The Canadian Income Tax and Cryptocurrency Staking: Knowing the Income-Tax Consequences for Canadians in the Validation of Cryptocurrency Transactions in Proof-of-Stake Blockchain

Modes of Verifying Cryptocurrency Transactions on the Blockchain: Proof of Work (Mining) and Proof of Stake (Staking/Forging) - An Introduction

A decentralized ledger system called a "blockchain" underpins all of the many cryptocurrency platforms, including Bitcoin (BTC), Wrapped Bitcoin (WBTC), Ethereum (ETH), BNB (BNB), Avalanche (AVAX), and Monero (XMR). The technology enables transactions and data to be recorded and shared in a synced and decentralized way across network members. It stores and transmits data in packages called "blocks," which are connected to each other in a digital "chain." As a result, transactions between network users can be handled without the need for a middleman or central entity.

Consensus mechanisms are used by blockchains to verify new bitcoin transactions. The proof-of-work system and the proof-of-stake system are the two consensus mechanisms that are employed the most frequently.

Proof-of-Work System (Cryptocurrency Mining)

"Mining" is the process used in blockchain protocols relying on the proof-of-work validation mechanism (e.g., the Bitcoin network). In the proof-of-work system, the validator, or the crypto miner, devotes computing power to solving mathematical problems. By doing this, the miner can verify cryptocurrency transactions and the results are shared with other network participants through the recording of such verified transactions as new blockchain blocks.

In proof-of-work systems, mathematical puzzles are designed to make validation costly in terms of the computing resources and electricity needed to solve them. As a result, a malicious user can only falsify the blockchain if doing so costs them a lot of money. According to experts, a malicious user would need to control more than 50% of the total computing power used by all miners in order to fake the blockchain. Even with other miners' participation, the malicious user still needs at least 25% of the overall processing power to pose a threat to the network. Furthermore, the cost of obtaining the necessary processing power to forge blockchain transactions will rise proportionately as the projected profit from forging blockchain transactions rises. This basically indicates that trying to forge a blockchain in a proof-of-work system is not profitable from an economic perspective.

Competition is there during cryptocurrency mining. The miner who validates the transaction first receives a reward. New tokens, either in the native cryptocurrency or transaction fees (or both), are typically the mining incentive. (Miners lose their mining rewards if they attempt to validate blocks repeatedly that the remaining network views as invalid, which serves as another deterrent for fraudulent users.)

See our article on cryptocurrency mining for details on the effects of cryptocurrency mining on Canadian income taxes.

Proof-of-Stake System (Cryptocurrency Staking)

"Staking" or "forging is the verification process used in blockchain protocols that use proof-of-stake validation mechanisms (e.g., the Polkadot network, Cardano network, Ethereum network (since The Merge), and the Avalanche network). The assigning of validation rights to users in the proof-of-stake system is based on their stake in the blockchain.

The validators, also known as "stakers" or "forgers," are required to own a minimum stake in the blockchain in order to take part in the validation process. Different proof-of-stake systems use different standards to determine the stake a validator has in the blockchain. For instance, in some systems, a validator's stake is determined by the amount of native cryptocurrency they own. Other systems require the validator to provide adequate security in the form of the network's native cryptocurrency, which is held in escrow for a predetermined amount of time.

Therefore, the proof-of-stake system chooses validators who are likely to behave in good faith, in contrast to the proof-of-work method, which necessitates each miner to wield enormous computer power and endure heavy electricity costs. Stakers often provide the necessary collateral or own a sizable amount of the native cryptocurrency. The staker is motivated to accurately validate transactions in both scenarios. The system's goal is to stop malicious users from taking control of the validation process by making them invest a lot of money in the blockchain before they can conduct a successful attack.

Cryptocurrency stakers get rewarded for verifying transactions on the blockchain, just like cryptocurrency miners do under the proof-of-work system. Similar to the mining reward, the staking reward typically takes the form of new tokens in the native cryptocurrency of the blockchain, transaction fees, or even both. A cryptocurrency staker, however, can only earn a staking reward in relation to their prior holdings in the blockchain's native token and proportion to their share of the platform's base, unlike cryptocurrency miners who can earn a mining reward without ever holding any of the blockchain's native tokens.

Therefore, cryptocurrency staking shows traits of both a service and an investment. One could argue that the cryptocurrency staker is rendering a service by validating transactions. But in order to receive staking rewards, a cryptocurrency staker or forger must first invest in the native tokens of the platform. As a result, staking cryptocurrencies raises a number of income-tax issues for Canadians, and without the right advice from a knowledgeable Canadian crypto-tax lawyer, Canadian cryptocurrency stakers and forgers frequently find themselves unsure of how to properly report their income to the Canada Revenue Agency.

