Introduction - Evolution of a Cryptocurrency Token: What Is a Blockchain Fork?
In 2017, the Bitcoin network underwent two hard forks. The first hard fork occurred in August 2017 and resulted in the creation of Bitcoin Cash (BCH). The second hard fork occurred in October 2017 and resulted in the creation of Bitcoin Gold (BTG). As a result of the two hard forks, Bitcoin owners received Bitcoin Cash units and Bitcoin Gold units that equalled the number of Bitcoin units that they owned at the time of the respective fork. Likewise, in 2016, after users exploited a security flaw in The DAO project's smart-contract software and made off with $50 million in Ether, the Ethereum network instituted a hard fork, thereby restoring the stolen funds. As a result, the Ethereum blockchain split into two branches, each with its own cryptocurrency: the original, unforked blockchain continued as Ethereum Classic, and the new blockchain remained as Ethereum.
So, what exactly is a blockchain fork? It basically refers to a change to the protocol underlying the cryptocurrency network. The underlying protocol of a cryptocurrency network establishes the rules governing how that cryptocurrency functions-e.g., transaction-processing speed. To alter the way that the cryptocurrency functions, you typically need to change the underlying protocol. Say, for example, that you wanted to improve transaction-processing speed (i.e., a function change). It will likely demand a protocol change such as, for instance, altering the amount of information contained in each block on the chain. These protocol changes are known as "forks."
Not every fork entails the creation of a new cryptocurrency token. Forks come in two main types: Hard forks and soft forks. A hard fork (also called a "chain split") alters the protocol code to create a new version of the blockchain alongside the old version, thereby creating a new token that operates under the rules of the amended protocol while the original token continues to operate under the existing protocol. A soft fork also updates the protocol, but no new coin is created; thus, the protocol change applies to all network users. The creation of Bitcoin Cash (BCH) and Bitcoin Gold (BTG), and the split between Ethereum and Ethereum Classic, all resulted from hard forks.
Hard forks invoke a number of Canadian income-tax issues. For example: If a Canadian taxpayer receives new cryptocurrency units because of a hard fork, does the receipt of those units constitute a tax-free windfall or taxable income? And if the receipt of a forked coin is a tax-free windfall, are your profits when you ultimately dispose of the forked coin tax-free as well? Or are they business income? Investment income? A capital gain? Or some combination of the three?
This article discusses some of the Canadian income-tax issues triggered by cryptocurrency hard forks. The article first gives a general overview of the Canadian tax rules about what constitutes a source of taxable income and how to distinguish one source from another. After reviewing the legal framework, this article analyzes the Canadian income-tax implications of receiving new cryptocurrency under a hard fork. It then analyzes the Canadian income-tax implications arising from the disposition of forked coins. This article concludes by providing pro tax tips from our top Canadian tax lawyers for Canadian taxpayers who trade or invest in cryptocurrency.
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 ultimately make up a person's taxable income. The corollary is that Canadian courts have invoked the "source" concept to exclude certain receipts from a taxpayer's income.
The notion of "income from a source" has proven influential to how Parliament drafted-and how courts interpret-the Income Tax Act. The basic idea is that a receipt constitutes income only if it comes from a productive source. Section 3 of the Income Tax Act codifies this idea by stating that only "income from a source" is included when calculating a taxpayer's income for the year. In Stewart v Canada (2002 SCC 46), the Supreme Court of Canada explained that "whether a taxpayer has a source of income is determined by considering whether the taxpayer intends to carry on the activity for profit, and whether there is evidence to support that intention."
Thus, an income source typically features one or more of the following characteristics:
- It produces a yield that recurs on a periodic basis;
- It requires organized effort, activity, or pursuit on the taxpayer's part;
- It involves a marketplace exchange;
- It gives the taxpayer an enforceable claim to receive payment; and
- It stems from the taxpayer's pursuit of profit (in the case of a source of business income or property income).
As a result, the tax-law concept of "income" excludes windfalls, such as amateur-gambling winnings. Amateur or casual gambling doesn't produce a source of income. Even for compulsive gamblers who continually try their luck at a game of chance-the lottery, for instance-the activity remains a personal endeavour, not a source of income (e.g., see: Leblanc v The Queen, 2006 TCC 680).
