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Cryptocurrency Tax Pitfall for Canadian Emigrants: Exiting Canadian Tax Residence May Trigger Departure Tax on Your Cryptocurrency Portfolio

posted 2 weeks ago

Overview: Departure Tax for Canadian Emigrants Holding Cryptocurrency

When a taxpayer no longer maintains Canadian tax residence, paragraph 128.1(4)(b) of Canada’s Income Tax Act deems the taxpayer to have disposed of nearly all property, encompassing cryptocurrency, non-fungible tokens (NFTs), and other digital assets, at their fair market value. This deemed disposition can trigger a capital gain, commonly referred to as “departure tax.” Through departure tax, Canadian taxpayers are required to pay income tax on any gains accumulated from investments held during their residence in Canada. This encompasses gains from cryptocurrencies such as Ripple (XRP), Bittensor (Tao), Chainlink (LINK), Zcash (ZEC), Dash, Litecoin (LTC), Ethereum (ETH), Bitcoin Cash (BCH), and of course Bitcoin (BTC).

However, certain properties are exempt from the deemed disposition under Canada’s Income Tax Act. Notably, Canadian real property is excluded from the deemed disposition, making it exempt from departure tax. Another example of exempt property is inventory within a business conducted through a permanent establishment in Canada.

Hence, in the majority of situations, a Canadian emigrant with cryptocurrency holdings will be subject to departure tax on their cryptocurrency portfolio. However, if these cryptocurrency holdings are considered inventory within a cryptocurrency-trading business, these crypto assets might be exempt from the deemed disposition and the accompanying departure tax.

This article explores the conditions in which a Canadian emigrant’s cryptocurrency may meet the criteria for the departure-tax exemption.

This article begins by providing an overview of the concept of Canadian tax residence. It subsequently delves into the deemed-disposition rule outlined in paragraph 128.1(4)(b) of Canada’s Income Tax Act and the inventory exemption as per subparagraph 128.1(4)(b)(ii). The conclusion of this article offers valuable crypto tax tips from a leading Canadian crypto-tax lawyer for Canadian cryptocurrency traders and investors.

Understanding Canadian Tax Residence and Its Importance

Canadian tax residents are obligated to pay taxes on their global income according to Subsection 2(1) and Section 3 of Canada’s Income Tax Act.

Conversely, Subsection 2(3) of the Canadian Income Tax Act mandates that non-residents of Canada are liable for tax solely on income sourced within Canada. This specifically includes income derived from: (1) employment in Canada; (2) conducting a business in Canada; and (3) the sale of taxable Canadian property. Therefore, your classification as a Canadian resident for income tax purposes dictates the scope to which Canada can levy taxes on your income.

Canadian tax residents can be categorized into two groups: factual residents and deemed residents. Moreover, under Canada’s Income Tax Act, you may be deemed a non-resident if the provisions in a tax treaty stipulate that you are a tax resident of Canada’s treaty partner.

Common-law residence, often referred to as factual residence, derives its principles from judicial decisions within Canada’s common law. While the Income Tax Act in Canada employs the terms “resident” and “ordinarily resident,” it provides no explicit definitions for either. Consequently, the task of defining residence lies with Canadian courts, specifically the Tax Court of Canada, the Federal Court of Appeal, and the Supreme Court of Canada.

The Supreme Court of Canada has offered different definitions for a taxpayer’s residence, including “the place where in the settled routine of his life he regularly, normally or customarily lives” and “the degree to which a person in mind and fact settles into or maintains or centralizes his ordinary mode of living” (Thomson v Minister of National Revenue, [1946] SCR 209, at paras 50 and 71).

Moreover, courts promptly acknowledge that your specific circumstances dictate whether you qualify as a factual resident in Canada. When adjudicating an individual’s residence status, a court (and consequently, the Canada Revenue Agency) may scrutinize any of the following factors (and more):

  • Previous and current lifestyle patterns;
  • Consistency and duration of visits in the jurisdiction claiming residence;
  • Connections within that jurisdiction;
  • Connections elsewhere; or
  • The permanence or objectives of a stay abroad.

The necessary analysis, therefore, necessitates a thorough examination of the individual’s circumstances. This is also why the common-law test is referred to as “factual residence.”

A deemed resident is an individual identified as a Canadian tax resident according to Canada’s Income Tax Act. Paragraph 250(1)(a) of Canada’s Income Tax Act designates a person as a Canadian resident for the entire year if they “sojourned” in Canada for 183 days or more in a year. To sojourn means to visit. Therefore, unlike a factual resident, a sojourner is not required to have a “settled routine” or “customarily live” in Canada. In essence, if your physical presence in Canada exceeds half a year, even if you are not a factual resident, you will be classified as a Canadian tax resident.

