Cryptocurrency Hard Forks: Implications on Canadian Income Tax - A Canadian Tax Lawyer’s Guide
Published: January 26, 2023
The Cryptocurrency Token Evolution and Blockchain Fork - An Overview
The Bitcoin network underwent two hard forks in 2017. In August 2017, there was the first hard fork, which led to the birth of Bitcoin Cash (BCH). In October 2017, there was a second hard fork that produced Bitcoin Gold (BTG). Owners of Bitcoin received an equal number of Bitcoin Cash units and Bitcoin Gold units at the time of each hard fork. This was similar to how the Ethereum network instituted a hard fork in 2016 after users stole $50 million in Ether using a security flaw in The DAO project's smart-contract software, the stolen funds were recovered. The original, unforked blockchain continued as Ethereum Classic, and the new blockchain continued as Ethereum. As a result, the Ethereum blockchain split into two branches, each with its own cryptocurrency.
What precisely is a blockchain fork, then? In essence, it alludes to a modification to the cryptocurrency network's underlying protocol. The rules governing how a cryptocurrency network operates, such as the speed at which transactions are processed, are established by the underlying protocol. Usually, the underlying protocol needs to be changed in order to change how a cryptocurrency operates. Say one wanted to increase the speed at which transactions were processed, for instance (i.e., a function change). It will probably require a protocol adjustment, such as changing the amount of information present in each block of the chain, for example. "Forks" are the name given to these protocol modifications.
Not all forks result in new cryptocurrency tokens being created. There are two main categories of forks: hard forks and soft forks. A hard fork, also known as a "chain split," modifies the protocol's code to produce a new version of the blockchain alongside the old one. This results in the creation of a new token that follows the modified protocol's rules while the original token continues to follow the original protocol. A soft fork also modifies the protocol, but no new coin is produced; as a result, all network users are affected by the protocol change. Hard forks led to the development of Bitcoin Cash (BCH) and Bitcoin Gold (BTG), as well as the division of Ethereum into Ethereum Classic and Ethereum.
A number of Canadian income-tax issues are raised by hard forks. For instance: Is the receipt of new cryptocurrency units by a Canadian taxpayer as a result of a hard fork considered a tax-free windfall or taxable income? And if receiving a forked coin is a tax-free windfall, are your profits when you sell the forked coin later also tax-free? Are they also business revenues? investment earnings? a capital gain? or perhaps some combination of the three?
The issues with Canadian income taxes brought on by cryptocurrency hard forks are covered in this article.
The first section of the article provides a general overview of Canadian cryptocurrency tax laws regarding what qualifies as a source of taxable income and how to differentiate between different sources. This article first examines the legal framework before analyzing the effects on Canadian income taxes of receiving new cryptocurrency as a result of a hard fork. After that, it examines how the sale of forked coins will affect Canadian income taxes. To help Canadian taxpayers who trade or invest in cryptocurrencies, this article's conclusion offers expert crypto tax tips from some of our top Canadian crypto tax lawyers.
Taxable Income Sources in Canada: Section 3 of the Canadian Income Tax Act
Every Canadian tax resident is required to pay tax on "taxable income" according to Section 2(1) of the Income Tax Act of Canada.
A taxpayer's "taxable income" is defined in subsection 2(2) as his or her "income for the year" less any deductions allowed under Division C of the Income Tax Act. (Division C contains a number of tax subsidies, tax-relief provisions, and policy-based deductions, including the loss-carryover rules, the lifetime-capital-gains exemption (LCGE), the part-year-resident rule, which exempts offshore crypto income earned while a taxpayer was a non-resident of Canada from taxation, and tax treaty exemptions.)
How to calculate a taxpayer's "income for the year" is explained in Section 3. In doing so, the section lists the following "sources" of income in (non-exhaustive) order:
- Properties; and
- Capital gains.
As a result, a person's taxable income is ultimately comprised of these sources of income. The implication is that Canadian courts have used the "source" concept to disallow some receipts from being counted as income for a taxpayer.
The concept of "income from a source" had a significant impact on how Parliament drafted the Income Tax Act and how courts interpreted it. The fundamental tenet is that a receipt only qualifies as income when it originates from a productive source. This concept is codified in Section 3 of the Income Tax Act, which specifies that only "income from a source" is taken into account when determining a taxpayer's annual income. "Whether a taxpayer has a source of income is determined by considering whether the taxpayer intends to carry on the activity for profit and whether there is evidence to support that intention," the Supreme Court of Canada said in Stewart v Canada (2002 SCC 46).