This isn't always true, however. Gambling winnings qualify as taxable business income in two types of cases. The first is when the gambling is an adjunct or incident of a business-e.g., a casino owner who gambles in his own casino or a horse owner who trains horses, races them, and bets on the races. The second case is when a person uses his or her own expertise to earn a livelihood from a gambling game in which skill is a significant component-e.g., a pool player who, in cold sobriety, habitually challenges inebriated pool players to a game of pool for money.
Distinguishing Sources of Income: Is it Business Income, Investment Income, or a Capital Gain?
Now, assuming that the activity constitutes a source of income, the next question is: Which source? Is it income from an office or employment? Income from business? Income from property? A capital gain?
This question is important because different tax rules apply to different sources of income. For example: While business income and investment income are each fully taxable, only one-half of a capital gain is included in taxable income. Business losses and investment losses are each fully deductible against any source of income. By contrast, 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.
We'll focus on distinguishing investment income (also called "income from property"), business income, and capital gains.
Investment income 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. An investment dealer, for instance, can purchase and actively manage a portfolio consisting of public shares, and a cryptocurrency trader actively seeks opportunities to purchase and flip cryptocurrency. The dealer operates an investment business, and the cryptocurrency trader operates a cryptocurrency-trading business. The revenues of each business constitute business income. Subsection 248(1) of Canada's Income Tax Act defines a "business" as including a "profession, calling, trade, or undertaking of any kind whatever." 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 pastime (Stewart v Canada, 2002 SCC 46).
Hence, the distinction between business income and investment income turns on the level of activity associated with generating the income. Although Canada's Income Tax Act refers to investment income as "income from property," the mere use of a property doesn't by itself guarantee that the income therefrom is investment income. It's the activity level that matters. For example, a taxpayer who actively manages a hotel and a taxpayer who leases a basement apartment both use a property, and they both receive payments for rent. Yet the hotel manager earns business income while the homeowner earns investment (rental) income.
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 that property's disposition. In other words, if you dispose of a property, the resulting profit doesn't qualify 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. Put another way: you start by determining the nature of the income, and then you characterize the property, not the other way around.
Notably, the capital/income determination is often unclear and requires guidance from an experienced Canadian tax lawyer. Over the years, Canadian tax courts have churned out an immense body of case law while 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;
- length of ownership;
- knowledge of the market;
- relationship or similarity to the taxpayer's employment or other business;
- time and energy expended on the endeavour;
- the use of financing; and
- the use of advertising.
Ultimately, the taxpayer's intention at the time of acquiring the property is the most important criterion that tax courts consider when determining whether the transaction produced a capital gain or business income. Specifically, the question is whether the taxpayer acquired the property with the intent to trade. To discern a taxpayer's intention, however, a court must review 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.
Canadian Income-Tax Implications of Receiving New Cryptocurrency under a Hard Fork: Tax-Free Windfall or Income from a Source?
The previous sections offer two key takeaways. First, a person's taxable income only includes "income from a source." This is why the winnings of an amateur gambler aren't taxed. Amateur or casual gambling doesn't produce a source of income because it's generally a personal endeavour that doesn't serve as a reliable means of generating profit. But if the gambling stems from another business or if the gambler earns a livelihood from a skill-based game, then the gambling qualifies as a source of income-and the taxpayer's winnings will be taxed as business income.
The second takeaay is that, depending on how a taxpayer uses it, a property can generate business income, investment income, or a capital gain. If the property itself generates income, that income may qualify as either business income or investment income. The appropriate tax characterization will depend on the level of activity associated with producing that income: an active venture suggests a business and thus business income; a passive undertaking implies an investment and thus investment income. If, on the other hand, the income stems from the disposition of the property, the resulting profit may qualify as business income or as a capital gain. In this case, the appropriate tax characterization depends on whether the taxpayer acquired the property with the intent to trade.
So, how do these takeaways bear on Canadian taxpayers who receive new cryptocurrency units as a result of a hard fork? Well, the first takeaway raises the question of whether the receipt of forked coins constitutes a source of income. The second takeaway bears on Canadian taxpayers for whom the receipt of forked coins absolutely constitutes a source of income. For them, the issue is how to properly report that income.
