Canadian Income-Tax Implications Of Cryptocurrency Hard Forks – Canadian Tax Guidance From A Canadian Tax Lawyer – Tax

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:

  • Office;

  • Employment;

  • Business;

  • 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.