In contrast, a deemed non-resident is an individual identified by Canada’s Income Tax Act as not being a tax resident of Canada. Canada has numerous bilateral tax conventions or agreements with other countries commonly known as tax treaties. These treaties include provisions aimed at preventing double taxation and addressing tax evasion. Notably, Canada’s tax treaties typically feature a tie-breaker clause resolving the question of a person’s country of tax residence when both countries’ domestic tax laws assert jurisdiction over the taxation of the person’s worldwide income based on domicile, residence, place of management, or similar criteria. To this effect, subsection 250(5) of Canada’s Income Tax Act designates a person as a non-resident of Canada if a tax treaty declares that the person is a tax resident of Canada’s treaty partner. Subsection 250(5) ensures alignment between Canada’s domestic cryptocurrency tax law and its tax treaties.

Deemed Disposition and Departure Tax: Exploring Paragraph 128.1(4)(b) in Canada’s Income Tax Act

Upon a taxpayer transitioning into a Canadian non-resident for tax purposes (distinct from becoming a non-resident for immigration-law purposes), paragraph 128.1(4)(b) of Canada’s Income Tax Act declares that the taxpayer is deemed to have disposed of specific types of properties at fair market value.

This deemed disposition will result in the emigrating taxpayer recognizing a taxable capital gain if, at the time the taxpayer ceases to be a Canadian tax resident, the fair market value of the specified property surpasses the taxpayer’s tax cost (or ACB) for that property.

In the majority of instances, this deemed-disposition rule will apply to cryptocurrencies like Chainlink (LINK), Zcash (ZEC), Bittensor (Tao), Ripple (XRP) Bitcoin Cash (BCH), Dash, Litecoin (LTC), Ethereum (ETH), and Bitcoin (BTC) and to NFTs (which will likely generate a loss which can offset gains . On Cryptocurrencies). Consequently, a Canadian emigrant with cryptocurrency holdings will generally be subject to departure tax on their cryptocurrency portfolio.

This departure tax essentially enables the Canada Revenue Agency to consider the specified property as if the taxpayer had sold it at fair market value upon departing Canada. The emigrating taxpayer is required to declare the departure tax on the Canadian income-tax return for the tax year in which the taxpayer ceased to be a Canadian tax resident.

Inventory Exemption: Subparagraph 128.1(4)(b)(ii) in Canada’s Income Tax Act Context

Certain properties are exempt from the deemed disposition that forms the basis of the departure tax under Canada’s Income Tax Act. One exempt category includes “property described in the inventory of a business carried on by the [emigrating] taxpayer through a ‘permanent establishment’ in Canada at the particular time.”

Hence, the cryptocurrency of an emigrating taxpayer may qualify for exemption from the deemed disposition (and consequently not be subject to departure tax) if the following two conditions are met:

  1. The cryptocurrency is categorized as business inventory (e.g., inventory in a cryptocurrency-trading business); and
  2. The emigrating taxpayer conducted that business through a “‘permanent establishment’ in Canada at the specific time.”

The subsequent two sections will individually analyze each condition.

Condition 1: Determining if Your Cryptocurrency is Considered Inventory – Trading versus Investing

For tax purposes, Canada’s Income Tax Act acknowledges only two general types of property:

  • capital property, resulting in a capital gain or loss upon disposition; and
  • inventory, factoring into the calculation of business income.

The classification of property as either capital property or inventory is contingent on the type of income it generates upon sale (capital gains or business income). In essence, one begins by establishing the nature of the income and subsequently categorizes the property accordingly, rather than the reverse. Therefore, the proceeds from a cryptocurrency transaction will be categorized as either (i) business income or (ii) a capital gain. If characterized as business income, the cryptocurrency units are considered inventory.

The income/capital differentiation carries additional significant tax consequences. The entire amount of business or property income is subject to taxation, whereas only half of a capital gain is taxable. Conversely, although only half of capital losses are deductible, losses and expenses linked to business or investment activity can be fully deducted.

Certain cryptocurrency transactions fall within the gray area between income and capital. Canadian courts have generated a substantial body of case law grappling with the uncertainty between investing, leading to a capital gain or loss, and trading, yielding business income or expenses. Courts consider various factors in determining whether to categorize a transaction’s gains or losses as pertaining to capital or income. When applied to cryptocurrency transactions, these factors may encompass:

  • frequency of transaction: A pattern of frequent buying and selling of cryptocurrency or rapid turnovers of cryptocurrency units may suggest a business;
  • duration of ownership: short periods of holding the cryptocurrency may indicate business dealings instead of capital investing;
  • familiarity with cryptocurrency markets: greater familiarity with or experience in cryptocurrency markets may favor a business characterization;
  • connection to the taxpayer’s other professional activities: if cryptocurrency transactions or similar dealings are integral to a taxpayer’s employment or other business, it tends to signify a business-related endeavor;
  • amount of time dedicated: a substantial commitment of time to studying cryptocurrency markets and investigating potential purchases may be more likely seen as a business endeavor;
  • financing: the use of leverage in cryptocurrency transactions may point toward a business context; and
  • advertising: if a taxpayer has advertised or publicly disclosed involvement in cryptocurrency, there is a higher probability of the activity being characterized as a business.

