresses for each cryptocurrency transferred; (6) a description of the transaction and of the other party (e.g., the other party's cryptocurrency address); (7) any exchange records for the transaction, if applicable; (8) records relating to any accounting and legal costs; and (9) records relating to any software costs for managing your tax affairs.
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.