The purpose of this essay is to inform Canadian income-tax payers about some of the tax concerns related to cryptocurrency staking. For Canadian taxpayers with crypto wallets who trade or invest in cryptocurrencies, this article's conclusion includes expert Canadian crypto tax advice from our top Canadian crypto-tax lawyers.

Receiving Reward Tokens from Cryptocurrency Staking and Forging: What are the Canadian Income-Tax Implications?

The character of the income determines how it is taxed under the Income Tax Act of Canada. In other words, different income sources are subject to different income tax laws. For instance, business and investment income are both wholly taxable in Canada. However, only 50% of a capital gain is counted toward taxable income.

Therefore, in order to understand how cryptocurrency staking and forging may affect Canadian income taxes, we must first ask: What kind of income do you get through cryptocurrency staking and forging? We must make a distinction between two methods of earning money from cryptocurrency staking and forging in order to respond to this question. The first is a reward for staking, which you get from a cryptocurrency platform in exchange for validating transactions on a blockchain that uses the proof-of-stake algorithm. The second is any potential profit from trading the reward tokens themselves.

Staking Reward Tokens Tax Characterization

Our skilled Canadian crypto-tax lawyers begin by examining reward tokens that a staker or forger obtains for staking cryptocurrency in order to ascertain the Canadian income-tax classification of cryptocurrency staking or forging. As previously said, cryptocurrency staking is similar to investing in that in order to receive staking benefits, the staker must first have a sufficient interest in the native tokens of the cryptocurrency platform. To put it another way, a cryptocurrency staker buys the necessary number of tokens as property, and by holding onto that property, the staker generates income through staking rewards from the cryptocurrency platform. Therefore, staking rewards received by a cryptocurrency staker or forger might qualify as investment income (or "income from property," as it is known under the Income Tax Act).

However, the investment-income characterization might not always be accurate. As was already established, the cryptocurrency staker may be seen as providing a service by validating transactions. Additionally, even if a taxpayer utilizes cryptocurrency-related assets to produce income, the correct tax classification will still depend on the level of activity involved in earning the money. Therefore, if you stake or forge cryptocurrency, and your operation demonstrates entrepreneurship, commercial risk, and the pursuit of profit, requiring a significant commitment of time, labour, and attention—like in frequently researching cryptocurrency markets, pursuing a number of strategic cryptocurrency-platform targets, leveraging to fund your ventures, immediately selling or collateralizing reward—your staking rewards may qualify as business income.

In any case, the overall tax treatment of business revenue and investment income is very similar. The receipt of reward tokens through cryptocurrency staking or forging is fully taxable under subsection 9(1) of the Income Tax Act as your profit from a business or an investment, as applicable, regardless of which tax classification is eventually appropriate. Therefore, you must factor in the fair-market value of the cryptocurrency you received as a staking reward—specifically, the value, expressed in Canadian dollars, at the time you received the cryptocurrency—when figuring out your taxable income.

Furthermore, you may raise the tax cost of the staking-reward cryptocurrency in accordance with subsection 52(1) of the Income Tax Act since you have declared the value of the staking-reward cryptocurrency as taxable income. When you eventually dispose of the cryptocurrency you received as a staking reward, the higher tax cost prevents double taxation.

Let's consider an example where you verify transactions for a cryptocurrency platform that uses the proof-of-stake mechanism and stake sufficient units of the native cryptocurrency of the platform. You are rewarded with new 2 units of the platform's cryptocurrency as a staking reward for doing this. Those 2 units have a $400 value at the time of issuance. You must record the $400 as business income or investment income in accordance with subsection 9(1) of the Income Tax Act of Canada (depending on the appropriate tax characterization). Your tax cost for the staking-reward units is $400 in accordance with subsection 52(1). Your taxable income will be determined by the $400 tax cost when you eventually sell the staking-reward units. For instance, your $400 tax cost means that you would generate a profit of $6,600, which you must declare as income or capital gains if you later sell the staking-reward units for $7,000 (or trade them for other cryptocurrency tokens worth $7,000).

The relevant tax characterization will once again determine the specific tax treatment of the income from the disposition. Particularly, the profit made by selling a property is either business income or capital gain. Therefore, any profits made by cryptocurrency stakers or forgers from the sale of staking-reward tokens must be disclosed and subject to taxation, either at a rate of 100% for business income or 50% for capital gains.