Ultimately, the primary criterion that courts consider when determining whether a cryptocurrency transaction resulted in a capital gain or business income is the taxpayer’s motive or intent at the time of acquisition. To discern this intent, courts focus on the objective factors surrounding both the purchase and the sale of the cryptocurrency. In essence, a taxpayer’s intention is determined by evaluating the factors mentioned above.

In summary, this multi-factored test not only establishes whether your cryptocurrency transactions generate business income but also determines whether your cryptocurrency units constitute inventory.

Condition 2: Are You Engaged in Business through a Canadian “Permanent Establishment” “at the Particular Time”?

Even if the cryptocurrency of the emigrating taxpayer is categorized as inventory in a cryptocurrency-trading business, departure tax will still be triggered unless the emigrating taxpayer operated that business through a “permanent establishment in Canada” “at the particular time”.

What Does it Signify to Possess a Permanent Establishment in Canada?

The definition of a Canadian “permanent establishment” for individuals is outlined in subsection 2600(2) of Canada’s Income Tax Regulations. Essentially, it pertains to a fixed place of business, such as a physical location, in Canada where the individual conducts his or her business. Consequently, the cryptocurrency of the emigrating taxpayer will be eligible for the inventory exemption only if the taxpayer operates the cryptocurrency-trading business through a physical location in Canada. This brick-and-mortar location will be recognized as a “permanent establishment” for Canadian income-tax purposes.

Additionally, the inventory exemption outlined in subparagraph 128.1(4)(b)(ii) includes a timing test. To be eligible for the exemption, the property must be associated with a business conducted through a Canadian permanent establishment “at the particular time.” The term “at a particular time” is defined in subsection 128.1(4) of Canada’s Income Tax Act, referring to the moment when the taxpayer ceases to be a resident.

Therefore, the inventory exemption is applicable only if the emigrating taxpayer maintains a Canadian permanent establishment (such as a brick-and-mortar location) at the moment when the taxpayer no longer qualifies as a Canadian tax resident. This situation might arise, for instance, if the emigrating taxpayer has employees or agents who carry on the cryptocurrency-trading operations from a fixed place of business in Canada.

Conversely, if the emigrating taxpayer is the sole individual managing the cryptocurrency-trading business, the taxpayer’s cryptocurrency is likely to be ineligible for the inventory exemption.

This is primarily due to the fact that most emigrating taxpayers, particularly those no longer classified as Canadian tax residents, typically do not retain a physical location in Canada at the time of their departure. Consequently, when they cease to be Canadian tax residents, they lack a permanent establishment in Canada. Therefore, even if we assume that the cryptocurrency qualifies as inventory in a cryptocurrency trading business, the inventory exemption would not be applicable because the cryptocurrency does not meet the timing test outlined in subparagraph 128.1(4)(b)(ii).

Tax Pro Tips: Tax Planning for Canadians Emigrating with Ownership of Cryptocurrency, NFTs, and Other Digital Assets

Upon the cessation of Canadian tax residency, paragraph 128.1(4)(b) of Canada’s Income Tax Act initiates a fair-market-value disposition of nearly all the taxpayer’s assets, encompassing cryptocurrency, non-fungible tokens (NFTs), and other digital assets. This departure tax has the potential to result in a substantial tax liability for Canadians who are emigrating and possess cryptocurrency, NFTs, and other digital assets.

However, departure tax on your cryptocurrency, NFTs, and digital assets can be avoided if these assets meet the criteria for inventory in a business that you still actively operated through a Canadian permanent establishment at the moment you ceased to be a Canadian tax resident.

As outlined in preceding sections, eligibility for this departure tax exemption necessitates (1) your cryptocurrency meeting the criteria for business inventory, (2) the business being conducted through a Canadian permanent establishment, and (3) the existence of the Canadian permanent establishment at the time of your transition from Canadian tax residency. To assess your qualification for this departure tax exemption, seek guidance from one of our experienced Canadian crypto-tax lawyers today.

Moreover, even if your cryptocurrency currently doesn’t qualify for a departure tax exemption, there might be opportunities to restructure your arrangements before departing Canada to minimize or eliminate departure tax on your cryptocurrency holdings. For instance, you could potentially meet the inventory exemption by hiring employees or agents who will continue the cryptocurrency-trading business from a designated place of business within Canada after your departure. However, in this scenario, your business income will remain subject to taxation in Canada. Therefore, careful consideration is required to weigh the tax savings from avoiding departure tax against the associated tax and compliance costs of continued operations within Canada.

