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Cryptic on Cryptocurrency: David Rotfleisch on CRA’s “Crypto Tax Tips” for Miners Lacking in Clarity

posted 8 months ago

CRA’s Tax Tips on Mining Cryptocurrency: An Introduction

The Canada Revenue Agency’s Media Room issued crypto tax tips regarding cryptocurrency mining on March 13, 2023. However, the CRA’s brief media release was conspicuously lacking in comprehensive information and offered only a handful of minimally useful tax suggestions for Canadian individuals involved in cryptocurrency mining.

This article commences by exploring the distinctions between cryptocurrency mining, cryptocurrency staking, and cryptocurrency liquidity mining. It subsequently delves into various Canadian tax implications concerning cryptocurrency mining, which were overlooked in the CRA’s media release. To provide comprehensive guidance, it concludes by presenting valuable tax tips from our expert Canadian crypto-tax lawyers.

Understanding Cryptocurrency Mining, Staking, and Liquidity Mining

Distinguishing between cryptocurrency mining, cryptocurrency staking, and cryptocurrency liquidity mining can be beneficial. Both cryptocurrency mining and cryptocurrency staking involve transaction verification processes, albeit with different mechanisms. On the other hand, liquidity mining is conceptually distinct from both mining and staking, despite its name and seemingly similar setup, which often leads to confusion among users.

Cryptocurrency mining

Cryptocurrency mining is a crucial verification process utilized by blockchain protocols that operate on the proof-of-work system. In order to maintain decentralization, blockchain networks depend on consensus mechanisms to validate new cryptocurrency transactions. The most commonly used mechanisms are the proof-of-work system and the proof-of-stake system. For example, the Bitcoin blockchain currently relies on the proof-of-work system. In this process, cryptocurrency miners dedicate computing power to solve complex mathematical problems. By doing so, they validate new transactions and share the results with other network participants, recording the verified transactions as new blocks on the blockchain. The mathematical complexity of proof-of-work systems is designed to make falsification highly expensive and impractical. To tamper with the blockchain, a malicious user would need to control over half of the total computational power deployed by all miners. From an economic perspective, attempting to falsify a blockchain under the proof-of-work system would be unprofitable due to the immense computational resources required. This characteristic reinforces the security and integrity of the blockchain network.

Cryptocurrency mining operates on a competitive basis, where miners race to be the first to validate transactions. The successful miner is rewarded for his or her efforts, typically receiving new tokens in the native cryptocurrency or a combination of transaction fees and new tokens. To discourage malicious behavior, miners risk losing their rewards if they persistently attempt to validate blocks that the rest of the network deems invalid.

Cryptocurrency staking

Cryptocurrency staking serves as the verification process for blockchain protocols utilizing the proof-of-stake system. For instance, the Ethereum blockchain adopts the proof-of-stake mechanism. To participate as validators in the validation process, individuals, known as cryptocurrency stakers, are required to hold a minimum stake in the blockchain. Different proof-of-stake systems employ varying criteria for measuring a validator’s stake. In some systems, a validator’s stake is determined by the quantity of native cryptocurrency he or she possesses. In contrast, other systems necessitate the validator to deposit a specified amount of the network’s native cryptocurrency, held in escrow for a predetermined period. Unlike the proof-of-work system that demands substantial computing power and high electricity costs from crypto miners, the proof-of-stake system selects validators based on their likelihood to act in good faith. Cryptocurrency stakers typically possess a substantial amount of the native cryptocurrency or provide the required collateral. In either case, the crypto staker has a strong incentive to honestly validate transactions. This system’s goal is to prevent malicious users from controlling the validation process by requiring them to make substantial investments in the blockchain before gaining the ability to launch any effective attack.

Similar to cryptocurrency miners in the proof-of-work system, cryptocurrency stakers also receive rewards for verifying transactions on the blockchain. These staking rewards usually comprise new tokens in the blockchain’s native cryptocurrency, transaction fees, or a combination of both. However, there is a fundamental difference between a crypto miner and a cryptocurrency staker when it comes to receiving rewards. A crypto miner can receive a mining reward without having any prior ownership of the blockchain’s native tokens. In contrast, a cryptocurrency staker is eligible for a staking reward only if such has a vested interest in the blockchain’s native tokens. This requirement ensures that stakers actively participate and have a genuine stake in the success and security of the blockchain network. 

