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David Rotfleisch: Everything You Need to Know About Bitcoin & Taxes

posted 3 years ago

The digital currency Bitcoin is currently under a white-hot spotlight after it plummeted on the market and lost more than half of its value this year. A crash like this attracts a lot of attention from the media and investors alike, but Bitcoin is an interesting commodity from a legal standpoint.

As a peer-to-peer digital currency, Bitcoin isn’t backed by gold or the USD like most assets on the Street. Instead, it relies on powerful computation processes to generate and maintain digital units outside a central bank. As a result, Bitcoin exists within a decentralized financial world that can complicate your tax filings and obligations.

These challenges are exacerbated by how the world treats crypto.

El Salvador is the first country to accept Bitcoin as its national legal currency, with Panama and Cuba making noises they’ll follow suit soon. China and Egypt, on the other hand, have cracked down on the industry and banned all cryptocurrency-based transactions.

Canada, like most countries, falls somewhere in the middle — cryptocurrencies are perfectly legal to use, but they are not considered legal tender. And while other countries may share Canada’s stance on crypto, few countries treat Bitcoins the same way when it comes to income taxation.

Navigating crypto tax in Canada isn’t easy, but an experienced Canadian tax lawyer can help.

What is Bitcoin?

Bitcoin is a cryptocurrency first created by an anonymous computer programmer in 2009. Since then, it has become the biggest cryptocurrency in the world, topping Litecoin, Dogecoin, and Ethereum in value.

All cryptocurrencies rely on a revolutionary data structure called blockchain. Blockchain uses highly complicated encryption methods to store and transmit data in packages called “blocks” that are connected to each other in a digital “chain”.

Blockchain comes with several advantages. For one thing, this technology allows transactions to be shared across network participants without needing a third party like a bank to verify. For another, crypto data is immutable, making it impossible to duplicate or tamper with.

Blockchain also allows for anonymous exchanges, which flag Bitcoin and other cryptocurrencies for income tax and other authorities around the world. That’s because this anonymity increases the potential for money laundering and other illegal activities.

Bitcoin is a Volatile Asset

Unlike traditional forms of currency like the Canadian dollar, Bitcoin is a volatile fund. It can rise and fall as much as 10% of its worth from one day to the next in response to supply and demand, media coverage, and market sentiment.

Today, market sentiment is staunchly bearish, and in a bear market, nothing is safe — not even decentralized cryptocurrencies. The bear’s paw swipes viciously downward, and Bitcoin is only the latest asset caught in its claws.

While no stranger to the news, Bitcoin made its most recent splash across international headlines as it lost 58% of its value in the second quarter of 2022. Its plummet heralds what experts call a “crypto winter,” in which traders can expect Bitcoin to perform poorly for the remainder of the year. This freeze is expected to ice out other cryptocurrencies, including Litecoin, Dogecoin, and Ethereum.

Bitcoin has lost more than half its value before, once in 2011 and again in 2013. And while there’s no guarantee Bitcoin will make up what it lost this year, a crash — and a bear market, for that matter — can’t last forever. Bear markets can be shocking, but they’re an expected and inevitable ebb of the economy.

How Does One Acquire Bitcoin?

Despite its volatility, many traders are interested in acquiring cryptocurrencies. You can obtain Bitcoin in the following three ways:

  1. As a consideration in exchange for services
  2. Buying them online through a Bitcoin exchange
  3. Mining

Unlike the first two items on the above list, mining is a complicated process using advanced algorithms to uncover new coins based on the architecture of the currency. And like ore in the Earth, there’s a finite number of coins available for miners to discover. Once all the coins have been mined, no further units are available.

Mining brings new coins into circulation, so miners are rewarded for their work with Bitcoin. While this may incentivize some to invest time into mining, it may have implications for taxation.

Mining should never be confused with staking. The process of staking crypto locks your portion of cryptocurrency as a way to contribute to the blockchain network and confirm transactions. And just like mining, stakers may receive rewards for their service, earning passive income on their crypto.

Why does it matter how you acquired your Bitcoins? With the uncertainty surrounding the taxation of Bitcoin in Canada, how you acquire crypto may impact your tax consequences.

Bitcoin Taxation in Canada: How Does the Canada Revenue Agency (CRA) Rule?

