A recent report by dappGambl, utilizing data from Non-Fungible Tokens (NFTs) Scan and CoinMarketCap, disclosed that among the 73,257 NFT collections analyzed, a remarkable 95% of them—equivalent to 69,795 collections—had a market capitalization of zero. This information was relayed by Business Insider on September 2023. Notably, about 23 million individuals currently hold NFTs in their cryptocurrency wallets.

The realm of NFTs has long been associated with speculative trading within the cryptocurrency domain. As the speculative enthusiasm wanes, a crucial question emerges: should cryptocurrency investors now contemplate involvement in the aftermath of this decline, and what are the implications for Canadian cryptocurrency tax? Gennady Volchek, CEO of Melbourne-based Shping, provides insights into this issue. Shping is an online shopping rewards app currently not available in the United States.

Volchek observes, “Initial hype tends to inflate prices, driven by the allure of limited supply and increasing demand. However, as the NFT market expands and the supply of NFTs increases, more conventional economic principles come into play.”

He underscores that the enduring value of NFTs hinges on genuine demand rather than being solely propelled by FOMO-induced excitement. NFTs demonstrating authentic scarcity and practical, real-world applications are more likely to withstand the test of time. As an illustration, he highlights the collaboration between Walmart and Pudgy Penguins, initially conceived as NFTs and announced in September. If an investment is linked to a project reliant on hype and “digital flexing,” like the multitude of profile picture NFTs, it may face challenges in maintaining its price point as the supply exceeds the demand. Nevertheless, it’s crucial to note that NFT holders cannot claim a ≈solely based on a decline in value; they must dispose of the NFTs to crystallize the losses.

Interest from investors in NFTs is on the decline, yet there persists a passionate commitment from genuine participants

In 2021, the cryptocurrency market transitioned into a bearish phase following a robust bull run in the early months of the pandemic. The downturn significantly impacted NFTs as investors began divesting their holdings. Alexander Casassovici, the co-founder and CEO of Azarus, a San Francisco-based web3 platform for live streaming, underscores the significance of differentiating between investors and genuine participants actively utilizing NFTs, especially within the gaming sphere. He notes, “The latter group remains dedicated and passionate about their NFT holdings,” suggesting their resilience in navigating market fluctuations.

Tax classification of a taxpayer’s gain or loss from the disposition of NFTs

The proceeds from the sale of NFTs can be classified as either business income or capital gains. In Canada, legal precedent has amassed a significant body of case law addressing the challenge of differentiating between investment activities leading to capital gains and trading activities resulting in business income. Courts consider a range of factors in determining whether to categorize the gains or losses of a transaction as being on a capital account or an income account. These factors include:

1. Frequency of Transactions: For example, consistently engaging in the frequent purchase and sale of non-fungible tokens or rapid turnovers of NFTs may suggest a business-oriented approach.
2. Ownership Duration: Holding non-fungible tokens for brief periods implies business transactions rather than capital investment.
3. Understanding of NFT Markets: Enhanced familiarity with and experience in NFT markets tends to lean towards categorizing the activity as a business.
4. Connection to the Taxpayer’s Other Work: If NFT transactions or similar dealings are integral to a taxpayer’s employment or other business activities, it tends to indicate a business-related endeavor.
5. Investment of Time: Devoting a significant amount of time to studying non-fungible token markets, researching potential purchases, or actively managing an NFT portfolio is more likely to be perceived as a business endeavor.
6. Financing: Engaging in leveraged NFT transactions indicates a business context.
7. Promotion: If a taxpayer has promoted or publicly disclosed his or her involvement in non-fungible tokens, there is an increased likelihood of the activity being classified as a business.

Ultimately, the paramount criterion for courts in discerning whether a transaction yielded a capital gain or loss, or business income or loss, is the taxpayer’s intent when acquiring the property. However, to ascertain a taxpayer’s intention, the court concentrates on the objective circumstances surrounding both the purchase and sale of the property. In essence, a taxpayer’s intent is established by evaluating the aforementioned factors.

Holders of NFTs and cryptocurrencies may need to submit Form T1135

Canadian tax residents (with an exemption for first-year residents) holding specified foreign property exceeding a total cost of $100,000 at any point during the year are obligated to file the T1135 form. The definition of “specified foreign property” under the Income Tax Act should encompass offshore cryptocurrency and NFTs, and other blockchain-based assets categorized as intangible property. The deadline for submitting the T1135 form is April 30 of the subsequent year. Failure to file crypto tax reports on time may incur a penalty of $25 per day for up to 100 days. Fortunately, a voluntary disclosure application may help alleviate penalties and provide partial interest relief to qualifying taxpayers under the general program. Therefore, taxpayers should seek counsel from an experienced Canadian crypto tax lawyer to ensure the accurate tax treatment of their cryptocurrency and NFT holdings and avoid potential T1135-related issues.

Tax Pro Tips – How to realize losses from NFTs with no value

NFTs that have experienced a decline in value are not eligible for tax deductions unless an actual loss is realized. Taxpayers may consider the following options to realize losses on depreciated NFTs:

• If a liquid NFT market persists, the most straightforward method to actualize losses is to either sell the NFTs at a nominal value or explore the possibility of swapping the NFTs.

Alternatively, taxpayers have the option to gift their NFTs, which results in the NFTs being considered disposed of at the fair market value at the time of gifting.

Frequently Asked Questions (FAQs):

I possess a substantial portfolio primarily consisting of NFTs with little to no value. How can I go about deducting these losses for tax purposes?

NFTs that have experienced a decrease in value do not qualify for tax deductions unless an actual loss is realized. To assert losses on depreciated NFTs, a holder can either sell the NFTs for a nominal value or swap them if a liquid market still exists. Alternatively, gifting the NFTs allows them to be considered as sold at the fair market value at the time of gifting.

What are the criteria for filing the T1135 form?

Taxpayers possessing specified foreign property (SFP) with a total cost surpassing 100,000 Canadian dollars at any point during a tax year must report these assets to the CRA by submitting form T1135.

Cryptocurrency and NFTs categorized as capital properties should meet the criteria for being specified foreign property (SFP), except for business inventories.

What does the voluntary disclosure program entail?

The voluntary disclosure application enables non-compliant Canadian taxpayers to re-enter the tax system by amending previously filed tax returns. Applicable only to the most recent ten years, successful applicants may benefit from partial interest relief and the complete removal of penalties.

Nevertheless, the CRA does not guarantee acceptance of all voluntary disclosure applications. It is strongly advised that taxpayers seek the guidance of an experienced Canadian tax lawyer to increase their likelihood of acceptance.

Disclaimer:

“This article just offers general information. It is only up to date as of the publication date. It hasn’t been updated, thus it might not be applicable anymore. It does not provide legal advice, hence it cannot or should not be relied upon. Every tax situation differs from the cases discussed in the articles since it is specific to its facts. If you have specific legal questions, you should get in touch with a Canadian tax lawyer.”

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