In contrast to cryptocurrency mining (the verification process in the proof-of-work system) and cryptocurrency staking (the verification process in the proof-of-stake system), cryptocurrency liquidity mining operates independently from verifying transactions on the blockchain network. Instead, it primarily involves activities within the realm of decentralized finance (DeFi) loans or investments. Crypto liquidity mining, also known as “yield farming,” revolves around investors lending or contributing capital to a cryptocurrency platform, often a startup seeking capital infusion. In return for their participation, investors receive various benefits such as interest payments, a share of the cryptocurrency platform’s transaction fees, or a specialized token granting them the right to redeem that token for a specific number of cryptocurrency units, or a combination of these rewards.

Simplifying the Complexities: Implications of Canadian Income-Tax to Cryptocurrency Mining

The media release from the Canada Revenue Agency regarding Canadian crypto tax on crypto mining is highly simplistic, to the extent that it barely addresses the actual income-tax implications:

Mining cryptocurrency can have significant tax implications. The income tax treatment varies based on whether your mining activities are considered a personal hobby or a business activity. Determining this classification is done on a case-by-case basis.

Typically, business activities exhibit regularity or involve repetitive processes over time. However, in certain instances, even a single transaction can be regarded as a business activity.

If you are in the process of setting up or preparing to start a business, like cryptocurrency mining, you might not be officially considered as having commenced your business yet. Generally, to be recognized as a business, you must engage in substantial activities that contribute to your income-earning process. However, if you are already operating cryptocurrency mining as a business, you are required to pay taxes on the business income generated from the mining of cryptocurrency and any capital gains resulting from the sale of the validated cryptocurrency.

Indeed, cryptocurrency mining can be categorized in at least three different ways, each carrying its own specific Canadian tax implications. Furthermore, it’s essential to recognize that mining itself and the subsequent disposition of the mined cryptocurrency are distinct activities, each subject to different Canadian tax regulations.  The complexities of an individual situation should be discussed with a top Canadian crypto tax lawyer.

For instance, a taxpayer may engage in cryptocurrency mining purely as a hobby or personal pursuit, without any commercial intent. However, it is worth noting that hobby mining has become less common nowadays due to the significant costs involved. As a result, hobby mining itself does not generate income. Consequently, when a hobbyist miner obtains cryptocurrency through mining, he or she is not required to report the value of the mined crypto units as income. Instead, the income inclusion or loss realization occurs when the taxpayer decides to sell or dispose of the mined crypto units. The disposition of these mined crypto units results in a capital gain or capital loss, as the hobbyist miner did not acquire the units with the intention to trade them actively.

Another perspective treats cryptocurrency mining as analogous to acquiring inventory, specifically inventory in a cryptocurrency-trading business. According to this view, crypto mining is not the primary source of income for the taxpayer but rather a part of that taxpayer’s income-generating activities. The taxpayer’s actual source of income stems from selling and trading the cryptocurrency units acquired through mining. Just as a gold miner doesn’t recognize income upon discovering gold deposits, a cryptocurrency trader need not recognize income when obtaining cryptocurrency through mining. Instead, the income inclusion or loss realization occurs when the individual decides to sell or dispose of the mined crypto units. However, unlike the hobbyist crypto miner who reports the resulting gain or loss on a capital account, a commercial cryptocurrency miner is required to report the resulting gain or loss on an income account, categorizing it as business income or a business loss. 

Another perspective considers cryptocurrency mining as a service provision. Through cryptocurrency mining, the taxpayer utilizes computing power to validate blockchain transactions, effectively providing a collective service to users. As compensation for this service, the cryptocurrency miner receives mining rewards. In this scenario, cryptocurrency mining becomes a source of income for the miner. Consequently, when the cryptocurrency miner receives mining rewards, these receipts are fully taxable as business income under subsection 9(1) of Canada’s Income Tax Act. For calculating taxable income, the Canadian cryptocurrency miner must include the fair-market value of the cryptocurrency received as a mining reward, expressed in Canadian dollars at the time of receipt. Furthermore, because the crypto miner reports the value of the mining-reward cryptocurrency as taxable income, subsection 52(1) of the Income Tax Act allows the miner to increase the tax cost of that cryptocurrency accordingly. This increased tax cost ensures that there is no double taxation when the crypto miner eventually disposes of the cryptocurrency acquired as a mining reward.