As a result, an income source frequently has one or more of the following characteristics:
- It results in a yield that occurs repeatedly;
- It calls for organized effort, activity, or pursuit on the part of the taxpayer;
- It involves a transaction in the marketplace;
- It gives the taxpayer an enforceable right to payment; and,
- It is the result of the taxpayer's desire for profit (when a source of income from a business or property).
As a result, windfalls are not considered "income" under tax law, such as winnings from amateur gambling. Gambling for fun or a living does not generate an income. Even for compulsive gamblers who repeatedly try their luck at a game of chance, such as the lottery, the activity continues to be a personal endeavour rather than a source of income (e.g., see: Leblanc v The Queen, 2006 TCC 680).
But this isn't always the case. In two different scenarios, gambling winnings are considered taxable business income. The first is when gambling is a byproduct or incident of a business, such as when a casino owner gambles in his own establishment or when a horse owner trains, competes, and bets on horse races. The second situation is when an individual uses his or her knowledge to support oneself while participating in a game of chance where skill plays a significant role, such as a pool shark who regularly plays inebriated pool players for the money.
Business Income, Investment Income, or a Capital Gain: Sources of Income Distinguished
Assuming that the activity is a source of income, the next question is: Which source? Is it a salary or wages from a job? income from a business? property income? A capital gain?
This inquiry is crucial because various income sources are subject to various tax laws. For instance, only one-half of a capital gain is included in taxable income, while business and investment income are both fully taxable. Any source of income may be used to offset business and investment losses in full. The allowable portion of a capital loss, on the other hand, can typically only be used to reduce the taxable portion of a capital gain and is only half of a capital loss that is deductible.
We’ll focus on how investment income (or property income), business income and capital gains are distinguished from one another.
The yield from a property is referred to as investment income. For instance, shares produce dividends. Interest is paid on bonds. Royalties are produced by intellectual property. Rent is produced by real property, and so forth. In other words, investment income is passive income that comes from owning property alone and doesn't require a lot of effort, time, or attention. For instance, a person can buy public shares and start receiving dividends right away. Therefore, the dividends are considered investment income.
Contrarily, business income necessitates organization, systematized effort, and some level of activity. A cryptocurrency trader actively looks for opportunities to buy and sell cryptocurrencies, much like an investment dealer can actively manage a portfolio of publicly traded shares. The dealer runs an investment business, whereas the cryptocurrency trader runs a trading business. Each business's revenues make up its business income. A "business" is defined as including a "profession, calling, trade, or undertaking of any kind whatever" in subsection 248(1) of the Income Tax Act of Canada. Therefore, the term "business" implies activity and a desire for profit. Activity, enterprise, entrepreneurship, and commercial risk are examples of a business's representative characteristics. A business involves the pursuit of profit above all else. In fact, what distinguishes a business from a simple hobby or pastime is the pursuit of profit (Stewart v Canada, 2002 SCC 46).
As a result, the difference between income from businesses and income from investments depends on the level of activity involved in producing the income. Despite the fact that investment income is referred to as "income from property" in Canada's Income Tax Act, the mere use of a property does not in and of itself imply that the income therefrom is investment income. What matters is the level of activity. For instance, a taxpayer who leases a basement apartment and a taxpayer who actively manages a hotel each make use of the same property and receive rent payments. However, the hotel manager makes money from his or her business while the homeowner makes money from rentals.
Despite the fact that the use of property may result in either business or investment income, the Income Tax Act's subsection 9(3) expressly distinguishes between investment income and capital gains. This paragraph makes it clear that a gain from the sale of a property is not included in income from that property (also known as investment income). In other words, if you sell a property, the profit that results is either a capital gain or business income, not investment income for tax purposes.
When you sell an item that meets the definition of "capital property," you may experience a capital gain (or loss). For tax purposes, only two broad categories of property are recognized by the Income Tax Act of Canada:
- Capital property, which results in a capital gain or loss upon disposal; and,
- Inventory, which is taken into account when calculating business income.
The type of income generated by the property upon sale—capital gains or business income—determines whether the property is a capital property or inventory. To put it another way, you determine the nature of the income first, then characterize the property, and not the other way around.
