Introduction - Blockchain Non-Fungible Tokens or NFTs: What Are They?
Lately, non-fungible tokens (or NFTs) have exploded news headlines. Artists and other personalities have been raking in millions by selling digital works of art as NFTs. In March 2021, musician and artist Grimes sold a collection of digital art as non-fungible tokens for almost $6 million. On March 11, 2021, digital artist Mike Winkelmann (also known as Beeple) cashed in on the NFT craze, selling an NFT of his work "Everydays: the First 5000 Days" at Christie's for $69 million. The billionaire co-founder of Twitter, Jack Dorsey, offered to sell his very first tweet as a non-fungible token. It sold for $2.9 million. Even the noted whistleblower Edward Snowden got in on the action, auctioning off an NFT image outlining his face with pages from the landmark 2015 US court decision about the mass-surveillance program that he had exposed. The Snowden NFT sold for over $5 million.
So, what exactly is a non-fungible token? A non-fungible token, or NFT, allows you to buy or sell ownership of unique digital items. Anything digital can be converted into an NFT-e.g., a drawing, a song, a tweet, this very article.
Blockchain technology allows the public to verify and track who owns a particular non-fungible token. (Most NFTs use the Ethereum blockchain, but other blockchains can also support their own versions of NFTs.) So, in that sense, an NFT is like cryptocurrency, such as Bitcoin, Ethereum (ETH), or Litecoin (LTC): it relies on blockchain technology to track ownership and transfers of ownership.
But non-fungible tokens are called "non-fungible" because each NFT can be given unique characteristics. Cryptocurrency, on the other hand, is fungible-trading one Bitcoin for another gets you exactly the same thing. A non-fungible token, however, is more akin to an original piece of art. If you trade a Monet for a Rembrandt, you don't end up with the same thing. The same holds true for NFTs. As such, non-fungible tokens have unsurprisingly garnered the most excitement and attention for their utility in commercializing digitized art and music.
In addition, NFTs allow an artist or musician to program a resale royalty directly into the NFT, thereby prompting commissions beyond the first point of sale. Facilitated by blockchain technology, this royalty could in principle continue forever. This enables the artist or musician to generate continuing revenue for future sales of an artistic work or song-generating even greater revenues as the art or the artist increases in popularity.
The purchase, creation, and sale of blockchain NFTs by Canadian taxpayers invoke a number of Canadian income-tax issues. Some of these issues include: Do Canadian taxpayers receive different income-tax treatment when creating NFTs for sale, on one hand, and when selling NFTs created by someone else, on the other? What is the character of the income that a Canadian taxpayer earns when selling blockchain non-fungible tokens? Is it business income? Investment income? A capital gain? Or some combination of the three? Canada's Income Tax Act contains different tax rules for each of these three sources of income. Hence, Canadian taxpayers who buy and sell blockchain NFTs will typically find themselves unsure about how to properly report their income to the Canada Revenue Agency without proper tax-planning guidance from an experienced Canadian tax lawyer.
This article aims to educate NFT creators, traders, and investors on the Canadian income-tax issues triggered by the non-fungible-token market. First, this article gives a general overview of the tax rules governing the following three sources of taxable income in Canada: business income, investment income, and capital gains. Second, this article discusses the features that distinguish these three sources of taxable income-that is, the features that allow us to discern whether a particular receipt constitutes business income, investment income, or a capital gain. After reviewing the legal framework, this article analyzes the Canadian income-tax implications of creating, buying, and selling blockchain non-fungible tokens. This article concludes by providing pro tax tips for Canadian taxpayers engaging in NFT transactions.
Sources of Taxable Income in Canada: Section 3 of Canada's Income Tax Act
Subsection 2(1) of Canada's Income Tax Act requires every Canadian tax resident to pay tax on "taxable income."
