David Rotfleisch on Tax Planning to Reduce the Effects of the FTX Collapse

Global Investors Have Been Affected by Major Cryptocurrency Crashes

On Friday, November 11, 2022, the cryptocurrency derivatives exchange FTX Trading Ltd., a corporation that had previously been valued at over USD $32 billion, declared that it had applied for Chapter 11 bankruptcy protection in the United States. This signified the conclusion of FTX.

The collapse of FTX came just a week after Binance, FTX’s biggest rival in the cryptocurrency exchange market and an investor in FTX, announced that it would be selling a sizable portion of its holdings in the native cryptocurrency tokens of FTX, or FTT. This announcement led to widespread investor concern and speculative talk about the viability of FTX’s business model.

Concerns about FTX’s true solvency were raised as a result of FTX’s collapse, also known as the FTX crash, and a leaked balance sheet that revealed that Alameda Research, a quantitative cryptocurrency trading company linked to FTX and its CEO, Samuel Bankman-Fried, owned the majority of FTT in circulation. To the amazement of cryptocurrency investors worldwide, one of cryptocurrency’s most well-known public forces has entirely collapsed following an unsuccessful rescue by Binance.

Many cryptocurrency traders who had holdings on FTX have lost access to their funds as a result of FTX’s implosion. The FTX crash has significantly reduced investor trust throughout the entire cryptocurrency market, which has caused a significant decline in value across almost all cryptocurrency assets. And many Canadian cryptocurrency investors have witnessed a significant decline in the value of their holdings as a result of the FTX meltdown. When disposing of any assets, care must be taken for Canadian taxpayers who invested in cryptocurrencies and want to continue their trading or investment operations.

A prudent Canadian cryptocurrency trader should take this opportunity to learn from the FTX collapse and focus on recovering losses immediately in order to optimize any prospective tax savings in the future from the genuine disposal of their investment. The “stop-loss” provisions of the Canadian Income Tax Act, in particular the “superficial loss” provisions for individual taxpayers, are there to prevent just such a gain for Canadian taxpayers.

It’s essential to be aware of these regulations in order to keep your tax deductions for cryptocurrency losses and to figure out how you may still profit from market volatility like the ones that have occurred since FTX’s implosion. Speak with one of our knowledgeable cryptocurrency tax lawyers in Canada to better understand your filing situation and potential if you’re a Canadian investor in cryptocurrencies who wants to take lessons from the FTX crash and consider how to optimize your tax savings and plan for the future.

Under the Canadian Income Tax Act, Accrued Losses and “Superficial Loss” Rules

In order to stop Canadian taxpayers from experiencing “superficial losses” on their property, the Canadian Income Tax Act has a number of measures. These rules are intended to stop a Canadian taxpayer from forcibly realizing an incurred capital loss by selling a property, then buying it again right away to ‘crystallize’ the loss while holding onto the underlying assets. A “superficial loss,” according to Section 54 of the Canadian Income Tax Act, is a loss resulting from the sale of a specific capital asset in the following circumstances:

• The taxpayer, or an “affiliated” person (which includes relationships such as spouses, common-law partners, and controlled corporations but excludes parents and children), acquires a substituted property that is the same property or “identical” to the previously owned property during the period beginning 30 days before, and 30 days after, the disposition;
• and at the end of that 61-day period, the taxpayer, or affiliated person, owns or had a right to acquire the substituted property

A taxpayer’s loss from the sale of a property, to the extent that it is a superficial loss, is assumed to be zero under subparagraph 40(2)(g)(i) of the Canadian Income Tax Act. As a result, a taxpayer is unable to deduct that loss until the property has been disposed of with a final purpose. Additionally, the criteria remain the same when a taxpayer purchases a replaced property that is “similar.” For the purposes of section 54 of the Canadian Income Tax Act, which defines a superficial loss, the CRA has taken the stance that “properties which are the same in all substantial characteristics, so that a potential buyer would not prefer one as opposed to another,” are included as “similar” properties. Analyzing the preferences of Canadian taxpayers is a fact-driven process that depends on a wide range of information about their objectives.

In the context of certain companies, Subsection 18(14) offers a comparable superficial loss provision. If a Canadian taxpayer sells a piece of property that is included in the inventory of a company that is “an adventure or concern in the nature of trade.” Similar to section 54, subsection 18(14) is applicable when the taxpayer or an affiliated person acquires the same or an identical property during the 61-day period beginning 30 days before and 30 days after the disposition, and at the end of that 61-day period, the taxpayer or affiliated person owns or has the right to the substituted property. Additionally, much like with subparagraph 40(2)(g)(i), subsection 18(15) determines the loss on disposal to be zero in the event that it was just a superficial loss.