The capital/income distinction depends on the goals of the cryptocurrency staker. The main concern is whether the taxpayer staked cryptocurrencies with the goal of profitably selling the staking-reward tokens. If so, the profit is considered income from the business. The sale proceeds will be placed on a capital account and subject to capital gain tax if the taxpayer can prove he or she had another intention, such as investing rather than trading, by citing objective criteria.

Suppose a taxpayer can show that, for example, the taxpayer wished to control a cryptocurrency platform and only looked for cryptocurrency-staking agreements delivering reward tokens that conferred voting power over the network's protocols. In that case, the taxpayer may be able to justify capital treatment. On the other hand, the taxpayer's involvement in cryptocurrency staking itself may show that such taxpayer have some level of sophistication and specialized understanding in the field. And this may indicate that the taxpayer's gains from the sale of the staking-reward tokens should be classified as business income, along with a number of other variables. Remember that the Income Tax Act defines a "business" as including "an adventure or concern in the nature of trade," so even a single cryptocurrency transaction's proceeds could result in income tax classification.

The ultimate lesson is that Canadian taxpayers need to be aware that no single analysis of the tax laws will address every situation. The effects on income taxes depending on the unique set of circumstances for each individual. This means that Canadian taxpayers who trade, invest in, develop, or stake in cryptocurrencies should all seek tax advice from a knowledgeable Canadian crypto-tax lawyer to understand their tax responsibilities.

Tax Pro Tips: Voluntary Disclosures Program for Unreported Income from Cryptocurrency Transactions and Tax-Law Analysis of Appropriate Cryptocurrency Tax Reporting

A tax memorandum analyzing whether earnings should be reported as business income, capital gains, or a combination of the two is usually beneficial for Canadian taxpayers who trade, invest, and stake cryptocurrency. Because different proof-of-stake systems have different characteristics, Canadian taxpayers who have staked cryptocurrencies will need skilled and specialized Canadian tax advice. Numerous clients have benefited from our expert Canadian Certified Specialist in Taxation crypto-tax lawyer's help in properly disclosing their cryptocurrency transactions and other blockchain-related agreements.

Canadian taxpayers who have unreported profits from cryptocurrency transactions should be concerned about the developments and collaborative efforts of international tax authorities. In the event that you filed Canadian income tax returns that excluded or underreported your cryptocurrency revenues, you run the danger of being subject to both civil monetary penalties, such as gross negligence fines, as well as criminal tax evasion charges. And if you didn't submit T1135 forms disclosing your holdings in cryptocurrencies, non-fungible tokens (NFTs), or other blockchain-based assets, the standard late-filing fine can be as high as $2,500 per incomplete form, and the T1135 gross-negligence fine can be as high as $12,000 per incomplete form.

Both unreported income and incomplete T1135 forms may qualify for relief under the CRA's Voluntary Disclosures Program (VDP). The Canada Revenue Agency will drop any criminal charges against you and waive gross negligence fines if your VDP application is approved, (and may even cancel or waive interest thereon).

A VDP application, however, has a deadline. This basically means that the VDP application must be received by the Voluntary Disclosures Program prior to the Canada Revenue Agency reaching out to you to inquire about any of the non-compliance you seek to disclose. If an application is not "voluntary," the CRA's Voluntary Disclosures Program will reject it and will deny any relief. See our page on the CRA Voluntary Disclosures Program for more information about meeting the requirements for relief under the VDP.

Numerous Canadian taxpayers have received assistance from our top crypto-tax lawyers in regards to unreported cryptocurrency profits and blockchain transactions. In addition, preparing a VDP application that not only improves the likelihood that the CRA will grant tax amnesty but also lays the groundwork for a judicial-review application to the Federal Court should the Canada Revenue Agency unjustly deny relief. A memorandum to analyse your cryptocurrency transactions will also be prepared in order to determine the best reporting methodology—that is, income or capital gains, or both.

Make an appointment for a private consultation with one of our knowledgeable Canadian crypto tax lawyers to find out if you are eligible for the Voluntary Disclosures Program of the Canada Revenue Agency. Information that is shielded by the solicitor-client privilege cannot be required to be produced by the Canada Revenue Agency. The confidential legal crypto tax advice you receive from our tax lawyers is protected by the solicitor-client privilege and is not disclosed to the CRA. However, your communications with an accountant are not protected since accountants do not enjoy this privilege. Therefore, you should first contact our Canadian crypto tax lawyers if you need tax guidance but want to keep that information concealed from the Canada Revenue Agency. If you also need an accountant's help, we can take steps to extend the solicitor-client privilege to interactions with the accountant.

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 lawyer."