Subsection 2(2) then explains that a taxpayer's "taxable income" equals that taxpayer's "income for the year" minus the deductions in Division C of the Income Tax Act. (Division C includes a number of tax subsidies, tax-relief provisions, and policy-based deductions, such as the loss-carryover rules, the lifetime-capital-gains exemption or LCGE, the part-year-resident rule, which renders offshore income non-taxable if earned while a taxpayer was a non-resident of Canada, and tax-treaty exemptions.)
Section 3 describes how to compute a taxpayer's "income for the year." In doing so, the section (non-exhaustively) lists the following sources of income:
- Property; and
- Capital gains.
Hence, these sources of income (plus any other source that section 3 doesn't expressly name) ultimately make up a person's taxable income.
This article focuses on the last three sources-that is, income from business, income from property, and capital gains.
Overview of Canadian Income-Tax Rules Governing Business Income, Investment Income & Capital Gains
Under Canada's Income Tax Act, a different set of tax rules applies to each source of income. "Source" refers to the character or the type of the income. As mentioned above, the sources of income named in section 3 of the Income Tax Act include income from business, income from property (investment income), and capital gains. The tax rules for all three of these sources are located in Division B of Part I of Canada's Income Tax Act. But the tax rules governing business income and investment income are found in subdivision b while the tax rules pertaining to capital gains are located in subdivision c.
Business income and investment income are subject to many of the same income-tax rules. Subsection 9(1), for instance, codifies the deductibility of income-earning related expenses when calculating business income and when calculating investment income. It does so by defining business income and investment income as the taxpayer's "profit" from that respective source. That is, a taxpayer's business income consists of the taxpayer's "profit from that business," and a taxpayer's investment income (which the Income Tax Act refers to as "income from property") consists of the taxpayer's "profit from that property." The starting point for each, then, is the calculation of profit or net income. In other words, business income and investment income qualify for many of the same types of deductions.
Capital gains, however, receive entirely different income-tax treatment. For starters, while business income and investment income are each fully taxable, only one-half of a capital gain is included in taxable income. Likewise, business losses and investment losses are each fully deductible against any source of income, yet only one-half of a capital loss is deductible, and the allowable portion of the capital loss may generally only be used to offset the taxable portion of a capital gain.
Characterizing Income: Is it Business Income, Investment Income, or a Capital Gain?
Investment income-that is, "income from property"-refers to the yield from property. Shares, for example, yield dividends. Bonds yield interest. Intellectual property yields royalties. Real property yields rent. And so on. In other words, investment income is passive income stemming from the mere ownership of property; it doesn't require any significant commitment of time, labour, or attention. For example, an individual can purchase public shares and earn dividends without any further effort. The dividends, then, constitute investment income.
Business income, by contrast, calls for organization, systematic effort, and a degree of activity. For example, an investment dealer can purchase and actively manage a portfolio consisting of public shares. The portfolio dealer operates an investment business, the revenues of which constitute business income. Subsection 248(1) of Canada's Income Tax Act says that a "business" includes a "profession, calling, trade, or undertaking of any kind whatever." A "business" also includes "an adventure or concern in the nature of trade." A "business" therefore implies activity and profit motive. The representative characteristics of a business include activity, enterprise, entrepreneurship, and commercial risk. Above all, a business entails the pursuit of profit. The pursuit of profit is indeed what distinguishes a business from a mere hobby or past time (Stewart v Canada, 2002 SCC 46).
The distinction between business income and investment income therefore turns on the level of activity associated with acquiring the income. The mere use of a property doesn't by itself guarantee that the income therefrom is income from property. For example, a taxpayer who actively manages a hotel and a taxpayer who leases a basement apartment both use a property, and both receive payments for rent. Yet the hotel manager earns business income while the homeowner earns investment income or income from property.