An adventure or concern in the nature of trade is included in the definition of “business” under subsection 248(1) of the Canadian Income Tax Act. As a result, whereas every adventure or concern in the nature of trade is inherently a business activity, the contrary is not always true. In general, a business exists if a Canadian taxpayer continuously engages in a trade or profession with the intention of making a profit. An “adventure or concern in the nature of trade ” usually refers to a single transaction or series of transactions in which a Canadian taxpayer buys a property with the goal of reselling it for a profit. Similarly, a highly fact-driven review will determine if a Canadian taxpayer is involved in a regular business, or an adventure or a concern in the nature of trade.

For the most part, regular income losses arising from business are not subject to the regulations for superficial losses. A taxpayer is thus not prevented from crystallizing a loss on the non-capital property in the absence of the application of these superficial loss rules or any other superficial loss rules that may apply under the Canadian Income Tax Act. A cryptocurrency trader functioning only as a trader may be able to sell and buy merchandise without violating the restrictions for superficial losses while crystallizing losses from that trader’s trading activity.  Whether this crystallization is possible will totally depend on whether a cryptocurrency trader’s actions are characterized as a business or an investment, in which case the cryptocurrency disposed of may be treated as a capital asset. In certain situations, the disposal will result in a superficial loss, which will be detrimental to the taxpayer. This may be the case if a Canadian taxpayer invests in cryptocurrency hedge funds and investment portfolios rather than actively trading cryptocurrency assets, or if the taxpayer holds cryptocurrency tokens as long-term investments.

Taxation on the Sale or Transfer of Cryptocurrency Tokens as a Capital Asset or a Business

The nature of the asset sold depends on the sort of income received, as per the Canadian Income Tax Act. Determining the sort of money received or loss incurred is therefore the first step in the analysis process. In addition to the CRA’s failure to offer any cogent guidance of its own on how to classify cryptocurrencies for Canadian tax reasons, no Canadian court has offered specific directions on the taxation of cryptocurrencies. To assess the characterization of a Canadian taxpayer’s cryptocurrency transactions, some fundamental advice is offered by the body of Canadian case law pertaining to the classification of business and investment income, as well as capital gains. Although the courts have not seen a single factor as being conclusive, the following considerations are significant in deciding whether a property transaction is being treated as capital or as a component of a business:

• The type of sold property.
• how long the taxpayer has owned the property.
• the quantity or regularity of additional transactions by the taxpayer that is comparable.
• the time spent working on or in relation to the property realized.
• The factors that led to the sale; and
• Most importantly for cryptocurrency owners, the taxpayer’s motivations for both purchasing the property and selling it.

Therefore, a number of factual factors pertaining to a Canadian taxpayer’s purchase and sale of a cryptocurrency token will affect how that transaction will be taxed. When determining whether the profits from the sale of your holdings will be taxed as capital gains or as business income, it is important to consider your reasons for trading in and engaging in various cryptocurrencies as well as your reasons for selling your holdings.

Pro Tax Tip: Avoid Getting Comfortable. Maintain Accurate Records and Obtain a Written Legal Opinion for Your Filing Position.

When confronted with the possible application of the superficial loss regulations under the Canadian Income Tax Act, a Canadian taxpayer should always take a cautious approach. This is particularly true if you take the stance that your losses were from a business and not the sale of capital assets. An economic loss has much more impact than a capital loss. While only half of the capital losses are tax deductible, losses and costs related to company or investment activity are completely deductible.

Therefore, the best defenses you have against a reassessment by CRA following a tax audit are caution and vigilance. Even while you may believe that your transactions classify your profits and losses as capital or business income, it’s always conceivable that the Canada Revenue Agency (CRA) and Canadian courts would have a different opinion, and disputing those views can be an expensive undertaking.

Therefore, it’s essential to keep proper records of your cryptocurrency trading activities to prevent the worst tax enforcement actions. You should always keep your own trading records and never rely on cryptocurrency exchanges to keep track of your transactions. In addition to other previous cryptocurrency exchanges like QuadrigaCX, the FTX catastrophe is the ideal illustration of what may go wrong if you don’t conduct your own due diligence. That is, you could be forced to work quickly to gather the proof you need to refute an unfair CRA audit or reassessment, and the onus will be on you to refute their presumptions.

