Taxation of Cryptocurrency
Cryptocurrency is digital currency that uses encryption techniques, rather than a central bank, to generate, exchange, and transfer units of currency. Unlike cash transactions, no bank or government authority verifies the transfer of funds. Instead, these virtual transactions are recorded in a digitized public ledger called a “blockchain.” Individual units of the currency are called “coins.”
Introduced in 2009, Bitcoin was the first cryptocurrency and remains the most widely used. Other forms have grown tremendously in popularity since then, including Litecoin, Ethereum, and Ripple. While cryptocurrency exchanges have experienced booms and busts in the market, experts predict the use of cryptocurrency will continue to increase, making it imperative that CPAs are prepared to understand and educate their clients on the tax implications of these virtual transactions.
In US the IRS addressed the taxation of cryptocurrency transactions in Notice 2014-21, which provides that cryptocurrency is treated as property for federal tax purposes. Therefore, general tax principles that apply to property transactions must be applied to exchanges of cryptocurrencies as well. Notice 2014-21 holds that taxpayers must recognize gain or loss on the exchange of cryptocurrency for cash or for other property. Accordingly, gain or loss is recognized every time that cryptocurrency is sold or used to purchase goods or services. How the gain or loss is recognized depends largely on the type of transaction conducted and the length of time the position was held.
There is nothing explicit within the Income Tax Act (“ITA”) that says that Cryptocurrencies are taxable. The CRA does not view Cryptocurrencies as legal currency, but rather, as a commodity. As a commodity, the use of it as a medium of exchanges falls under the category of a barter transaction, and CRA discusses the tax implications in Interpretation Bulletin, IT-490 (Barter Transactions).
A barter transaction happens when one good or service is exchanged for another good or service without any money switching hands. For example, a car mechanic provides his repair services to an accountant, who in return agrees to prepare the mechanic’s financial statements and tax returns for the year.
It is a fundamental tax principle that in an arm’s length transaction, the value of what is given up is at least equal to the value of what is received in return, with all amounts translated into Canadian dollars.
CRA considers that barter transactions can be included in income under sections 3 and 9 of the ITA or can result in a disposition or acquisition of capital property, eligible capital property, personal-use property or inventory.
Where a vendor accepts Cryptocurrencies as payment for providing goods or services which are usually provided by him in the course of carrying on a business or profession, the fair market value of those goods or services (i.e. the price) , in Canadian dollars, is to be included in the vendor’s income.
The cost of the Cryptocurrencies received by the vendor is considered by CRA to be the same amount as the total value of the goods or services that were given up by the vendor, plus or minus any cash involved. In a non-arm’s length transaction, the cost of the Cryptocurrency or crypto coin received is restricted by Section 69 to their fair market value.
From the standpoint of the purchaser, where the Cryptocurrencies given by the purchaser originated from a business or profession, the purchaser is considered to have received income or proceeds of disposition equal to the fair market value of the Cryptocurrency, expressed in Canadian dollars. Any gain or loss on disposition would need to be calculated at that time either on account of income (100% taxed) or capital (50% taxed). This is determined from the facts and circumstances of the taxpayer’s situation. Similarly, the cost of the services, goods or property received by the purchaser is the same amount as the Cryptocurrency given up, plus or minus any cash involved. In non-arm’s length transactions, the cost of the services, goods or property received would be restricted by section 69 to their fair market value.
When it is difficult to determine a value for the goods or services given up, the CRA will allow the value of the goods or services received to be the price at which the transaction took place as long as the parties were dealing at arm’s length. For example, if the purchaser above was not able to determine the value of the Cryptocurrency given up, the value of the services, goods or property received could be used to value the transaction for tax purposes. With the current technology available, it is easier to value the Cryptocurrency in Canadian dollars. Going forward, we may see the Cryptocurrency value being used more often for valuing the transaction.
In a 2013 technical interpretation (2013-051470117), the CRA outlined its position when a taxable supply is made. Basically, when a business sells goods or services for Cryptocurrencies and the sale is subject to GST/HST, the business must collect GST/HST on the fair market value of the Cryptocurrencies at the time of the sale. Initial coin offerings (ICO) would likely fall under this rule, particularly when they are issued in exchange for other cryptocurrencies.
It is interesting that CRA’s position on the treatment of GST/HST is contrary to its position regarding the treatment of cryptocurrency as a “barter transaction” for income tax purposes.
Investors can earn cryptocurrency by using computers to solve a complex mathematical puzzle. As a reward for solving the puzzle, they receive newly “minted” coins. Notice 2014-21 states that when a taxpayer successfully mines a cryptocurrency, the fair market value of the coins mined is includible in gross income. Furthermore, an individual whose mining operations constitute a trade or business is subject to self-employment tax on the income derived from those activities.
The amount of this income equals the market price of the coins on the day they were awarded on the blockchain. This amount also becomes the miner’s basis in the coins going forward and is used to calculate future gains and losses.
An investor mines one Bitcoin in 2013. On the day it was mined, the market price of Bitcoin was $1,000. The investor has $1,000 of taxable income in 2013. Going forward, the basis in that Bitcoin is $1,000. If the investor later sells it for $1,200, there is a taxable gain of $200 ($1,200 − $1,000).
It is a question of fact as to whether the Cryptocurrencies are held as capital property or inventory.
If the miner is instead viewed as acquiring a capital property, then his adjusted cost base would be the market value of bitcoin at the time he was rewarded with the Cryptocurrency token for his services. The adjusted cost base would also include the cost of electricity used to run his computers. The miner would incur a capital gain or loss when he sells the Cryptocurrency, depending on its market value at that time.
CRA does not provide any clear guidance on whether mining activities are subject to GST/HST. If mining is considered to be a taxable supply of services to the entire network, it would be difficult (if not impossible) to identify any particular recipient of the service provided by the miner in order for the miner to collect GST/HST. While in theory GST/HST should be charged, it is difficult to see how this will work in practice.
Instead of selling the cryptocurrency and donating the after-tax proceeds, a taxpayer can donate it directly to a charity. This approach provides significant benefits: the tax deduction will be equal to the fair market value of the donated coins (as determined by a qualified appraisal), and the donor will not pay tax on the gain. This also results in a larger donation because, instead of paying capital gains taxes, the charity will receive the full value of the donation. For this strategy to work, the coins must have been held for longer than one year. For example, Fidelity Charitable, a donor-advised fund, reported receiving over $69 million in cryptocurrency contributions in 2017.
In US the IRS’s guidance clarifies various aspects of the tax treatment of cryptocurrency transactions, but many questions remain unanswered, such as how cryptocurrencies should be treated for international tax reporting [e.g., Report of Foreign Bank and Financial Accounts (FBAR) & Foreign Accounts and Tax Compliance Act (FATCA) reporting] and whether cryptocurrency trades prior to 2018 are subject to the like-kind exchange rules.
Cryptocurrency appears to be here for the long term, and thus the scrutiny surrounding its reporting will continue to intensify. It behooves CPAs—especially those whose clients maintain positions in one or more cryptocurrencies—to keep abreast of the evolving regulatory picture surrounding this new kind of asset.