While the use of property may give rise to either business income or investment income, subsection 9(3) of the Income Tax Act expressly distinguishes investment income from capital gains. This subsection clarifies that income from a property (i.e., investment income) excludes a gain arising from the disposition of that property. (It also states that a loss from property excludes a loss upon disposing of that property.) In other words, if you dispose of a property, the resulting profit isn't characterized as investment income for tax purposes; it's either a capital gain or business income.
A capital gain (or capital loss) arises when you dispose of an asset that qualifies as "capital property." Canada's Income Tax Act recognizes only two broad sorts of property for tax purposes:
- capital property, which creates a capital gain or loss upon disposition; and
- inventory, which figures into the computation of business income.
The type of income that the property generates upon sale-that is, capital gains or business income-determines whether that property is a capital property or inventory. In other words, one starts by determining the nature of the income and then characterizes the property, not the other way around.
Canadian courts have amassed a large body of case law grappling with the ambiguity between investing, which produces a capital gain, and trading, which results in business income. Courts assess a wide range of factors when deciding whether to characterize a transaction's gains or losses as on capital account or income account. These factors may include:
- transaction frequency-e.g., a history of extensive buying and selling of non-fungible tokens or of a quick turnover of NFTs might suggest a business;
- length of ownership-e.g., very brief periods of holding non-fungible tokens indicate business dealings, not capital investing;
- knowledge of NFT markets-e.g., increased knowledge of or experience with NFT markets favours a business characterization;
- relationship to the taxpayer's other work-e.g., if NFT transactions (or similar dealings) form a part of a taxpayer's employment or other business, it points toward business;
- time spent-e.g., a greater likelihood of characterization as a business if a substantial part of the taxpayer's time is spent studying non-fungible-token markets and investigating potential purchases or actively managing a portfolio of non-fungible tokens;
- financing-e.g., leveraged NFT transactions indicate a business; and
- advertising-e.g., increased likelihood of business characterization if the taxpayer has advertised or otherwise made it known that he deals in non-fungible tokens.
Ultimately, the taxpayer's intention at the time of acquiring the property is the most important criterion that courts consider when determining whether the transaction produced a capital gain or business income. Yet to identify a taxpayer's intention, a court will focus on the objective factors surrounding both the purchase and the sale of the property. In other words, courts will determine a taxpayer's intent by evaluating the factors listed above.
In summary, depending on how a taxpayer uses it, a property can generate business income, investment income, or a capital gain, and two Canadian taxpayers with similar portfolios may receive different tax treatment. If the property itself generates income, that income may comprise either business income or investment income (i.e., income from property). The appropriate tax characterization depends on the level of activity associated with acquiring the income: business income requires activity; investment income implies passivity. If the income stems from the disposition of the property, the profit may comprise either business income or a capital gain. In this case, the appropriate tax characterization depends on whether the taxpayer acquired the property with the intent to trade.
To be clear: The Income Tax Act's definition of "property" includes intangible property, such as cryptocurrency and non-fungible tokens. So, the foregoing analysis applies to both cryptocurrency transactions and transactions involving blockchain NFTs. Also, as mentioned above, the tax characterization of the non-fungible token itself derives from the character of the income stemming from the NFT. In other words, the tax character of the income entails the tax characterization of the non-fungible token used to generate that income. For example, if a taxpayer carried on an NFT-trading business-thereby using NFTs to generate business income-that taxpayer's non-fungible tokens qualify as inventory. If, on the other hand, the disposition of a non-fungible token would give rise to a capital gain, the non-fungible token constitutes a capital property in the hands of the taxpayer for whom the disposition would result in the capital gain.
In addition, an NFT might conceivably qualify as a business's goodwill. For example, a business could create a non-fungible token out of digitized information that includes aspects of that business's goodwill-e.g., client lists, trade secrets, indefinite-life licences, etc. So, if a Canadian taxpayer purchased that business as a going concern-and thereby acquired the NFT that contained aspects of the business's goodwill-the NFT might qualify as a Class 14.1 property under the Income Tax Act's CCA (capital cost allowance) regime.
