Introduction: Proof of Work (Mining) and Proof of Stake (Staking/Forging) for Blockchain Transaction Verification

A decentralized ledger system known as a “blockchain” is the foundation for all of the many cryptocurrency platforms, including USD Coin (USDC), Binance USD (BUSD), Cardano (ADA), Dogecoin (DOGE), and Polkadot (DOT). A blockchain is one specific kind of data structures. It uses “blocks,” or bundles of data, for both storing and transmitting information. These blocks are linked to one another in a digital “chain.” Through the use of technology, network participants may record and exchange data and transactions in a synchronized and decentralized manner. As a result, transactions between network users can be completed without a middleman or central authority.

Consensus procedures are used by blockchains to approve fresh cryptocurrency transactions. The proof-of-work system and the proof-of-stake system are the two consensus techniques that are utilized the most frequently.

The System of Proof-of-Work (Cryptocurrency Mining)

The verification procedure is referred to as “mining” in blockchain protocols that depend on the proof-of-work validation mechanism (such as the Bitcoin network). In a proof-of-work system, the validator, or cryptocurrency miner, uses computational power to solve mathematical puzzles. By doing this, the miner validates fresh cryptocurrency transactions and disseminates the findings to other network users by adding the validated transaction as a fresh block to the blockchain.

In proof-of-work systems, the mathematical issues are designed to make validation costly in terms of the electricity and processing power needed to solve them. A malevolent user may thus only successfully alter the blockchain if doing so costs them a lot of money. According to experts, more than 50% of the total computing power used by all miners must be used by a malevolent user in order to falsify the blockchain. The attacker needs at least 25% of the overall computing power to pose a danger to the network, even if the malevolent user is able to secure the support of other miners. Furthermore, the price of obtaining the necessary processing power to falsify blockchain transactions will rise correspondingly to the predicted increase in revenue from blockchain fraud. This effectively indicates that trying to falsify a blockchain under a proof-of-work system is not beneficial from an economic perspective.

Mining cryptocurrencies takes place in a competitive environment. The miner who validates the transaction initially receives credit for a reward. New tokens in the local cryptocurrency or transaction fees are frequently used as the mining incentive (or both). (Miners lose their mining incentives if they repeatedly attempt to verify blocks that the remaining network views as invalid, which serves as another deterrent to malicious users.)

Visit our article on cryptocurrency mining to learn more about the consequences of mining on Canadian income taxes.

The System of Proof-of-Stake (Cryptocurrency Staking)

The verification procedure is referred to as “staking” or “forging” in blockchain protocols (such as the Cardano network, the Solana network, and the Ethereum network) that depend on a proof-of-stake validation mechanism. According to their stake in the blockchain, users are given different levels of validation privileges under the proof-of-stake mechanism.

The “stakers” or “forgers,” also known as the validators, are required to own a particular minimum stake in the blockchain in order to take part in the validation process. Different proof-of-stake systems use distinct metrics to determine a validator’s stake in the blockchain. For instance, in some systems, the stake of a validator is determined by the amount of native cryptocurrency held by the validator. In some systems, the validator is required to provide adequate collateral in the form of the network’s native cryptocurrency, which is kept in escrow for a certain amount of time.

Therefore, the proof-of-stake system chooses validators who are likely to behave in good faith, in contrast to the proof-of-work method, which necessitates each miner to wield enormous computer power and endure hefty electricity expenses. Stakers often provide the necessary collateral or hold a sizable amount of the local cryptocurrency. The speaker is motivated to accurately confirm transactions in both scenarios. The system’s goal is to stop malevolent users from taking control of the validation process by making them invest a lot of money in the blockchain before they can conduct a successful attack.

Stakers of cryptocurrencies are paid in reward for confirming transactions on the blockchain, much as cryptocurrency miners in the proof-of-work method. The staking reward is similar to the mining reward in that it frequently consists of new tokens in the native cryptocurrency of the blockchain or transaction fees, or even both. To the contrary, a cryptocurrency staker can only receive a staking reward in relation to their prior holdings in the blockchain’s native token and in proportion to their share of the platform’s base. This is in contrast to a cryptocurrency miner, who can receive a mining reward regardless of having ever owned any of the blockchain’s native tokens.

Staking cryptocurrencies demonstrate features of both a service and an investment, so to speak. On the one hand, the cryptocurrency staker may be seen as performing a service by validating transactions. However, the cryptocurrency staker or forger cannot get staking incentives without first making a pre-requisite investment in the native tokens of the cryptocurrency platform. As a result, cryptocurrency staking raises a number of Canadian income-tax issues, and without the proper crypto-tax advice from an experienced cryptocurrency tax lawyer, Canadian crypto stakers and forgers will frequently find themselves uncertain about how to properly report their income to the Canada Revenue Agency.