Fortunately, Canadian cryptocurrency traders and investors have the opportunity to steer clear of tax planning pitfalls by consulting a Canadian crypto-tax lawyer early in the process. Our Certified Specialist in Taxation Canadian crypto-tax lawyer has provided valuable assistance to numerous Canadian cryptocurrency traders and investors in emigration tax planning, enabling them to minimize or eliminate departure tax associated with cryptocurrency, NFTs, and other digital assets. Connect with one of our knowledgeable Canadian crypto-tax lawyers today for expert guidance.

FAQs (Frequently Asked Questions)

What does the term “departure tax” refer to?

When an individual transitions to non-resident status for tax purposes in Canada, paragraph 128.1(4)(b) of the Income Tax Act triggers a deemed disposition of specific property at fair market value. This results in a taxable capital gain if the fair market value (at the time the taxpayer ceased to be a Canadian tax resident) surpasses the taxpayer’s tax cost (or ACB) for that property. Commonly referred to as “departure tax,” this tax liability allows the Canada Revenue Agency to treat the designated property as if the taxpayer had sold it at fair market value upon departing Canada. Reporting of the departure tax is mandatory on the Canadian income-tax return for the tax year in which the taxpayer ceases to be a Canadian tax resident.

Is departure tax applicable to cryptocurrency holdings?

In general, yes. In most instances, the departure tax is applicable to cryptocurrencies, including Chainlink (LINK), Zcash (ZEC), Bittensor (Tao), Ripple (XRP) Bitcoin Cash (BCH), Dash, Litecoin (LTC), Ethereum (ETH), and Bitcoin (BTC). Consequently, a Canadian emigrant with cryptocurrency holdings at the time of emigration will usually be subject to departure tax on their cryptocurrency portfolio.

Is it accurate that departure tax exemptions may apply to cryptocurrency, NFTs, and other digital assets in certain cases?

Yes. Canada’s Income Tax Act provides exemptions for specific properties, excluding them from the deemed disposition triggering departure tax. A notable category of exempt property encompasses assets detailed in the inventory of a business conducted by the emigrating taxpayer through a “permanent establishment” in Canada “at the particular time.”

Therefore, the cryptocurrency belonging to an emigrating taxpayer may qualify for exemption from the deemed disposition, and consequently, be spared from departure tax, if the following two conditions are met:

  1. The cryptocurrency must be categorized as business inventory, for instance, as inventory within a cryptocurrency-trading business; and
  2. The emigrating taxpayer must have conducted that business through a “permanent establishment” in Canada “at the particular time.”

To assess your eligibility for this departure-tax exemption, seek guidance from one of our experienced Canadian crypto-tax lawyers today.

What is the definition of having a “permanent establishment” in Canada?

The term “permanent establishment” for individuals is defined in subsection 2600(2) of Canada’s Income Tax Regulations. It primarily signifies a fixed place of business, typically a physical location like a brick-and-mortar establishment, within Canada where the individual conducts their business activities. For instance, if a non-resident cryptocurrency trader operates their cryptocurrency-trading business from a physical location in Canada, that specific location would be recognized as a “permanent establishment” for the purpose of Canadian income tax.

Can I reorganize my affairs to minimize or eliminate departure tax on my cryptocurrency holdings?

Certainly, you have the option to strategically reorganize your affairs prior to leaving Canada, potentially reducing or eliminating the departure tax that would typically apply to your cryptocurrency holdings. It is advisable to initiate the tax-planning process at the earliest opportunity by consulting with a knowledgeable Canadian crypto-tax lawyer. For instance, you might explore meeting the conditions of the inventory exemption outlined in subparagraph 128.1(4)(b)(ii) of Canada’s Income Tax Act. This could involve hiring employees or agents who will continue to operate the cryptocurrency-trading business from a fixed place of business within Canada after your departure. However, it’s important to note that your business income would still be subject to taxation in Canada. Consequently, you should carefully weigh the potential tax savings against the associated costs and compliance obligations of continued operations within Canada.

The positive news is that Canadian cryptocurrency traders and investors can benefit from the expertise of a Certified Specialist in Taxation Canadian crypto-tax lawyer to navigate the complexities of emigration tax planning. Our experienced professionals have successfully assisted numerous individuals in minimizing or avoiding departure tax related to cryptocurrency, NFTs, and other digital assets. Contact one of our skilled Canadian crypto-tax lawyers today for personalized guidance.

DISCLAIMER: This article offers general information and does not constitute legal advice. The content is current as of the publication date and will not be updated, potentially making it irrelevant by your reading date. It is not a replacement for legal advice. Tax situations are individualized, and the solutions outlined in this article may not apply to your specific case. For personalized legal guidance, it is recommended to consult with a Canadian tax lawyer for specific inquiries.

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