Before 2017, goodwill fell under the Income Tax Act's definition of "eligible capital property" (or ECG), and the Act's eligible-capital-property regime allowed a Canadian taxpayer to annually deduct from the taxpayer's business income a portion of the cost to acquire the eligible capital property. In 2017, Parliament eliminated the ECG rules and granted a similar annual deduction as a capital cost allowance (or CCA). As a result of the 2017 amendment, the Income Tax Act's definition of "property" now includes "the goodwill of a business," and, for the purposes of the CCA (capital cost allowance) regime, subsection 13(34) of the Act deems each business to have a single "goodwill property," which generally qualifies under CCA Class 14.1 for an annual capital-cost-allowance deduction of 7% (on a declining balance) of the business's cost to acquire the goodwill. Basically, the CCA rules prohibit a business from deducting the entire cost of a capital expenditure on a current basis. The benefits of a capital expenditure will extend beyond the year in which the business incurred the expense. As such, the business must amortize such expenditures over multiple fiscal years, during which they would continue to confer a benefit.
Canadian Tax Implications of Generating Income from Creating, Holding, and Trading Blockchain Non-Fungible Tokens
The takeaway from the foregoing analysis is that the character of the income determines how it is taxed under Canada's Income Tax Act. So, to determine the Canadian income-tax implications of buying and selling non-fungible tokens, we must first ask: What is the character of the income that you earn when engaging in NFT-blockchain transactions?
To answer this question, we need to distinguish between two means by which you can derive income from non-fungible tokens. The first is the profit that you might enjoy from selling or trading the blockchain NFT itself. The second is the royalty that you may receive from holding copyright NFTs. (The copyright NFT is gaining popularity in the music and publication industries. Blockchain-based tools, such as Bluebox, record full or fractional ownership of a copyright to a song or published work, and it distributes royalty payments accordingly. So, by issuing a series of non-fungible tokens, a musicians or author can sell a percentage interest in an upcoming song or publication to the public.)
Canadian Income-Tax Characterization of Royalties from Copyright Non-Fungible Tokens
As mentioned above, a copyright NFT is a blockchain arrangement whereby an artist, author, or musician issues non-fungible tokens, thereby selling a percentage of the rights to a created work. As a result, the owner of the non-fungible tokens receives a corresponding proportion to any royalty payments on the underlying work. Hence, these receipts generally constitute investment income (or "income from property," as it's described in the Income Tax Act).
Still, the investment-income characterization might not always fit. As mentioned above, if a taxpayer uses cryptocurrency or non-fungible tokens to generate income, the appropriate tax characterization will ultimately depend on the level of activity associated with acquiring that income. So, your receipts may qualify as business income if you receive a portion of the royalties on copyright NFTs that you created and issued to the public. This is especially true if your particular operation demonstrates entrepreneurship, commercial risk, and the pursuit of profit, and it calls for a significant commitment of time, labour, and attention.
Canadian Income-Tax Treatment of Royalties from Copyright Non-Fungible Tokens
In any event, business income and investment income receive largely similar tax treatment overall. So, regardless of which tax characterization is ultimately correct, if you receive royalties from copyright NFTs, those receipts are fully taxable under subsection 9(1) as your profit from a business or from an investment, as the case may be. If you receive the royalty payments in cash (i.e., fiat currency), you must include the full amount when calculating your taxable income in the year of receipt.