Ultimately, Canadian taxpayers must recognize that the Canada Revenue Agency’s media release on crypto mining oversimplifies the complexities involved. Each case of cryptocurrency mining will have unique income-tax implications, contingent on individual circumstances. As a result, it is crucial for Canadian taxpayers engaged in mining to comprehend their income-tax responsibilities by seeking guidance from an expert cryptocurrency tax lawyer in Canada.

Excluding GST/HST Developments Related to Cryptocurrency Mining

The media release from the Canada Revenue Agency on crypto mining fails to address the applicable GST/HST rules related to cryptocurrency transactions in general and neglects to mention recent developments specifically related to cryptocurrency mining. 

In general, a cryptocurrency-trading business is considered a financial service, making it exempt from GST/HST under Canada’s Excise Tax Act. According to this act, businesses providing financial services are not required to charge or collect GST/HST. The definition of a “financial service” within the Excise Tax Act encompasses various transactions involving money or a “financial instrument.” In June 2021, the Canadian Parliament made an amendment to the Excise Tax Act, broadening the definition of a financial instrument to include a “virtual payment instrument.” This term refers to “property that is a digital representation of value, functioning as a medium of exchange and existing solely at a digital address of a publicly distributed ledger.” Essentially, this expanded definition now encompasses nearly every type of fungible cryptocurrency. As a result, cryptocurrency trading is considered GST/HST exempt.

Additionally, in February 2022, Canada’s Department of Finance introduced draft GST/HST legislation specifically addressing cryptocurrency mining. The proposed rules aim to treat cryptocurrency mining as an exempt supply. Under these regulations, the cryptocurrency miner is not required to collect and remit GST/HST on the compensation earned from mining activities. However, it also means that the crypto miner cannot claim input tax credits (ITCs) for expenses related to the cryptocurrency mining operation.

As these proposals have not been implemented yet, Canadians involved in cryptocurrency, non-fungible tokens, and other blockchain-based assets should proactively educate themselves about the potential new GST/HST rules. To gain more insights into the proposed GST/HST amendments for cryptocurrency mining, you can refer to our article titled “Proposed GST/HST Amendments for Cryptocurrency Mining: What’s Included and What’s Not.”

Tax Pro Tips: Understanding CRA Publications and the Significance of Seeking Legal Advice for Accurate Cryptocurrency Tax Reporting

While the Canada Revenue Agency’s media release on cryptocurrency mining fails to address the numerous intricate tax issues associated with such activities, it is essential for Canadian taxpayers to be aware that they should not solely rely on the CRA for advice on reporting their cryptocurrency transactions. The Canada Revenue Agency is primarily responsible for enforcing Canada’s tax laws, and it does not have the authority to interpret or create laws—those roles belong to the judiciary and the legislature, respectively. Additionally, the CRA lacks the jurisdiction and expertise to provide legal opinions to Canadian taxpayers, particularly concerning the tax implications of emerging technologies like DeFi arrangements and other blockchain-based assets. 

In essence, the Canada Revenue Agency is not legally bound by its own publications. If the CRA decides to audit your tax return, the tax auditor has the authority to disregard the CRA’s previously released guidelines. The doctrine of estoppel does not prevent the CRA from issuing an assessment that contradicts a previously published document. This principle was established in the case of Stickel v MNR, [1973] CTC 202, 73 DTC 5178 (FCA), aff’d. [1974] CTC 416, 74 DTC 6268 (SCC). The interpretation of tax legislation is entrusted to the Tax Court of Canada and the appeal courts. While the courts may consider CRA publications during their deliberations, these publications may not always accurately reflect the tax laws in question.

