Canadian Cryptocurrency, Bitcoin Investor or a Trading Business?: How To Compute Inventory, Claim Costs
Published: June 12, 2023
Canadian businesses that deal with cryptocurrency trading are confronted with unique challenges. The increased danger of fraud and cybercrime results from the market's primarily unregulated nature. Profits could be lost due to the erratic markets. Additionally, some cryptocurrency traders misreport their profits as capital gains without even realizing they are operating a business.
In order to comply with Canadian cryptocurrency tax laws, cryptocurrency traders must determine the expenses of their cryptocurrency inventory. This article seeks to educate cryptocurrency traders on this important income-tax concern. The article first examines how the Canadian tax system distinguishes between a cryptocurrency investor and a cryptocurrency trading business, where cryptocurrency is inventory and capital property, respectively. The following part examines how inventory costs should be calculated and claimed for income tax purposes by a cryptocurrency trading business. The article ends with some expert tax advice beneficial for Canadian cryptocurrency-trading businesses.
Cryptocurrency Inventory: Know if Trading or Investing
For tax purposes, only two significant types of property are recognized by the Income Tax Act of Canada:
- capital property, the sale of which results in a capital gain or loss; and
- inventory, which is taken into account when calculating business income.
Whether a piece of property is considered a capital property or inventory depends on the kind of income it produces when it is sold, such as capital gains or business income. In other words, characterizing the property comes first, followed by establishing the type of income, not the other way around. As a result, the earnings from a cryptocurrency transaction will either be classified as (i) business income or (ii) capital gain and if they are categorized as business income, your cryptocurrency units such as bitcoin will be considered to be inventory.
Important tax implications stem from the distinction between income and capital. While just half of a capital gain is taxable, the full amount of business or property income is taxed. However, whereas capital losses are only partially deductible, losses and costs related to business or investment activities are entirely deductible.
The line that separates income and capital becomes fuzzy in some cryptocurrency transactions. In fact, Canadian courts have produced a substantial body of case law dealing with the vagueness between investing, which results in a financial gain or loss, and trading, which generates income or expenses for a business. When considering whether to classify a transaction's gains or losses as on an account of capital or income, courts consider a variety of factors. These factors may be present in cryptocurrency transactions as follows:
- transaction frequency—e.g., a pattern of substantial cryptocurrency buying and selling or a rapid turnover of cryptocurrency units may point to a business;
- period of ownership—e.g., brief periods of holding for cryptocurrencies suggest business activities rather than capital investing;
- understanding of the cryptocurrency marketplaces—e.g., better understanding or expertise with the markets favours a business categorization;
- tie to the taxpayer's other work—e.g., if a taxpayer's occupation includes any bitcoin transactions (or similar dealings), it points toward business;
- time invested—e.g., there is a higher chance that a taxpayer may be categorized as running a business if he or she spend a lot of time researching cryptocurrency markets and potential acquisitions;
- financial support—e.g., leveraged cryptocurrency transactions signify a business; and
- advertising—e.g., if the taxpayer has announced or otherwise made it known that he deals in cryptocurrencies, there is a higher possibility that the business will be classified as such.
The key consideration that courts take into account when deciding whether the transaction resulted in a capital gain or business income is the taxpayer's intention or reason for purchasing the cryptocurrency. However, courts will concentrate on the objective circumstances surrounding both the purchase and sale of the cryptocurrency in order to determine a taxpayer's intention. In other words, courts will consider the aforementioned elements when determining a taxpayer's intent.
For Income-Tax Purposes: Compute and Claim Costs of Cryptocurrency Inventory
A taxpayer's business income is defined as the taxpayer's "profit from that business" in subsection 9(1) of the Income Tax Act of Canada. When assessing how a taxpayer calculated profit, a court may inquire as to whether a particular deduction complies with generally accepted accounting principles (GAAP). However, determining a taxpayer's profit for income tax purposes is ultimately a legal matter. In other words, while accounting principles and business practices may have an impact on a court's decision about whether a deduction was appropriate, they do not constitute the relevant legal standards. Many times, otherwise permissible accounting procedures are expressly prohibited under the Income Tax Act. The courts have done the same.
However, Canada's income-tax law mostly follows commercial practice and generally accepted accounting principles when it comes to calculating inventory expenses. For instance, commercial practice dictates that the majority of businesses—especially those with rapid inventory turnover—use accrual accounting. As a result, businesses engaged in cryptocurrency trading will account for inventory expenses on an accrual basis, meaning they won't deduct the cost of the cryptocurrency as an expense for the financial period in which it was bought. Instead, the business records the cost of the inventory as a cost of goods sold for the accounting period in which the cryptocurrency was sold. The inventory at cost is shown as an asset on the balance sheet for the fiscal term for any cryptocurrency that is still in possession at the conclusion of the period.