If you receive the royalty payments in cryptocurrency, you must include the fair-market value of the cryptocurrency when calculating your taxable income-specifically, the value, expressed in Canadian dollars, as of the time that you received the cryptocurrency. In addition, because you've reported the value of the cryptocurrency as taxable income, subsection 52(1) of the Income Tax Act allows you to increase the tax cost of that cryptocurrency accordingly. The increased tax cost prevents double tax when you ultimately dispose of the cryptocurrency. For example, you purchase a copyright NFT. As a result, you receive a royalty payment in the form of 2 units in XYZ cryptocurrency. At the time of receipt, the 2 units in XYZ cryptocurrency are worth $400.00. Under subsection 9(1) of Canada's Income Tax Act, you report the $400.00 as business income or as investment income (depending on the appropriate tax characterization). Under subsection 52(1), your tax cost for the 2 units in XYZ cryptocurrency is $400.00. The $400.00 tax cost will determine your taxable income upon disposing of the 2 units in XYZ cryptocurrency. That is, if you later sell those units for $7,000.00 (or trade them for other cryptocurrency units worth $7,000.00), your $400.00 tax cost means that you will realize $6,600.00 in profit, which you must report as income or capital gains. The specific tax treatment of this income will again turn on the appropriate tax characterization. Note that these cryptocurrency gains are separate and apart from any gain that you may make from selling the interest in the NFT itself.
Expenses incurred to earn business income or investment income are deductible under subsection 9(1). To create the non-fungible token, you must typically pay a "gas fee," which is a processing fee for the computing energy that goes into creating and validating the unique NFT on the blockchain. If you created a copyright NFT to earn business income or investment income, your gas fee qualifies as a deductible expense.
Canadian Income-Tax Characterization of Profits from Disposing of Blockchain Non-Fungible Tokens
We now turn to analyzing the tax characterization of a taxpayer's profit from disposing of the non-fungible tokens themselves. As mentioned above, income from the use of property can be characterized as investment income or business income, depending on the level of activity involved. When you dispose of a property, however, the Income Tax Act rules out the investment-income characterization. Thus, the resulting profit is either a capital gain or business income. So, when you turn a profit from selling blockchain non-fungible tokens, that profit must be reported and taxed as either business income or a capital gain.
The capital/income distinction turns on the taxpayer's intentions. The key question is whether the taxpayer acquired or created the blockchain NFT with the intention of flipping the non-fungible token for profit. If so, the profit constitutes business income. For example, a musician can sell an interest in the royalties to an upcoming song by creating and issuing copyright NFTs. Because the musician aimed to monetize the song, the musician's profit from creating and selling the copyright NFT will likely qualify as business income. Similarly, if you acquired that copyright NFT with the sole purpose of selling it for a profit shortly thereafter, your profit on the NFT sale will likely qualify as business income.
But if, by pointing to objective factors, the taxpayer can demonstrate the intent to invest (rather than to trade), the sale proceeds will be on capital account and taxed as a capital gain. For instance, you might justify capital treatment if you can demonstrate that, say, you purchased the copyright NFT because you wanted to reap the royalties and hold the copyright NFT as a long-term investment. You might also justify capital treatment if you acquired a non-fungible token to quench a personal interest in the digital-art or digital-music scene. On the other hand, if your NFT transactions resembled those of an art dealer or speculator, it might suggest that your profits from selling blockchain non-fungible tokens should be characterized as business income. Keep in mind that the Income Tax Act defines a "business" as including "an adventure or concern in the nature of trade." This means that even an isolated NFT sale can trigger business-income treatment for the resulting profits.
Canada's income-tax jurisprudence brims with case law analyzing the numerous factors that bear on the capital/income distinction. The case law is complex, fact-specific, and sometimes inconsistent. If anything, these decisions show that the required legal analysis demands advice from a top Canadian tax lawyer who has knowledge of cryptocurrency and of other blockchain-based assets, like non-fungible tokens.
Canadian Income-Tax Treatment of Profits from Disposing of Blockchain Non-Fungible Tokens
Canada's Income Tax Act sets out two entirely different tax regimes for business income, on the one hand, and for capital gains, on the other. If you trade NFTs and thereby earn business income, your non-fungible tokens constitute inventory, and your NFT-trading profits are fully taxable. Most marketplaces charge a gas fee for each NFT transaction. As mentioned above, a gas fee is a processing fee for the computing power it takes to validate NFT transactions on the blockchain. If you carry on an NFT-trading business, your transactional gas fees qualify as deductible business expenses.