Additionally, getting a tax memo on how to characterize your gains and losses from cryptocurrency disposal might be beneficial to you. In the event that you are ever subject to a CRA crypto tax audit over your cryptocurrency dispositions, obtaining a tax memorandum is a significant piece of evidence proving that you exercised due attention while calculating your right Canadian income tax filing position. Furthermore, there may still be ways to realize your losses if your cryptocurrency holdings may be considered capital assets. When two cryptocurrencies do not meet the criteria for similar qualities, the superficial loss rules may not apply if one cryptocurrency is sold and another is immediately acquired (like Bitcoin for Ethereum). Investors in cryptocurrencies now have a very potent possibility for tax planning using cryptocurrencies, although this analysis will be highly influenced by the investor’s specific facts and circumstances. Our knowledgeable Canadian cryptocurrency tax lawyers can offer more insightful guidance on how to keep your records and can offer you legally supported opinions on the correct reporting position for your cryptocurrency dispositions to guard against CRA overreach that would deny you valid business losses.

FAQs

Question: What Does FTX Mean In The Crypto World?

Answer: The Bahamas-based cryptocurrency exchange FTX specialized in derivatives and leveraged products. By enabling users to swap cryptocurrencies and NFTs, trade, and more, the FTX crypto exchange supported the liquidation and exchanges of coins and tokens. Additionally, it promoted collectibles trading. Other users from around the world could use this platform up until investigations started and the company filed for bankruptcy, which led to the FTX crash. US residents were not allowed to trade on its platform due to current cryptocurrency regulations, but other users from around the world were able to do so.

Question: FTX: What does it mean?

Answer: Another illustration of the ramifications of when cryptocurrencies fail is the cryptocurrency exchange firm known by its full name, Futures Exchange, or simply FTX. The company has recently undergone a collapse.

Question: How did the FTX Crash happen?

Answer: FTX Trading Ltd., the second-largest cryptocurrency derivatives exchange in the world at the time, filed for Chapter 11 bankruptcy in the US in November 2022. The abrupt liquidation of FTX’s native cryptocurrency token FTT by Binance, its main rival, served as the catalyst for the company’s downfall. Binance’s failed attempt to acquire FTX after it fell into a freefall also contributed to the demise of FTX. A significant decline in the value of cryptocurrency tokens was caused by the market crisis brought on by the FTX crash, which affected almost all cryptocurrency investors and portfolios.

Question: An explanation of “Superficial Loss”

Answer: In accordance with various provisions of the Income Tax Act, a “superficial loss” occurs when a Canadian taxpayer disposes of qualifying property and, within the period beginning 30 days before and 30 days after the disposition, the taxpayer or a person with whom they are affiliated acquires property that is “identical” or “the same” as the property that was disposed of. The extent to which the taxpayer’s loss from the disposition is judged superficial, it will be regarded to be zero if the taxpayer or a connected person still holds the property at the conclusion of the 61-day period. The Canadian Income Tax Act’s restrictions on superficial losses are intended to stop a Canadian taxpayer from artificially realizing an incurred loss for tax planning reasons, where

Question: To “Crystallize” My Tax Losses: What Does That Mean?

Answer: When the property is sold, a gain or loss on it is realized for tax purposes. In principle, a taxpayer may sell an item at a loss and then buy it back right away to assure access to the proceeds for tax planning. However, the Canadian Income Tax Act has a number of subtle provisions that aim to discourage improper tax planning by inducing “superficial losses”. To guarantee that these laws do not apply to you and disallow you those losses, any attempt to crystallize your losses should be reviewed and overseen by a knowledgeable Canadian tax lawyer.

In cases where your cryptocurrency holdings qualify as capital assets, a knowledgeable Canadian crypto tax lawyer can also assist in determining what tax planning opportunities are available to crystallize your losses. For example, you could exchange your cryptocurrency holdings for other cryptocurrencies that do not qualify as identical properties or plan the repurchase of the same cryptocurrencies after the superficial loss limitation period has expired.

Question: How Are Superficial Loss Rules Differently Applicable to Business Losses and Capital Losses from Cryptocurrency Transactions?

Answer: A Canadian taxpayer who owns cryptocurrency tokens as a long-term investment may get profits of disposal as a capital gain, or from a company, as an adventure, or as an adventure or concern in the nature of trade, which is instead an income transaction and not a capital gain. In certain situations, a Canadian taxpayer is prohibited from selling and buying cryptocurrency tokens again in order to crystallize cumulative losses by the superficial loss regulations of the Canadian Income Tax Act. What we may infer from the demise of FTX is that, if a Canadian taxpayer is involved in an active trading firm, the superficial loss rules may not apply to a sale and reacquisition, allowing the Canadian taxpayer to crystallize operational losses for tax planning reasons.

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