NFT Rug-Pulls Taxation: A Canadian Tax Lawyer's Perspective

What Is An NFT?: A Brief Background

A non-fungible token (NFT) is a one-of-a-kind digital asset based on the blockchain system. It is one-of-a-kind, meaning there is only one original, unique NFT. Cryptocurrencies (such as Bitcoin, Solana, or Palm) and traditional fiat currency are fungible, which means that each coin, token, dollar, or pound is identical and thus interchangeable.

Furthermore, with NFTs being built on the blockchain, you can monitor ownership and verify the asset's legitimacy. As a result, while you can screenshot an NFT of a bored ape (equivalent to making a replica of a painting), the original NFT preserves its worth because it is a verifiably unique, authentic, and original version.

NFTs can be bought, traded, or transferred using cryptocurrencies like Etherium, Polygon, Tezos, Flow, and Arbitrum because they are built on the blockchain. The rise in popularity of cryptocurrency has resulted in a surge in interest in NFTs. As a result, numerous artists, musicians, and prominent people have begun creating and selling NFTs, frequently for enormous sums of money.

Understanding NFT Rug-Pulls

With the surge in popularity of NFT, investors, speculators, and even scammers have invaded the market. The term "rug-pull" is derived from the statement "having the rug pulled out from under you." Essentially, a person or organization deceives the investor and steals their money.

An NFT rug pull happens when an NFT developer sells an NFT, or set of NFTs and then sets the conditions for the NFT's value to plummet drastically. For example, if an NFT gets its value on being part of a community or collection, and the developer decides to quit the group, the value of the NFT may drop.

NFT Rug-Pull Types

There are numerous ways for a developer to "rug-pull" and by doing so devalue the NFT. One simple method is to simply disappear with investor funding prior to the completion of a project. Moreover, suppose an NFT belongs to a collection; if the developer abandons the collection before it is completed, it will affect the value of the previously sold NFTs.

Another frequent rug-pull approach involves purchasing the NFT with a specific "scam-coin." Typically, after substantial investment, the developers will sell all of the "scam-coin" they have on hand, depreciating the cryptocurrency (and hence the NFT) to a portion of its original purchase price. Because the creators established the "scam-coin," they can keep the majority of the coins or tokens. This means that any sale by the developer will almost certainly lower the price of the cryptocurrency, and hence the NFT.

Other rug-pulling tactics include:

• A "hard" rug-pull would entail the developer building a back-door intrusion into the NFT.
• The Cryptocurrency liquidity stealing occurs when developers use a smart contract to artificially inflate the value of a "scam-coin" with a real cryptocurrency before depreciating it.

The Tax Implications Of An NFT Acquisition

Despite the fact that the investor's NFT only has a fraction of its original purchase price left after a rug-pull, the investor is still likely to receive sizeable tax benefits after selling the asset at a loss. While owning an asset does not result in tax implications, selling it does cause the gain or loss to "crystallize," which results in crypto tax reporting requirements for the taxpayer. A tax deduction is not possible if the loss is not crystallized through a disposition, so the crystallization is crucial for income tax planning. The Canadian Income Tax Act makes distinctions between income sources, including capital gains, and income from employment, business, and property (including investment income). Each of these different sources of income is taxed differently. This is why it is so important to accurately categorize the source of revenue (or loss).

A disposition of property, including an NFT, is typically treated as either capital property or a commercial kind of property under the Canadian Income Tax Act. Selling business property, including an adventure in trade, results in business income or loss as opposed to capital gains or losses when selling capital property. The income Tax Act of Canada, however, operates backwards: the Courts first establishes the sort of income—capital gain or business income—and based on the nature of the income, the property is then considered either capital property or business property.

To put it another way, the nature of the property is determined by the type of revenue it produces upon sale, whether it be business income or capital gains. Because of this, it's crucial to know if the property will result in capital gains (or losses) or commercial income upon sale (or loss).

Canadian Tax Courts have frequently been tasked with determining between capital gains and business income, and as a result, Canadian crypto tax law has gathered a variety of case law on the subject. Trading typically generates business income while investing generates capital gains. The Courts have cited a variety of characteristics that effectively differentiate them. There is no single criterion that is determinative, and all relevant factors must be considered, including: intent when obtaining the item. These are often one the most crucial factors;

• Length of ownership: Brief ownership of NFTs often suggests a trading motive and so business income.
• Transaction frequency: Frequent buying and selling of NFTs usually suggests a trading motive and thus business income.
• Background knowledge: In most cases, advanced knowledge of NFT markets usually suggests business income.
• Time spent: Investing significant time in researching NFTs and the NFT market, as well as managing a portfolio, frequently results in a profit.
• Financing: Debt-backed investment usually signals business income; and
• Advertising: If a taxpayer declares that they deal in or specialize in NFTs, this will usually show business income.

However, as previously indicated, the most essential component in this study is the taxpayer's intention when purchasing the non-fungible token. While the taxpayer's intention is important, the Court can consider objective factors, such as those stated above, to verify and investigate that intention. The Supreme Court of Canada stated in Macdonald v Canada that the taxpayer's desire cannot trump objective analysis. Simply put, if the objective circumstances significantly favor one form of income, the taxpayer's declared intention will not suffice to prove otherwise (on its own).

Tax Implications Of An NFT Rug-Pull

The taxpayer's property will be severely depreciated in the context of an NFT rug-pull. While there are no tax benefits for penalties for just having a depreciating asset; there are tax consequences when the taxpayer sells the asset. The tax effects will be determined by whether the disposal results in a capital loss or a business loss. If all of the criteria point to investing, the outcome will be a capital loss. If the factors point to trading or a single trading experience, the result will be a business loss.

Between capital and business losses, a taxpayer will typically desire to incur business losses whenever possible. Similarly, capital gains are generally preferred by a taxpayer. This is due to the 50% inclusion rate on capital gains and losses, which means that only half of the gain or loss is taxable. As a result, while business losses are completely deductible, capital losses are not.  Furthermore, capital losses can only be deducted against capital gains while business losses can be deducted against any source of income.

Pro Tax Tip: Make Sure You Can Deduct Your Loss

The first phase in deducting a loss is to dispose of the NFT.

Once the loss has been crystallized, the taxpayer's intention at the time of purchase is the most essential aspect in determining whether the sale of an NFT results in a capital loss or a business loss. Contact our qualified Canadian crypto tax lawyers to ensure that your losses are deductible and for further information on the distinction between business income and capital income. We can analyze your cryptocurrency or NFT portfolio and advise on the right tax treatment or tax-saving techniques, such as loss crystallization.

FAQs:

1. What exactly is an NFT (non-fungible token) rug-pull?

An NFT rug-pull occurs when the developer or inventor of the NFT or NFT community purchases an NFT and then creates conditions for the NFT's price to fall dramatically. As a result, the investor has an NFT worth only a proportion of the purchase price.

2. Is it possible to claim the loss without selling the NFT?

The Income Tax Act needs a disposition in order to incur a loss. When you sell or trade the NFT, you make a disposition. Following a rug-pull, the NFT must be sold in order to incur a loss and benefit from the tax deduction connected with the loss.

3. How can I determine if I've suffered a capital or business loss?

It is vital to appraise your purchase based on the following factors: length of ownership, transaction frequency, background knowledge, time spent, finance, and advertisement. Our Canadian tax lawyers are specialists in crypto tax in Canada and have advised countless taxpayers in determining the sort of crypto income they have incurred.

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."