Notably, the determination of capital/income is frequently ambiguous and calls for the advice of a knowledgeable Canadian tax lawyer. While attempting to resolve the ambiguity between investing, which results in a capital gain, and trading, which produces business income, Canadian tax courts have produced a vast body of case law over the years. When determining whether to classify a transaction's gains or losses as on a capital account or income account, courts consider a wide range of factors. These factors could consist of:
- frequency of transactions;
- duration of ownership;
- market knowledge;
- connection to, or resemblance to, the taxpayer's employment or other business;
- time and effort invested in the endeavour;
- use of financing; and,
The most crucial factor that tax courts take into account when deciding whether the transaction resulted in a capital gain or business income is the taxpayer's intention at the time of acquiring the property. If the taxpayer bought the property with the intention of trading is the specific question at hand. However, a court must look at the objective circumstances of both the purchase and sale of the property in order to determine a taxpayer's intent. To put it another way, the factors mentioned above will be considered by courts when determining a taxpayer's intent.
Receiving New Cryptocurrency as a Result of a Hard Fork in Canada: Tax-Free Windfall or Income from a Source?
Two main conclusions can be drawn from the earlier sections. First off, "income from a source" is the only thing that qualifies as taxable income. Because of this, an amateur gambler's winnings are not subject to taxes. Because amateur or casual gambling is typically a personal endeavour and isn't a reliable way to make money, it doesn't generate a source of income. However, gambling qualifies as a source of income if it is related to another business or if the gambler makes their living playing skill-based games, in which case their winnings will be taxed as business income.
The second takeaway is that a property can produce business income, investment income, or capital gain depending on how a taxpayer uses it. If a piece of property generates income on its own, that income is either investment income or business income. The level of activity involved in generating that income may be part of the determination of the appropriate tax classification: an active venture suggests a business and therefore business income; a passive undertaking implies an investment and therefore investment income. The profit that results from the sale of the property, on the other hand, may count as either business income or a capital gain. Whether the taxpayer purchased the property with the intent to trade will determine the proper tax characterization in this situation.
In light of these takeaways, how do they affect Canadian taxpayers who receive new cryptocurrency units as a result of a hard fork? The first takeaway raises the question of whether receiving forked coins counts as an income source. The second takeaway is relevant to Canadian taxpayers, for whom receiving forked coins is unquestionably a source of income, how to accurately report that income is the problem for them.
A receipt is not taxable unless it comes from an income source, as was already mentioned. An income source has one or more of the following characteristics: it generates a yield that occurs on a regular basis; it necessitates organized effort, activity, or pursuit on the part of the taxpayer; it involves a market exchange; it gives the taxpayer an enforceable claim to payment; and, in the case of an income source from a business or investment, it results from the taxpayer's pursuit of profit.
Therefore, it would appear that receiving forked coins does not constitute a source of income unless the recipient can change the cryptocurrency network's underlying protocol and implement a hard fork. Remember that a fork simply denotes a modification to the cryptocurrency network's underlying protocol. A "hard fork" (also known as a "chain split") modifies the protocol code to produce a new version of the blockchain alongside the old version, resulting in the creation of a new token that follows the modified protocol's rules. In contrast, the original token continues to follow the rules of the original protocol. The majority of cryptocurrency users lack the authority to change the network protocols that support the currency they own. They, therefore, have no control over whether a hard fork takes place.
Consider the two Bitcoin hard forks that provided users with Bitcoin Cash (BCH) and Bitcoin Gold (BTG). The developers of the Bitcoin protocol made the choice to implement the two hard forks. As a result, most Bitcoin owners had no say in whether the two forked coins were issued, and they automatically received Bitcoin Cash or Bitcoin Gold. As long as they had Bitcoin units in their cryptocurrency wallets at the time, they received the forked coins. Furthermore, for many of the taxpayers who received the forked BCH and BTG units, the two Bitcoin hard forks did not exhibit the characteristics of an income source. The forks didn't happen on a regular basis; they didn't require any organized effort, activity, or pursuit on the part of most taxpayers involved; they were the result of a change to the Bitcoin protocol rather than a market exchange; and it's possible that the people who received the forked coins had no legal right to them because they gave no payment in exchange. Therefore, it's conceivable that many Canadian taxpayers who received Bitcoin Cash and Bitcoin Gold as a result of the hard forks received these units as a tax-free windfall.
