Introduction — Crypto Currency Mining and Income Tax
Cryptocurrencies such as Bitcoin or Dash are digital assets which use which use cryptographic techniques to verify the transfer of assets and control the creation of additional units of the crypto currency. The key feature of a cryptocurrency is that the ledger that records transactions, known as a blockchain, is not controlled by a central authority. Instead, each cryptocurrency implements a system where transactions on the blockchain are validated by a large number of independent parties. These independent parties who do the work of verifying transactions are known as cryptocurrency miners. These systems are set up so that crypocurrency miners are rewarded for mining with newly created units of the cryptocurrency such as Ethereum. As the popularity and valuation of cryptocurrencies, such as Ripple, rises, it becomes more important to understand the Canadian income tax consequences of cryptocurrency mining.
Cryptocurrency Mining – Canadian Income Tax Characterization
The tax treatment of cryptocurrency mining for a particular individual depends on the facts and circumstances of that particular individual. The two main possible characterizations for the activity are as a personal hobby or as a business. The courts have determined that in order for an activity to be a business, the taxpayer's predominant intention in carrying out the activity was to make a profit and that the activity was carried out in accordance with the objective standards of businesslike behaviour. Therefor if the personal elements, if any, in the activity outweigh the extent to which the taxpayer carried out the activity in a commercial manner, then the activity is a hobby not a business. There is no fixed list of objective factors that courts look to as indications that the activity is being carried out in an objectively businesslike manner. However, common factors the courts look to include:
- Profits and losses arising from the activity in prior years;
- The taxpayer's training;
- The taxpayer's intended course of action;
- The capability of the activity to show a profit;
- The presence of conventional business financing like bank loans; and
- A formal business plan;
As these factors will vary between individual miners, whether their mining was a hobby or a business will depend on the facts and circumstances of the individual miners. For example, miners who have training in computer programming, blockchain technology, or computer hardware and who borrow money to pay for their mining rig are more likely to be treated as running a business than a layperson mining from their personal computer. If you are unsure if your Zcash, Monero, or other cryptocurrency mining activities constitute a business or a hobby for Canadian income tax law purposes, please consider contacting one of our experienced Toronto tax lawyers.
Cryptocurrency Mining – Income Tax Consequences of Mining as a Business
If your mining activity constitutes a business, it will have several different tax consequences. When a miner receives a new unit of a cryptocurrency such as Litecoin through their mining activity, the miner will not have an income inclusion until the miner disposes of that Litecoin. The new Litecoin will be considered part of the inventory of the business and be subject to the inventory valuation rules of the Canadian Income Tax Act. When the miner eventually disposes of the Litecoin and other cryptocurrency they have mined they will most likely earn business income or incur business loses as opposed to capital gains or losses. This is important as only 50% of a capital gain is included in a taxpayer's taxable income, which can significantly reduces the amount of tax owing if the taxpayer has large gains.
Since the miner is running a business, he or she will be able to claim deductions for business expenses and the depreciation of depreciable property employed in the business. This is important as the expenses associated with a commercial cryptocurrency mining operation for computers, electricity, rent and interest on loans can be large. Note however that the expenses which are included in the cost of inventory can only be deducted in the tax year in which the inventory is sold. This means if you sell Bitcoins or other cryptocurrency you mined in a previous year, you will only be able to deduct the cost of mining those coins in the year you sell them. However, if the value of your unsold inventory, as determined by Canadian tax law, declines, you may be able to get a corresponding deduction in that year. Normally, the value of your unsold inventory at the end of the year is deemed for Canadian tax law purposes to be the lower of your cost of acquiring the inventory and the fair market value of your inventory at the end of the year. This means that if the fair market value of your unsold cryptocurrency inventory falls below the cost of your inventory at the end of the year, you may be able to get a deduction in that year. These deductions and inventory rules only apply if the miner treated as running a business and the Etheruem or other cryptocurrency the miner has produced are not treated as capital property. Under the capital property treatment, no deductions are available but the cost to the miner of creating the coins becomes the cost base of the coins. When the coins are sold the gain or loss from the sale is calculated by subtracting the cost base of the coins from the proceeds received from the sale of the coins. The miner's taxable capital gain or loss from the sale is equal to half of the gain or loss realized. The miner's income is only affected by the coins when they are disposed of, before that time any unrealized gains or losses will not affect the miner's income.
Cryptocurrency Mining – Income Tax Consequences of Mining as a Hobby
If the miner is mining as a personal hobby and not as a business then the activity of mining will have somewhat different tax consequences than those outlined above. As with the treatment of commercial mining, the hobbyist miner will not have an income inclusion when they receive cryptocurrency such as Stellar from their mining activities. However, unlike when mining is carried on a business, the Dash, Ada or other cryptocurrency the miner receives will most likely be treated as capital property and not as inventory. This means that when the miner disposes of the cryptocurrency later, they will realize a capital gain or loss as opposed to business income or a business loss. This is very important as only half of the capital gains realized by a taxpayer are included in their income where as the full amount of the gain realized when selling inventory is included as business income. Hobbyist miners are also not able to claim deductions for the expenses they incur to carry out their mining activities. Instead, the cost to the miner of producing the Bitcoin or other cryptocurrency will be the cost base used to compute the miner's capital gain or loss as described above.
Cryptocurrency Mining - Tax Tips
The question of whether an individual's mining activities is business or a hobby is both complicated and important. It is complicated because it requires knowledge of the Canadian tax case law covering this question and because it is very dependant on the specific circumstances of the individual miner. This means that obtaining proper legal advice from expert Canadian income tax lawyers is essential. It is important because individuals who realize large gains selling NEO or other cryptocurrency they obtained through mining will significantly reduce their tax payable if they can characterize the gain as a capital gain and not business income. Under ordinary circumstances, it is unlikely that a hobby could produce large gains, but the sharp increase in value in Bitcoin and some other cryptocurrencies over the last few years has resulted in significant unanticipated gains for hobbyists. In some circumstances it may be possible for commercial miners to segregate some of the coins they have mined into a long term portfolio and credibly claim that those coins underwent a change in use from inventory to capital property. This would mean that gains from disposing of these coins would be capital gains not business income and considerable tax savings. Commercial miners who are not holding on to their coins for the long term should consider incorporating to gain access to lower rates on active business income through the small business deduction.
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.