Hence, Canadian taxpayers engaging in cryptocurrency trading, investing, mining, or staking, along with non-fungible tokens (NFTs) and other DeFi and blockchain-based assets, are strongly advised to seek tax-law guidance from a specialized Canadian crypto-tax lawyer. Given the unique and innovative nature of different DeFi arrangements and blockchain assets, individuals involved in DeFi arrangements or transactions with blockchain-based assets should instruct their Canadian crypto-tax lawyer to prepare a confidential and privileged tax-law memorandum. This memorandum will comprehensively examine their GST/HST obligations under Canada’s Excise Tax Act and their income-tax obligations under Canada’s Income Tax Act, ensuring compliance with the complex and evolving tax regulations.

In addition, the solicitor-client privilege safeguards the Canada Revenue Agency from accessing any confidential legal advice provided by our Canadian crypto-tax lawyers. The tax-law memorandum, being privileged, will remain out of the reach of the CRA, as they cannot force the production of a document protected by solicitor-client privilege. This protection ensures that the memorandum will not be disclosed to the CRA. Despite this, the memorandum can be utilized to counter any attempts by the CRA to justify imposing gross-negligence penalties.

Frequently Asked Questions (FAQs)

What does cryptocurrency mining mean?

Cryptocurrency mining serves as the verification process in blockchain protocols utilizing the proof-of-work system. In order to maintain decentralization, all blockchain networks depend on consensus mechanisms to validate new cryptocurrency transactions. The two most widely used consensus mechanisms are the proof-of-work system and the proof-of-stake system.

 For instance, the Bitcoin blockchain currently operates on the proof-of-work system. In this process, cryptocurrency miners verify transactions by dedicating computing power to solve mathematical problems. The miner who successfully validates the transaction first receives a mining reward, usually comprising new tokens in the native cryptocurrency or a combination of transaction fees and new tokens.

In March 2023, the Canada Revenue Agency released tax tips concerning cryptocurrency mining. While these tips offer valuable information, can I solely rely on this publication to understand how to report my crypto-mining transactions for Canadian tax purposes?

Absolutely not. The CRA publication on cryptocurrency mining is overly simplistic and fails to cover the comprehensive Canadian income-tax implications. Additionally, it overlooks the crucial GST/HST rules related to cryptocurrency transactions and the recent developments specific to cryptocurrency mining. Moreover, it is crucial to understand that the Canada Revenue Agency is not legally bound by its own publications. Therefore, seeking reliable tax-law advice on reporting your crypto-mining transactions is essential. We recommend consulting one of our expert Canadian crypto-tax lawyers to receive accurate and personalized guidance.

If I use one of the Canada Revenue Agency’s publications on cryptocurrency transactions to aid in preparing my Canadian tax return, does this imply that the CRA is obligated to accept and adhere to my tax return as per the information in the publication?

No.It is important to note that the Canada Revenue Agency (CRA) is not legally bound by its own publications. Therefore, relying solely on a CRA publication for your tax return does not guarantee the CRA’s acceptance or adherence to your tax filing.

In the event of an audit, the crypto tax auditor can exercise discretion and may not be obligated to follow the guidelines presented in the publication. The doctrine of estoppel does not prevent the CRA from issuing an assessment that contradicts a previously released publication. This was evident in the case of Stickel v MNR, [1973] CTC 202, 73 DTC 5178 (FCA); aff’d. [1974] CTC 416, 74 DTC 6268 (SCC).

The CRA’s role is primarily to enforce Canada’s tax laws, and it lacks jurisdiction to interpret or create laws, which falls under the purview of the judiciary and the legislature, respectively. Additionally, the CRA does not have the authority to provide legal opinions to Canadian taxpayers.

For reliable and accurate tax-law advice on cryptocurrency-related matters, it is advisable to consult an expert Canadian crypto-tax lawyer. If you have been involved in DeFi arrangements or dealt with unique blockchain-based assets, you may consider instructing your lawyer to prepare a confidential and privileged tax-law memorandum. This memorandum can thoroughly examine your GST/HST obligations under Canada’s Excise Tax Act and your income-tax obligations under Canada’s Income Tax Act, offering personalized guidance tailored to your specific situation.

Disclaimer:

“This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.”

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