But not all situations will be subject to this tax treatment. For instance, Canadian taxpayers who develop cryptocurrency platforms, start hard forks, and thereby gain new cryptocurrency units may be required to report their receipt of forked coins as income. Here, the hard fork undoubtedly shows some signs of being a source of income for the developers of cryptocurrencies. For instance, the cryptocurrency developer must put forth organized effort, activity, or pursuit. Additionally, because it is something that the developer can influence, the hard fork may occur again from time to time. Therefore, for Canadian cryptocurrency developers who receive forked coins of their own volition, a hard fork is very likely a source of taxable business income. The Canadian cryptocurrency developer must declare the value of the forked coin as income for the year in which he or she received it in order to comply with crypto income tax regulations.
The bottom line is that Canadian taxpayers must realize that no single crypto tax law analysis will address every case. Each taxpayer's unique set of facts will determine the tax repercussions. This means that Canadian taxpayers who trade, invest, or develop cryptocurrencies should consult a top Canadian crypto tax lawyer to learn more about their tax obligations.
Income Tax Implications of Disposing of Fork Coins in Canada: Business Income or Capital Gains?
The preceding section demonstrates that receiving forked coins is either taxable or not. However, while receiving forked coins may not be a source of income, disposing of those coins is. So, even if the acquisition of a forked coin is not a taxable event, disposing of a forked coin is. The profit or loss from the disposition must be reported. The only question is how you will report the profit or loss.
We will now examine how a taxpayer's profit from disposing of forked cryptocurrency tokens is characterized for income tax purposes. As previously mentioned, depending on the level of activity involved, income from the use of property can be classified as either investment income or business income. But the Income Tax Act disallows the investment-income characterization when you sell a property. Profit as a result is either a capital gain or business income. Therefore, a taxpayer's profit from selling forked cryptocurrency tokens must be declared and taxed as either business income or capital gain.
The intention of the taxpayer determines the capital/income distinction. The main issue is whether the taxpayer participated in blockchain forks or cryptocurrency transactions with the intention of profitably trading cryptocurrency units. In that case, the profit counts as business income. The sale proceeds will be placed on a capital account and subject to capital gain tax if the taxpayer can show they were intended to be invested in rather than traded by presenting solid proof. If a taxpayer can show, for example, that he or she had no control over the cryptocurrency platform and didn't even anticipate receiving the forked cryptocurrency tokens, let alone buy them with the intention of selling them, that taxpayer must be able to justify capital treatment. The profits from ultimately selling the forked tokens, however, may be considered business income if the taxpayer had prior knowledge of a hard fork that was about to occur or the authority to initiate a hard fork.
The Income Tax Act of Canada establishes completely different tax regimes for capital gains and business income. Your cryptocurrency transaction profits are fully taxable if they meet the criteria for business income. To calculate your taxable income for the year in which you disposed of the cryptocurrency, you must only include one-half of the profits from cryptocurrency transactions if they qualify as capital gains. In either scenario, the profit is determined by deducting your tax cost from your proceeds of disposition (for example, your adjusted cost base). Whether or not the receipt was a source of income in and of itself will determine how much tax you owe on a forked coin. If you didn't have to report the value of the receipt as income because it was a tax-free windfall, you have no tax cost because you didn't have to pay taxes on the receipt's value. If you reported the value of the forked coin as taxable income for the year of acquisition because the hard fork was a source of income, then your tax cost for the forked coin is equal to the sum you reported as income as a result of the receipt.
The Federal Court of Appeal, the Tax Court of Canada, and the Supreme Court of Canada have all produced a substantial body of case law over the years that examines the various aspects that affect the capital/income distinction. The case law is intricate, fact-specific, and occasionally contradictory. If anything, these decisions demonstrate the need for legal counsel from an expert Canadian crypto tax lawyer with experience in cryptocurrencies.
Tax Pro Tips: Proper Record-Keeping and Tax Reporting for Individuals Who Engage in Cryptocurrency Transactions, Seeking a Legal Opinion on the Matter and a Voluntary Disclosure Program for Any Unreported Income from Crypto Transactions
If the Canada Revenue Agency chooses a Canadian cryptocurrency investor or trader for a cryptocurrency tax audit, (which the CRA now initiates on a regular basis) they will do poorly if they don't keep good records. Taxpayers who engage in cryptocurrency transactions should keep track of not only their contributions and transactions in cryptocurrency but also any new cryptocurrency tokens they obtain from airdrops or hard forks of the blockchain.
