Do you own any cryptocurrencies? Have you ever purchased something with a cryptocurrency? The interesting thing is that it takes a rocket scientist – or computer scientist – to understand the technology behind these currencies. And if you don’t know any scientists, just speak to any 14-year-old for an explanation.
The only thing more complicated than the technology behind cryptocurrencies is the taxation of them. Today, I want to share a primer on the topic.
Cryptocurrency defined
A cryptocurrency is a digital representation of value. These currencies are not legal tender issued by any central bank, authority or government. A cryptocurrency is a digital asset that works as a medium of exchange for goods and services between parties who agree to use it. There are strong encryption techniques that are used to control how units of cryptocurrencies are created and to verify transactions. The technology, referred to as “blockchain," makes it nearly impossible to counterfeit or double-spend these currencies.
Transactions defined
When it comes to cryptocurrencies, you can have transactions that are acquisitions or dispositions of these currencies. Acquisitions typically include using government-issued currency (e.g. Canadian dollars) to purchase a cryptocurrency on a cryptocurrency exchange. You can also acquire a cryptocurrency by earning, or “mining," that currency. Mining is complicated, but basically involves using specialized computers to solve complicated mathematical problems that confirm, or validate, cryptocurrency transactions. Those who perform the mining processes are paid in the cryptocurrency that they’re validating as compensation for their efforts.
Dispositions of cryptocurrencies are important, because they could trigger a taxable event. Dispositions take place when you give, sell or otherwise transfer those currencies. Dispositions also take place when you convert a cryptocurrency to Canadian dollars (or another government-issued currency), or when you use the cryptocurrency to buy goods or services.
Tax rules defined
You could face tax on your cryptocurrency transactions. How so? If you’re into mining these currencies, you could face tax if it’s a business activity for you – as opposed to a hobby. If you want the taxman’s view of what constitutes a business, go to Canada Revenue Agency’s website (cra.gc.ca) and enter “what is a business?” in the search field. If your mining is considered a business by the taxman, then the value (expressed in Canadian dollars) of any cryptocurrency you receive could be taxable as business income.
When you dispose of a cryptocurrency (by giving, selling, transferring, converting or using the currency), any gain or profit you realize could be taxable as business income, or a capital gain. The taxman looks at well-established factors, that also apply to transactions in real estate or securities, when evaluating whether your cryptocurrency profits (or losses) should be taxed as business income (or losses) or capital gains (or losses). I won’t go into that criteria today, but you might want to visit the CRA’s website and search for publication IT-479R: Transactions in Securities, and particularly read paragraphs 9 to 32, which the CRA has said will apply to cryptocurrencies.
The examples
Consider these examples and how the taxman would generally tax each case.
Jack buys and sells cryptocurrencies. Jack closely follows the fluctuations in value of each currency and intends to profit from these changes in value. In 2019, he has sold $100,000 worth of cryptocurrencies that he purchased for $75,000. His net profit of $25,000 will be taxed as business income on his 2019 tax return since he’s actively trading the currencies – which is a commercial activity.
Wendy buys furniture with bitcoin. Wendy purchased one bitcoin at a cost of $1,000. The bitcoin rose in value to $5,000. She then found a dining room set for sale online, which she purchased from the vendor for one bitcoin. Using that bitcoin to make the purchase is a disposition of that bitcoin. Since she paid $1,000 for that bitcoin, and it was worth $5,000 at the time she used it, she’ll face tax on a $4,000 capital gain (half of which is taxable) which she’ll have to report on her personal tax return.
Grant trades one currency for another. This year, Grant bought 100 units of ethereum, which had a value of $20,000. He bought the ethereum using two bitcoins, which were trading at $10,000 a unit that day. The taxman will consider Grant to have disposed of his bitcoins. If Grant had purchased those bitcoins for, say $7,000 a unit, or $14,000 in total, then exchanging them for ethereum with a value of $20,000 causes him to realize a $6,000 profit. Grant will face tax on this profit as either a capital gain or business income, depending on the factors noted in IT-479R mentioned above.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
Tim Cestnick