Bitcoin Mining Tax: Bitcoin Mining and Its Tax Consequences
Published: December 9, 2022
The Bitcoin and Bitcoin Mining
Bitcoin is a decentralized cryptocurrency that uses a distributed ledger technology called a blockchain to record transaction data. The whole history of all transactions involving Bitcoin that take place within its network is recorded on the blockchain. In this system, coins are divided and dispersed among "nodes" or "peers," that work together to verify the legality of each transaction. For instance, the network of nodes, which contains the exact same history of transactions, must validate the transaction if two parties want to transfer a specific amount of Bitcoin. The transfer will be registered in the public ledger and become authenticated if the transactions are confirmed.
Every "block" in the blockchain contains a precedent block and the solution to a "complex" mathematical puzzle that verifies the transactions it contains. A chain of verified blocks is created when a block is connected to the most recently verified block after being verified and finished by other nodes or peers in the network.
Bitcoin Mining Definition: What is Bitcoin Mining
Bitcoin mining is the process of resolving complex mathematical puzzles to validate Bitcoin transactions. To be clear, the mathematical problem isn't particularly challenging. Being the first miner to determine the proper 64-digit hexadecimal number, commonly known as the hash value, that is less than or equal to a target hash is the essence of the work involved. In effect, the work is guesswork, to put it another way.
The Process of Bitcoin Mining: How Does Bitcoin Mining Work
Finding a hash value that is the same as or less than a given target value is where the Bitcoin mining process revolves, which can be divided into the following:
- a miner must first connect to other nodes and join the Bitcoin network;
- the miner has to wait and listen for the network broadcast of new blocks;
- validation by the miner of the new blocks by way of finding a nonce value to constitute such blocks valid; (A nonce value that is hashed produces an output hash. The task of the miner is to adjust the nonce value until the output hash value is equal to or less than a specified target hash. The miner will validate the block if he or she discovers the correct nonce value.)
- the miner who worked on the block will be rewarded with Bitcoin allocation if the block is validated by other miners.
Bitcoin mining is crucial to the upkeep of the Bitcoin system because it is the sole way to record and confirm Bitcoin transactions. In other words, when a miner generates Bitcoin, it can help ensure the integrity of the Bitcoin system. The Bitcoin system won't work without miners since no transactions would be confirmed.
Rewards in Bitcoin Mining
Mining for Bitcoin have two consequences or outcomes. The blockchain's accuracy and legitimacy are first ensured. No transactions are copied or recorded more than once, according to miners. Second, when a Bitcoin miner successfully validates a block of a Bitcoin transaction, that miner is rewarded with newly minted Bitcoin by the Bitcoin protocol as well as transaction fees from the users who took part in the transaction, also paid in Bitcoin. In other words, the miner who validates the block will be paid, and the reward comes in the form of both Bitcoin transaction fees and newly minted Bitcoin rewards.
A portion of newly minted Bitcoin is awarded to a Bitcoin miner when he or she correctly verifies a block. Since Bitcoin mining is essential to creating new Bitcoin, this process is the sole way to create it. In other words, new Bitcoins are created in accordance with the Bitcoin protocol when a miner successfully verifies a block, and a set quantity is released to the miner as a reward. A Bitcoin miner additionally receives transaction fees from the users engaged in the transaction, as mentioned above. Currently, the transaction cost is typically equal to 1% of the block reward. As a result, as opposed to transaction fee rewards, the Bitcoin rewards (i.e. the freshly minted Bitcoin) make for the majority of the miner's revenue.
The newly minted Bitcoin rewards, however, will eventually begin to dwindle in the future. In particular, every four years the block rewards are cut in half. Initially, the block reward for mining Bitcoins was 50 Bitcoins, which was the case from January 2009 to November 2012. The reward for each block has now been reduced to 6.25 Bitcoins due to the three Bitcoin halvings that took place over more than ten years.
Mining for Bitcoins and the Tax Consequences: Three Bitcoin Mining Tax Options
When it comes to Bitcoin mining taxes, Income tax legislation pertaining specifically to cryptocurrency mining or transactions has not yet been passed in Canada. (Canada, however, passed GST/HST legislation pertaining to "virtual payment instruments," and in 2021, the Excise Tax Act was amended to include "virtual payment instruments" in the definition of "financial instruments.") In addition, the Canadian courts have not yet reached any decisions on a tax matter involving cryptocurrency transactions and cryptocurrency or Bitcoin mining taxes. Therefore, it will be interesting and crucial to see how the legal system and government policies handle the taxes of cryptocurrency transactions and crypto or bitcoin mining taxes.
In our viewpoint, there are three options when it comes to the tax on Bitcoin mining. The best course of action for Bitcoin mining tax relies on the taxpayers' plans for using the BTC they have earned by mining, as we'll go over in more detail below.
The three parts that follow go into greater depth about each option.
Alternative 1: The Hobbyist Miner
The first option is that the taxpayer mined Bitcoin purely out of hobby and had no commercial motives. In certain situations, the mining reward is not considered to be a source of income. When the mining rewards are received, the hobbyist won't have to declare their worth as income. Instead, when the Bitcoin miner disposes of the earned Bitcoin, the income inclusion (or loss realization) takes place.