Businesses engaged in cryptocurrency trading frequently see high levels of inventory turnover. Therefore, keeping a continuous tally of the cost of goods sold each day is neither feasible nor desirable. Therefore, the only practical method for figuring out the cost of goods sold is to (i) add up the value of inventory that was on hand at the start of the tax year plus the cost of inventory that was bought throughout the year, and (ii) deduct that value from the value of inventory that was still on hand at the end of the year.
We can use the formula below as a result of this accounting exercise:
Cost Of Goods Sold = Opening Inventory + Acquisitions – Closing Inventory
The calculation is not particularly challenging as long as inventory costs are steady. Problems occur when prices change. A cryptocurrency trading business, for instance, has 15,000 units of Dash on hand at the start of the year, with a current price of $2 per coin. The business will have 15,000 of the same coin, priced at $8 each, on hand by the end of the year. 200,000 Dash units were exchanged throughout the year by the business in the same coin, whose value climbed month over month as the business purchased and sold cryptocurrency units. It is hard to determine whether the 15,000 units in the closing inventory correspond to those in the opening inventory, or if any of the opening inventory still exists.
As a result, there are two phases involved in the calculation of the cost of goods sold: valuation and tracing.
Valuation of Inventory
The process of assigning an overall cost (or value) to the opening inventory and the closing inventory is known as valuation. The Income Tax Act of Canada recognizes two standard techniques for inventory valuation:
- valuation for each inventory item at the lower cost or fair market value; or
- valuation of the total inventory's fair market value.
Between these two options, a taxpayer may select one and must use it consistently moving forward. Additionally, the Income Tax Act stipulates that the value of a business's opening inventory must be identical to the value of the business's closing inventory from the immediately preceding year (unless the taxpayer first obtains approval from the Canada Revenue Agency). Therefore, a taxpayer's opening inventory for the next year is equal to the value of the taxpayer's closing inventory.
Tracing of Inventory
The process of tracing involves figuring out what goods make up the closing inventory and how much such goods cost. The two tracing options allowed by Canadian income tax law are (1) averaging, and (2) first in, first out (FIFO). The assumption behind averaging is that the average cost of all the units in the opening inventory and all the units bought throughout the year is equal to the cost of each unit in the closing inventory and the cost of goods sold during the year. The most recent expenditures are assigned to closing inventory, and the oldest costs are assigned to products sold throughout the year. First in, first out is the presumption, meaning that the goods that were sold were those that were initially purchased.
There is also a third tracing GAAP technique known as last in, first out (LIFO). The oldest costs are allocated to closing inventory and the most recent costs are allocated to products sold during the year since LIFO operates under the opposite premise from that of FIFO. But Canadian courts have ruled that it is invalid. Thus, LIFO cannot be used for income tax purposes by Canadian cryptocurrency trading businesses. This is an illustration of how the use of otherwise acceptable accounting methods is expressly prohibited by Canadian income tax law.
Tax Pro Tips: Keeping of Records, Welcoming Cryptocurrency Tax Audits, Availing of Voluntary Disclosures Program, & Enjoying Solicitor-Client Privilege
A cryptocurrency tax audit by the CRA will not go well for a cryptocurrency trading business that doesn't keep good records. The 13-page cryptocurrency audit questionnaire, which has more than 50 questions on a variety of topics, is routinely sent to Canadian cryptocurrency traders who are chosen by the Canada Revenue Agency for a cryptocurrency tax audit, such as
- The time frame for possessing or utilizing cryptocurrencies;
- The origin of the cryptocurrency that was bought;
- The utilization of third-party exchange wallets;
- The funding source used to buy cryptocurrencies;
- The taxpayer's methods for keeping transaction records;
- Initial coin offers (ICOs) participation;
- Whether the taxpayer's cryptocurrency holdings (such as Nodes, Masternodes, Supernodes, etc.) provide passive income;
- Participation in cryptocurrency mining, including inquiries regarding the technology used for mining and energy costs associated with mining;
- The ability to pay with cryptocurrencies for goods and services;
- How often do cryptocurrency transactions occur; and
- The period devoted to researching cryptocurrency marketplaces.
The taxpayer must also provide bank account statements and any other documents that would help the tax auditor from the Canada Revenue Agency verify the taxpayer's responses.