This article intends to inform Canadian income-tax payers about some of the concerns related to cryptocurrency staking that are relevant to cryptocurrency stakers and forgers. For Canadian taxpayers with cryptocurrency wallets who trade or invest in cryptocurrencies, this article offers pro-tax advice from our leading Canadian cryptocurrency tax lawyers who specialize in cryptocurrency.

Receiving Reward Tokens from Cryptocurrency Staking and Forging: Canadian Income-Tax Consequences

The nature of the income dictates how it is taxed under the Income Tax Act of Canada. To put it another way, various income sources are subject to different income tax laws. For instance, business income and investment income are both fully taxed in Canada. However, only half of a capital gain is included in taxable income.

Therefore, we must first ask: What is the character of the money that you make when engaging in cryptocurrency staking and forging? in order to understand the Canadian income-tax consequences of cryptocurrency staking and forging. We must make a distinction between two ways to earn money from cryptocurrency staking and forging in order to respond to this query. The initial one is the staking incentive you get from the cryptocurrency platform for validating transactions on a blockchain that makes use of the proof-of-stake method. The second is any potential financial gain from exchanging or selling the reward tokens themselves.

Tax Characterization of Reward Tokens for Staking

Our skilled Canadian cryptocurrency tax lawyers begin by examining the reward tokens that a staker or forger receives for staking cryptocurrencies in order to ascertain the Canadian income-tax classification of cryptocurrency staking or forging. As was already said, cryptocurrency staking is similar to investing in that it requires a staker to have a significant stake in the native tokens of the cryptocurrency platform in order to collect rewards. In other respects, a cryptocurrency staker obtains the necessary number of tokens as part of their acquisition of a property, and as a result of owning that property, the staker earns money in the form of staking incentives from the cryptocurrency platform. Therefore, staking incentives that a cryptocurrency staker or forger obtains might conceivably be considered investment income (or “income from property,” as it is known under the Income Tax Act).

Yet not every situation will meet the investment-income description. The staker of a cryptocurrency may be seen as providing a service because they are validating transactions, as was previously stated. Furthermore, if a taxpayer utilizes cryptocurrency property to create revenue, the right tax characterization will still depend on the amount of effort involved in obtaining that money. Therefore, if you engage in cryptocurrency staking or forging and your particular operation demonstrates entrepreneurship, commercial risk, and the pursuit of profit, requiring a significant commitment of time, labor, and attention—for example, frequently researching cryptocurrency markets, pursuing a number of strategic cryptocurrency-platform targets, leveraging to fund your ventures, immediately selling or collateralizing reward—your staking rewards may qualify as business income.

In any case, the general tax treatment of company revenue and investment income is very similar. Therefore, regardless of which tax classification is eventually right if you get reward tokens through cryptocurrency staking or forging, such receipts are fully taxed under subsection 9(1) of the Income Tax Act as your profit from a company or an investment, as the case may be. As a result, you must consider the fair market value of the cryptocurrency you received as a staking reward when figuring up your taxable income. More specifically, you must consider the value of the cryptocurrency as of the moment you received it, expressed in Canadian dollars.

Furthermore, under subsection 52(1) of the Income Tax Act, you will increase the tax cost of the staking-reward cryptocurrency in accordance with the fact that you have declared the value of the cryptocurrency as taxable income. The higher tax rate eliminates paying two taxes on the cryptocurrency you earned as a staking reward when you eventually dispose of it.

Let’s consider an example where you verify transactions for a cryptocurrency platform that uses the proof-of-stake mechanism and stake a significant amount of the native cryptocurrency of the platform. You are rewarded with new 2 units of the platform’s cryptocurrency as a staking incentive for doing this. Those 2 units are worth $400 at the moment of their issue. You must record the $400 as business income or investment income in accordance with subsection 9(1) of the Income Tax Act of Canada (depending on the appropriate tax characterization). Your tax cost for the staking-reward units is $400 in accordance with subsection 52(1). Your taxable income will be determined by the $400 tax expense when you eventually sell the staking-reward units. For instance, your $400 tax expense means that you would generate a profit of $6,600, which you must declare as income or capital gains if you subsequently sell the staking-reward units for $7,000 (or exchange them for other cryptocurrency tokens for $7,000).

Once more, the proper tax categorization will determine the exact tax treatment of the revenue from the disposition. In particular, the profit made by selling a property is either a capital gain or an income from a corporation. As a result, any profits made from selling the staking-reward tokens by cryptocurrency stakers or forgers must be recorded and subject to taxation, either at 100% as business income or at 50% as a capital gain.