The process of selling Bitcoin that has been mined is distinct from the process of buying Bitcoin that has been mined. When it comes to Bitcoin mining tax reporting, the gain that results from selling the mined Bitcoin must be reported as either income or capital. In other words, a separate legal analysis will be needed to determine the Bitcoin mining tax consequences. To be clear, since the taxpayer does not declare the mined Bitcoin as income, the a hobbyist's Bitcoin mining tax cost would be zero. As a result, at the moment of disposition, the Bitcoin mined by the hobby miner cannot result in a loss. Instead, the hobbyist will generate a gain upon selling the mined Bitcoin. The gain will be calculated as A minus B, where A represents the proceeds from the sale and B represents the tax expense of the disposed property. The gain will be equal to the proceeds received upon disposition because the tax cost of the disposed property in this scenario is nil.
Alternative 2: Bitcoin Mining Along With The Operation of a Cryptocurrency Trading Business
The second possibility is that the taxpayer mined Bitcoin while running a business that dealt in cryptocurrencies with commercial intent. In such circumstances, obtaining Bitcoin via mining would be comparable to obtaining inventory, particularly inventory for a cryptocurrency trading business. In this instance, the mining activity is not the taxpayer's primary source of income. Instead, the mining activity is a byproduct of the taxpayer's primary source of income, which is the sale and trading of Bitcoin units obtained from mining. Therefore, just as a gold dealer does not register income upon acquiring gold deposits via mining, a cryptocurrency trader does not do so while acquiring Bitcoin through mining.
Instead, the cryptocurrency trader, like the hobbyist miner, acknowledges income when the generated Bitcoin rewards are disposed of. The gain (or loss) that results from the disposition of mined Bitcoin rewards must, however, be recorded on the trader's income account. In other words, the trader of cryptocurrencies is not eligible for capital treatment with regard to the disposition of Bitcoin that was mined.
It is vital to emphasize that the inventory-acquisition model will only be suitable if the Bitcoin miner runs the mining activities inside the framework of a cryptocurrency trading business. The inventory-acquisition approach will not be applicable if the Bitcoin miner is not operating the mining operations in the context of a cryptocurrency trading business.
Alternative 3: Mining Bitcoin as Services
The final option is that Bitcoin mining was done as a service provided by the taxpayer. The role that mining serves in the Bitcoin network and the portion of the mining rewards known as the transaction fee component both enable this form of tax treatment. In order to confirm the legitimacy of Bitcoin transactions, a Bitcoin miner uses mining software. The parties involved in Bitcoin transactions are the receivers of miners' services as a result of this verification work, which also helps to maintain the integrity of the Bitcoin network. The miners are compensated with newly minted Bitcoin and transaction fees.
The services model assumes that the Bitcoin mining reward is a source of income in contrast to the hobbyist model and the inventory acquisition model. As a result, in accordance with this model, the Bitcoin miner is required to include the value of mining awards in their yearly income reports after receiving them. The amount that the miner reports as income will be equal to the cost of the Bitcoin rewards that are mined.
The services model will only be viable if the Bitcoin miner does not run a cryptocurrency trading business and if the mining activities are done with commercial intent. The Bitcoin rewards from mining will be the acquisition of inventory if the Bitcoin miner runs a cryptocurrency trading business. On the other hand, the rewards cannot be seen as a source of income if the Bitcoin miner does not undertake the mining activities with commercial intent. As a result, the service model should only be used when a Bitcoin miner is doing it for commercial purposes and not operating a cryptocurrency trading business.
Position of the CRA Regarding Bitcoin Mining Taxes
The CRA's stance on whether Bitcoin miners should include the reward's value in income at the time of mining was made public in 2019. According to CRA, Bitcoin miners must include the rewards they receive for mining Bitcoin in their income when they are earned. The tax authority justified this stance by arguing that since cryptocurrencies are considered commodities, Bitcoin mining is fundamentally a bartering transaction. According to CRA, Bitcoin miners offer services and are paid with the cryptocurrency in exchange.
Despite the CRA's stance on the matter, it is crucial to remember that its interpretative publications lack legal power and that the CRA's point of view is in fact contrary to law. A one-dimensional view of Bitcoin mining is insufficient. The Canadian cryptocurrency tax on Bitcoin mining depends on both the nature of mining Bitcoins in general and the specifics of how the taxpayer obtained the Bitcoins they mined. The CRA's position disregards the taxpayer's intentions and the context in which the mining activities were carried out. Contact one of our expert Canadian tax crypto lawyers for guidance if you believe that the CRA has incorrectly taxed your income from Bitcoin mining.
Tax Pro Tip: Analyzing the Nature of Bitcoin Mining Taxes and the Circumstances Surrounding the Taxpayer's Acquisition of the Bitcoin Rewards From Mining is Necessary for the Correct Tax Consequence
As was previously discussed, the appropriate tax on Bitcoin mining relies not only on the nature of Bitcoin mining itself but also on the conditions under which the taxpayer obtained the Bitcoin through mining. The Bitcoin mining rewards may be taxed immediately or may not be taxable until they are ultimately disposed of, depending on the taxpayer's circumstances. The tax treatment of Bitcoin mining rewards is a legal issue. As a result, if you are mining Bitcoin and have concerns about how your mining activities should be taxed, we encourage you to get in touch with one of our top Toronto tax lawyers to discuss your Bitcoin mining tax responsibilities.
"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 lawyer."