Trading in cryptocurrencies requires keeping track of all transactions. To prevent losing your transaction data if you utilize a cryptocurrency exchange, you should periodically export it. (When the Canadian cryptocurrency exchange QuadrigaCX collapsed, many cryptocurrency traders suddenly found themselves without any records.). You should also keep the following records about your cryptocurrency transactions:
- The day each transaction occurred;
- Receipts for any cryptocurrency purchases or transfers;
- The value of the cryptocurrency at the time of the transaction in Canadian dollars;
- The cryptocurrency addresses and digital wallet records;
- A description of the deal and the other party, such as their cryptocurrency address;
- The records of the exchange;
- A record of any expenses for accounting and legal counsel; and
- Records pertaining to any software fees you may have paid to manage your taxes.
In addition to your records of cryptocurrency transactions, if you mine cryptocurrencies, you should also keep the following records:
- Receipts for hardware purchases related to cryptocurrency mining;
- Receipts for costs incurred by your cryptocurrency-mining operation (such as power charges, mining pool fees, and maintenance costs);
- Records regarding how you mine cryptocurrencies, such as hardware specifications and hardware operation times; and
- Details and records about the mining pool.
In order to prevent the CRA from holding you responsible for misrepresenting the information in your tax returns, our Certified Specialist Canadian crypto tax lawyer can offer guidance on record-keeping and accurate reporting of your cryptocurrency profits. An analysis of your cryptocurrency profits to determine if they should be declared as capital gains, business income, or a combination of both, for instance, may be helpful to you. It's also crucial to keep in mind that an intermediary transaction, such as purchasing Bitcoin solely for the purpose of obtaining a trading pair, may result in a taxable transaction on its own.
The Canada Revenue Agency, the Internal Revenue Service, and other tax administrators have improved their methods for identifying cryptocurrency users for tax audits or prosecuting them for crypto tax evasion since joining an international alliance focused on cryptocurrency transactions. The secrecy that cryptocurrency users believed they had once enjoyed is now gone attributable to advancements and collaborative efforts of tax authorities. Taxpayers in Canada should be extremely concerned about unreported profits from cryptocurrency transactions. If you underreported or withheld your cryptocurrency profits on your tax returns, you could be subject to criminal tax evasion charges in addition to civil monetary penalties like gross negligence fines.
The Voluntary Disclosures Program (VDP) of the CRA may be able to provide you with relief. If your VDP application is approved, the CRA will forgo criminal prosecution, waive gross negligence fines, and perhaps lower interest. However, a voluntary disclosure application has a deadline. This effectively means that the VDP must receive your voluntary disclosure application before the CRA contacts you about the non-compliance you wished to disclose. The CRA's Voluntary Disclosures Program will reject an application—and so deny any relief—unless the application is "voluntary." Our expert Canadian crypto tax lawyers can carefully plan and swiftly prepare your voluntary disclosure application because they have dealt with many Canadian taxpayers involved with cryptocurrencies. A well-prepared disclosure application not only improves your chances of having your disclosure accepted by the CRA, but it also paves the way for a request for judicial review to the Federal Court should the CRA unjustly deny your disclosure.
To find out if you're eligible for the Voluntary Disclosures Program, arrange a confidential and privileged consultation with one of our experienced Canadian crypto tax lawyers. Information that is shielded by the solicitor-client privilege cannot be demanded by the Canada Revenue Agency. Solicitor-client confidentiality keeps the CRA from knowing about the legal guidance you obtained from your tax lawyer. But until the accountant has been hired on your behalf by a Canadian crypto tax lawyer, all of your communications with them are still unprotected. So, consult an expert Canadian tax lawyer first if you want tax guidance on cryptocurrencies from Canada but don't want the CRA to know. If an accountant is required, your Canadian crypto tax lawyer will hire one and enable the privilege for you.
Frequently Asked Questions
I have been trading Ethereum throughout the year and I have some coins left at year end. How do I handle this for tax purposes?
You first have to have a Canadian crypto tax lawyer determine if your trading gives rise to a capital gain or business income. If it is determined that you have been carrying out a business then you have to value your year end Ethereum inventory using either the average cost or the first in first out (FIFO) inventory valuation method.
I mine Bitcoin and have coins left at the end of the year. How do I value my Bitcoin inventory?
There are three different ways in which Bitcoin mining would you be can be taxed, only one of which actually gives rise to year end inventory. If you mined Bitcoin while operating a cryptocurrency trading business with commercial intent, acquiring Bitcoin through mining would be akin to acquiring inventory – in particular, acquiring inventory for a cryptocurrency trading business. The cost determination requires an allocation of all expenses incurred in the mining activity against all Bitcoin mined during the year.
"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."