The distinction between capital and revenue depends on the goals of the cryptocurrency staker. The crucial inquiry is whether the taxpayer staked cryptocurrencies with the goal to sell the staking-reward tokens for a profit. In that case, the profit counts as business income. However, the sale profits will be placed on a capital account and subject to capital gain tax if the taxpayer can show some other intention by citing objective criteria, such as the desire to invest rather than to trade.

If a taxpayer can show that they were exclusively interested in cryptocurrency-staking agreements that offered reward tokens that gave them voting power over the platform’s protocols because they intended to control a cryptocurrency platform, for example, then they may be able to justify capital treatment. The taxpayer’s involvement in cryptocurrency staking itself, on the other hand, may show that they are rather sophisticated and have a lot of information about the industry. And this, together with a number of other elements, may indicate that the taxpayer’s gains from the sale of the staking-reward tokens should be classified as business income. It’s important to 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 the earnings from even a single cryptocurrency transaction might result in income tax treatment.

The ultimate lesson is that Canadian taxpayers need to be aware that no single study of the tax laws will address every situation. The consequences of income taxes depend on the unique combination of circumstances for each taxpayer. This implies that Canadian taxpayers who trade, invest in, develop, or stake in cryptocurrencies should all obtain tax advice from a knowledgeable Canadian crypto-tax lawyer to understand their tax responsibilities.

Pro Tax Advice: Voluntary Disclosures Program for Unreported Income from Cryptocurrency Transactions and Tax-Law Analysis on Appropriate Cryptocurrency Tax Reporting

Canadian taxpayers who engage in cryptocurrency trading, investing, and staking often benefit from a tax memorandum assessing whether their revenues should be declared as business income, as capital gains, or as a combination of the two. Canadian taxpayers who have staked cryptocurrencies will need skilled and specialized Canadian tax guidance due to the specific characteristics of various proof-of-stake systems. Our knowledgeable Canadian crypto tax lawyer who is a Certified Specialist in Taxation has helped a large number of customers record their cryptocurrency transactions and other blockchain-related agreements in the right way.

Canadian taxpayers who have unreported earnings from cryptocurrency transactions should be concerned about the innovations and collaborative efforts of international tax authorities. In the event that you submitted Canadian income tax returns that omitted or underreported your cryptocurrency revenues, you run the danger of being subject to both civil monetary penalties, such as gross negligence fines, as well as criminal tax evasion charges. Additionally, the standard late-filing penalty can be as high as $2,500 per unfiled form, and the T1135 gross-negligence penalty can be as high as $12,000 per unfiled form if you failed to file T1135 forms disclosing your holdings in cryptocurrencies, non-fungible tokens (NFTs), or other blockchain-based assets.

The Voluntary Disclosures Program (VDP) of the CRA may provide relief for both unreported income and incomplete T 1135 forms. The Canada Revenue Agency will discharge any criminal charges against you and waive gross negligence penalties if your VDP application is accepted (and may cancel or waive interest).

However, a VDP application has a time window. A request will be rebuffed by the CRA’s Voluntary Disclosures Program unless it is “voluntary,” in which case any remedy would be denied. This basically implies that the Canada Revenue Agency cannot approach you over any of the non-compliance you intend to reveal until after the Voluntary Disclosures Program has received your VDP application. See our article on the CRA Voluntary Disclosures Program for additional details on the requirements for receiving relief under the VDP.

Numerous Canadian taxpayers with unreported cryptocurrency revenues and blockchain transactions have got support from our skilled Canadian crypto-tax lawyers. In addition to preparing a VDP application that not only improves the likelihood 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 relief, we will also prepare a memorandum to analyze your cryptocurrency transactions in order to determine the best reporting methodology—that is, income or capital gains or both.

Make an appointment for a professional consultation with one of our experienced Canadian tax lawyers to find out if you are eligible for the Voluntary Disclosures Program of the Canada Revenue Agency. Information that is shielded by the solicitor-client privilege cannot be required to be produced by the Canada Revenue Agency. Because of the solicitor-client privilege, the CRA cannot find out about the private legal counsel you receive from our Canadian tax lawyers. Your communications with an accountant are not protected since there is no such privilege for accountants. As a result, you should first contact our Canadian tax lawyers if you need tax guidance but don’t want the Canada Revenue Agency to know about it. We can take steps to extend our solicitor-client privilege to discussions with the accountant if you also need their help.

Disclaimer: 

“Only general information is offered in this article. Only as of the publishing date is it current. It hasn’t been updated, therefore it could no longer be relevant. It cannot or ought not to be relied upon since it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should speak with a lawyer if you have particular legal inquiries.”