To prevent losing their transaction information, taxpayers who engage in cryptocurrency should periodically download and export it. In addition, they need to keep the following records of any cryptocurrency transactions:
- The day each transaction occurred;
- Receipts for any cryptocurrency purchases or transfers;
- The cost of the cryptocurrency at the time of the transaction in Canadian dollars;
- The cryptocurrency addresses and digital wallet records;
- A description of the transaction and the other party, such as their cryptocurrency address;
- The records of the exchange;
- The agreement's legal terms and conditions;
- Records pertaining to any accounting and legal fees; and,
- Records pertaining to any software fees for keeping track of your taxes and cryptocurrencies.
In order to prevent the Canada Revenue Agency (CRA) from faulting you for misrepresenting the information in your tax returns, charging you with gross negligence penalties, or, worse yet, prosecuting you for tax evasion, our expert Canadian tax lawyers can offer advice about record-keeping and the proper reporting of your cryptocurrency profits.
Canadian taxpayers who invest in, trade, or receive cryptocurrency as a result of blockchain hard forks will typically benefit from a tax memorandum that examines whether their earnings are sources of income and, if so, whether they should be reported as capital gains, business income, or a combination of the two. Due to the peculiar nature of cryptocurrency hard forks, affected Canadian taxpayers will need qualified and experienced Canadian crypto tax lawyer advice on a number of unresolved issues. Numerous clients have sought help from our knowledgeable Certified Specialist in Taxation Canadian crypto tax lawyer with issues relating to the accurate categorization and reporting of their cryptocurrency transactions and other blockchain-based transactions.
The anonymity that cryptocurrency users thought they had once enjoyed is coming to an end due to the advancements and collaborative efforts of international tax authorities. Taxpayers in Canada should be extremely concerned about unreported profits from cryptocurrency transactions. If you submitted Canadian tax returns that failed to disclose or underreported your cryptocurrency profits, you run the risk of being subjected to both civil monetary penalties, such as gross negligence fines, and criminal tax evasion charges. Additionally, if you didn't submit T1135 forms for your holdings in cryptocurrencies, non-fungible tokens, or other blockchain-based assets, the standard late-filing penalty could be as high as $2,500.00 per unfiled form, and the gross-negligence penalty could be as high as $12,000.00 per unfiled form.
According to the CRA's Voluntary Disclosures Program, you might be eligible for relief (VDP). The CRA will forego criminal prosecution and waive penalties for gross negligence if your VDP application is approved (and may reduce interest). However, a VDP application has a deadline. If an application is not "voluntary," the CRA's Voluntary Disclosures Program will reject it, depriving the applicant of any relief. This basically means that before the Canada Revenue Agency contacts you about the non-compliance you seek to disclose, the Voluntary Disclosures Program must first receive your VDP application.
Numerous Canadian taxpayers have benefited from our experienced Certified Specialist in Taxation Canadian tax lawyer's assistance with unreported cryptocurrency and blockchain transactions. We can meticulously plan and expeditiously prepare your VDP application. A properly prepared voluntary disclosure application not only increases the chances of the CRA granting tax amnesty but also lays the groundwork for a judicial-review application to the Federal Court if the Canada Revenue Agency denies your VDP application unfairly.
Book an appointment for a privileged and confidential consultation with one of our knowledgeable Canadian tax lawyers to find out if you are eligible for the Canada Revenue Agency's Voluntary Disclosures Program. Information that is shielded by the solicitor-client privilege cannot be required to be produced by the Canada Revenue Agency. The CRA is not permitted to learn about the legal advice you obtained from your tax lawyer owing to the solicitor-client privilege. However, none of your communications with an accountant are secure. So you should first contact our Canadian tax lawyers if you need tax advice but don't want the Canada Revenue to know. If you need an accountant, we can hire them for you while maintaining the solicitor-client privilege.
FREQUENTLY ASKED QUESTIONS
I received new coins as a result of a fork. Are these coins taxable?
In most, but not all, cases the receipt of new coins as a result of a fork is not a taxable event. However, the disposition of these coins is always taxable.
I received coins as a result of a hard fork and I immediately sold them. Are the prophets a capital gain or an income transaction?
The distinction between capital gains and regular income is one of the more difficult issues in income tax. The courts have developed numerous tests that will be applicable and will depend on the actual circumstances of your case. You will benefit from a memorandum analyzing the tax treatment prepared by one of our top Canadian crypto tax lawyers.
"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."