The CRA has yet to address Bitcoin tax in any of its Information Circulars or Interpretation Bulletins.

That said, the Income Tax Rulings Directorate issued comments on goods and services exchanges involving Bitcoins in response to a recent medical enquiry about the tax treatment of Bitcoin.

In March 2014, the CRA outlined its position regarding Bitcoin taxation in Canada in an Income Tax Rulings and Technical Interpretation. Find the CRA’s guidance on Bitcoin activities below:

1. Paying for Something with Bitcoins

If a Canadian taxpayer pays for a product using Bitcoins, the CRA will consider this a barter transaction.

What does it mean to barter from a taxation perspective? If a taxpayer pays for goods or services using Bitcoins, they must note the fair market value of the goods or services they receive into their income when filing their tax return. In other words, the full value of the goods or services in question are accounted for in the taxpayer’s income.

Since Bitcoin is not an official currency in Canada, the value of the product in CAD is used for tax purposes rather than the value in Bitcoin.

So for example, let’s say a taxpayer buys something from a store for $100 when the store owner purchased it for 1 Bitcoin. The store owner will use the $100 when determining their income, not the 1 Bitcoin.

2. Disposing of Bitcoins

If a Canadian taxpayer disposes of Bitcoins, they will be taxed in one of two ways:

  1. As income from a business source
  2. As capital gains from the disposition of property

This distinction is important to note, as business income gets taxed at 100% while capital gains are taxed at 50%.

The CRA will refer to Stewart v the Queen, 2002 SCC 46 when determining whether a taxpayer’s Bitcoin activities should apply to income or capital accounts. In particular, Stewart v the Queen helps the CRA determine if such activities commercial enough in nature.

Why does this matter? Different taxation rules apply to speculation — or the buying and selling of Bitcoin with the intention of making a profit — than with Bitcoin used as currency in a barter transaction.

As a general rule, Bitcoin is like any other piece of property — a capital gain will arise if you dispose of Bitcoins for a price higher than what you paid. And as a capital gain, one-half of this gain will be included in your taxable income.

However, speculating in Bitcoin frequently throughout the taxation year can complicate your tax filings. Taxpayers may receive a notice of a CRA cryptocurrency audit if they repeatedly purchase and sell Bitcoin for profit.

The CRA may also assess taxpayers as being in the business of speculating. This means they will include all profits in the taxpayer’s income as business income rather than capital gain.

What Are the Tax Implications for Bitcoins Held Outside of Canada?

According to a Technical Interpretation issued in April 2015, Bitcoins held abroad are considered “specified foreign property,” provided they are not used exclusively in carrying on an active business.

In this scenario, Canadians must report the value of the Bitcoins in a T1135 Statement to the CRA if the total cost of all specified foreign property exceeds $100,000. This may play out in one of two ways:

  1. A resident taxpayer may already have T1135 filing obligations, in which case they must disclose any Bitcoins they own.
  2. A taxpayer must disclose the value of their Bitcoins in a T1135 filing if they acquire more than $100,000 worth of Bitcoins.

A T1135 Statement may also be necessary when dealing with a foreign partnership. Bitcoins may be “specified foreign property” if non-resident shares of income or loss of the property equal to more than 90% of the total income or loss of the partnership.

The resident must report the value of Bitcoins in a T1135 Statement, provided that the following is true:

  • The Bitcoins are held outside of Canada,
  • They’re not used exclusively for carrying on an active business; and
  • If a Canadian resident has an interest in the specified foreign partnership for tax purposes.

Bitcoin Taxation is Unclear in Canada: Contact a Canadian Tax Lawyer for Advice

Bitcoin taxation in Canada is a challenging subject. Despite the rules outlined above, you may have questions about how taxation works.

  • Should you be taxed on the Bitcoins when they are first mined, or should you defer the income until you can exchange them for CAD?
  • How do foreign currency transactions apply to cryptocurrency?

Without knowing the answers, you can easily fail your reporting obligations. To avoid significant tax consequences, speak to an experienced Canadian tax lawyer. In addition to offering a T1135 guide for cryptocurrency claims, these professionals can expertly answer any questions you may have about reporting crypto assets. More importantly, they can make sure you only pay the taxes that you owe, and not a cent more.

Image Credit: André François McKenzi via Unsplash

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