As mentioned above, a receipt is non-taxable unless it stems from a source of income. A source of income possesses one or more of the following characteristics: it produces a yield that recurs on a periodic basis; it requires organized effort, activity, or pursuit on the taxpayer's part; it involves a marketplace exchange; it gives the taxpayer an enforceable claim to receive payment; and, in the case of a source of business or investment income, it stems from the taxpayer's pursuit of profit.
It seems, then, that the receipt of forked coins doesn't constitute a source of income unless the recipient can alter the protocol underlying the cryptocurrency network and thereby institute a hard fork. Recall that a fork simply refers to a change to the protocol underlying the cryptocurrency network. A hard fork (or chain split) alters the protocol code to create a new version of the blockchain alongside the old version, thereby producing a new token that operates under the rules of the amended protocol while the original token continues to operate under the existing protocol. Most cryptocurrency users don't wield the power to alter the network protocols underlying the cryptocurrency that they own. As such, they have no say in whether a hard fork occurs.
Take, for instance, the two Bitcoin hard forks under which Bitcoin users received Bitcoin Cash (BCH) and Bitcoin Gold (BTG). The decision to institute the two hard forks rested with the developers of the Bitcoin protocol. Most Bitcoin owners therefore had no influence over the issuance of the two forked coins, and they received the Bitcoin Cash units or Bitcoin Gold units without any action on their part. They received the forked coins so long as their cryptocurrency wallets contained Bitcoin units at the relevant time. Moreover, the two Bitcoin hard forks didn't exhibit the characteristics of an income source for many of the taxpayers who received the forked BCH and BTG units. The forks didn't recur on a periodic basis; they required no organized effort, activity, or pursuit on the part of most taxpayers involved; they stemmed from an alteration to the Bitcoin protocol, not a marketplace exchange; and the recipients of the forked coins arguably had no enforceable claim to receive them because they provided no consideration for them. So, it's possible that, for many Canadian taxpayers who received Bitcoin Cash and Bitcoin Gold as a result of the hard forks, their receipt of these units was a tax-free windfall.
This tax treatment won't apply universally, however. For example, the receipt of forked coins likely constitutes taxable income for Canadian taxpayers who develop cryptocurrency platforms, initiate hard forks, and thereby reap new cryptocurrency units. Here, the hard fork certainly exhibits some characteristics of an income source for the cryptocurrency developer. For instance, it requires organized effort, activity, or pursuit on the part of the cryptocurrency developer. And, as something under the developer's control, the hard fork can conceivably recur on a periodic basis. So, a hard fork is very likely a source of-taxable-business income for Canadian cryptocurrency developers who receive forked coins by their own doing. The income-tax result is that the Canadian cryptocurrency developer must report the value of the forked coin as income for the year in which the developer received it.
Ultimately, Canadian taxpayers must understand that no single tax-law analysis will cover every case. The tax implications will turn on each taxpayer's specific set of facts. This means that Canadian taxpayers who trade cryptocurrency, who invest in cryptocurrency, or who develop cryptocurrency should learn their tax obligations by seeking tax guidance from an expert Canadian tax lawyer.
Canadian Income-Tax Implications when Disposing of Fork Coins: Business Income or Capital Gains?
The previous section demonstrates that the receipt of forked coins may or may not be taxable income. Yet while the receipt of forked coins might not be a source of income, the disposition of those coins is. So, even if the acquisition of a forked coin isn't a taxable event, the disposition of a forked coin always is. You must report the profit or loss resulting from the disposition. The only question is: How do you report that profit or loss?
Hence, we now turn to analyzing the income-tax characterization of a taxpayer's profit from disposing of the forked cryptocurrency tokens. 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. But when you dispose of a property, the Income Tax Act rules out the investment-income characterization. The resulting profit is either a capital gain or business income. So, when a taxpayer turns a profit from selling forked cryptocurrency 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 engaged in cryptocurrency transactions or participated in blockchain forks with the intention of flipping the cryptocurrency units for profit. If so, the profit constitutes business income. 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, a taxpayer might justify capital treatment if the taxpayer can demonstrate that, say, the taxpayer had no control over the cryptocurrency platform and didn't even expect to receive the forked cryptocurrency tokens-much less acquire them with an intent to flip them. On the other hand, a taxpayer's prior notice of a pending hard fork or a taxpayer's power to institute a hard fork might suggest that the taxpayer's profits from ultimately selling the forked tokens should be characterized as business income.