If your non-fungible token qualifies as capital property because you acquired it for investment purposes, then you include only one-half of the gain when computing your taxable income for the year in which you disposed of that non-fungible token. In this case, gas fees on NFT purchases are capitalized and included in the adjusted cost base (ACB) of that non-fungible token. Gas fees on an NFT sale will offset the proceeds of disposition for that non-fungible token.
Pro Tax Tips: Legal Opinion on Proper Tax Reporting of Non-Fungible Tokens & Voluntary Disclosures Program for Unreported Income from Blockchain-Based Transactions
Canadian taxpayers engaging in NFT transactions and blockchain-based arrangements may benefit from a tax memorandum examining whether their royalties on copyright non-fungible tokens should be reported as investment income, as business income, or as a blend of both. And if they've traded any non-fungible tokens, they'll face a similar issue as to whether their profits should be reported as business income, as capital gains, or as a blend of the two. In addition, if the tax cost of your aggregate cryptocurrency and NFT holdings exceeds $100,000, you might be required to file a T1135 form. And although this article focuses on Canadian income-tax issues, you should be aware that non-fungible-token transactions might also give rise to GST/HST obligations. Fungible cryptocurrency, like Bitcoin, Ethereum, or Chainlink, arguably meet the definition of "money" in Canada's Excise Tax Act. Yet non-fungible tokens don't readily meet that definition of "money." So, while a cryptocurrency-trading business might constitute a supply of financial services, which is exempt from GST/HST, an NFT-trading business might qualify as a taxable supply. So, if an NFT-trading business generates over $30,000 in annual revenue, the business might be required to register for a GST/HST number with the CRA, charge GST/HST on sales, collect that GST/HST from clients, and pay it to the Canada Revenue Agency.
Our experienced Certified Specialist in Taxation Canadian tax lawyer as assisted numerous clients with issues concerning the proper characterization and reporting of cryptocurrency transactions and other blockchain-based transactions. If you've executed cryptocurrency transactions or transactions involving non-fungible tokens, contact one of our knowledgeable Canadian tax lawyers for tax guidance.
The advances and cooperative efforts of international tax authorities signal the end of the anonymity that cryptocurrency users thought they once enjoyed. This should definitely concern Canadian taxpayers with unreported profits from cryptocurrency transactions. And while blockchain non-fungible tokens are relatively novel, taxpayers engaging in any blockchain-based transactions, such as those involving NFTs, should be equally concerned. If you filed Canadian tax returns that omitted or underreported your cryptocurrency profits or your profits from non-fungible tokens, you risk facing not only civil monetary penalties, such as gross-negligence penalties, but also criminal liability for tax evasion. And if you failed to file T1135 forms for your NFT holdings, the standard late-filing penalty can be upwards of $2,500.00 per unfiled form, and the gross-negligence penalty can be upwards of $12,000.00 per unfiled form.
You may qualify for relief under the CRA's Voluntary Disclosures Program. If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). But your voluntary-disclosure application is time-sensitive. The CRA's Voluntary Disclosures Program will reject an application-therefore denying any relief-unless the application is "voluntary." This essentially means that the Voluntary Disclosures Program must receive your voluntary-disclosure application before the Canada Revenue Agency contacts you about the non-compliance you seek to disclose.
Our expert Certified Specialist in Taxation Canadian tax lawyer has assisted numerous Canadian taxpayers with unreported cryptocurrency and blockchain transactions. We can carefully plan and promptly prepare your voluntary-disclosure application. A properly prepared disclosure application not only increases the odds that the CRA will grant tax amnesty but also lays the groundwork for a judicial-review application to the Federal Court should the Canada Revenue Agency unfairly deny your voluntary-disclosure application. To determine whether you qualify for the Canada Revenue Agency's Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers.
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.