Canada's Income Tax Act sets out entirely different tax regimes for business income, on the one hand, and for capital gains, on the other. If your profits from cryptocurrency transactions qualify as business income, those profits are fully taxable. If, however, your profits from cryptocurrency transactions qualify as capital gains, then you include only one-half of the gain when computing your taxable income for the year in which you disposed of the cryptocurrency. In either case, the profit is calculated by subtracting your tax cost (e.g., adjusted cost base) from your proceeds of disposition. Your tax cost for a forked coin will depend on whether the receipt was itself a source of income. If the receipt of the forked coin was a tax-free windfall, you acquire the forked coin for a nil tax cost because you needn't report the value of the receipt as income. If the hard fork was a source of income, and you therefore reported the value of the forked coin as taxable income for the year of acquisition, then your tax cost for the forked coin equals the amount that you reported as income due to the receipt.
Over the years, the Tax Court of Canada, the Federal Court of Appeal, and the Supreme Court of Canada have produced a massive body of 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 cryptocurrency-competent Canadian tax lawyer.
Pro Tax Tips: Record-Keeping for Taxpayers Engaging in Cryptocurrency Transactions, Legal Opinion on Proper Cryptocurrency Tax Reporting & Voluntary Disclosures Program for Unreported Income from Cryptocurrency Transactions
A Canadian cryptocurrency investor or trader who lacks proper records will fare poorly if selected by a Canada Revenue Agency for a cryptocurrency tax audit (which the CRA now initiates on a regular basis). Taxpayers engaging in cryptocurrency transactions should keep records not only of their cryptocurrency contributions and transactions, but also of any new cryptocurrency tokens that they receive from blockchain hard forks or from air drops.
Taxpayers engaging in cryptocurrency transactions should periodically download and export their transaction information to avoid losing it. They should also maintain the following records about any cryptocurrency transactions:
- The date of each transaction;
- Any receipts for purchasing or transferring cryptocurrency;
- The value of the cryptocurrency in Canadian dollars at the time of the transaction;
- The digital-wallet records and cryptocurrency addresses;
- A description of the transaction and of the other party (e.g., the other party's cryptocurrency address);
- The exchange records;
- Legal terms and conditions of the arrangement;
- Records relating to any accounting and legal costs; and
- Records relating to any software costs for managing your cryptocurrency and tax affairs.
Our experienced Canadian tax lawyers can provide advice about record-keeping and proper reporting of your cryptocurrency profits to ensure that CRA doesn't fault you for misrepresenting the information in your tax returns and charge you with gross-negligence penalties-or, even worse, prosecute you for tax evasion.
Canadian taxpayers who trade cryptocurrency, who invest in cryptocurrency, or who have received cryptocurrency under blockchain hard forks will typically benefit from a tax memorandum examining whether their earnings constitute a source of income and, if so, whether those earnings should be reported as business income, as capital gains, or as a blend of the two. The peculiarity of cryptocurrency hard forks means that affected Canadian taxpayers will require competent and expert Canadian tax guidance on several unsettled issues. Our experienced Certified Specialist in Taxation Canadian tax lawyer has assisted numerous clients with issues concerning the proper characterization and reporting of their cryptocurrency transactions and other blockchain-based transactions.
The advances and cooperative efforts of international tax authorities signal the end of the anonymity that cryptocurrency users believed that they'd once enjoyed. This should definitely concern Canadian taxpayers with unreported profits from cryptocurrency transactions. If you filed Canadian tax returns that omitted or underreported your cryptocurrency profits, 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 cryptocurrency holdings, your non-fungible token holdings, or your holdings in other blockchain-based assets, 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 (VDP). If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). A VDP application is time-sensitive, however. 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 VDP application before the Canada Revenue Agency contacts you about the non-compliance you seek to disclose.
Our experienced 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 VDP application. A properly prepared voluntary-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 VDP 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 Canada Revenue Agency cannot compel the production of information protected by solicitor-client privilege. Solicitor-client privilege prevents the CRA from learning about the legal advice that you received from your tax lawyer. Your communications with an accountant, however, remain unprotected. So, if you seek tax advice but want to keep that information away from the Canada Revenue, you should first approach our Canadian tax lawyers. If you require an accountant, we can retain the accountant on your behalf and extend solicitor-client privilege.
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.