The Effects of Cryptocurrency on Taxes Flash Loans: Canadian Tax Lawyer Analysis
Published: February 1, 2023
Introduction: The Development of Cryptocurrency Trading and Taxation
The Canadian tax system has seen significant difficulties with tax compliance as a result of the recent years' spectacular development in cryptocurrency trading. As Canada's tax enforcement body, the Canada Revenue Agency (CRA) has frequently found it challenging to keep up with the rate of economic innovation brought on by the unregulated, decentralized cryptocurrency market. One such new development that will undoubtedly cause problems for the Canada Revenue Agency and Canadian courts is "flash loans." You should speak with one of our knowledgeable Canadian cryptocurrency tax lawyers if you have or are currently engaged in cryptocurrency trading, particularly when using flash loans so that you can navigate the tax implications of your actions, especially given the rapidly evolving views of cryptocurrency trading held by the Canada Revenue Agency.
What exactly is a Cryptocurrency Flash Loan?
Prior to exploring flash loans, it would be beneficial to examine a near counterpart that is accessible under our current, regulated financial system. A day loan, sometimes known as a "daylight loan," is a popular financial instrument offered by banks and other institutions. A daylight loan is one in which the principal is borrowed, and the interest is paid over the course of a single day. Because it makes it simple to access additional capital, reduces the cost of interest and any risks that might come with a loan with a longer maturity date, and provides thorough documentation of fund transfers for the transactions, daylight loans are a popular tool for crypto tax planning and planning subsequent same-day transactions.
Uncollateralized loans come in the form of flash loans. A flash loan is meant to enable a borrower to conduct quick transactions without making a long-term commitment, therefore in theory it is comparable to a daylight loan. However, in contrast to a daytime loan, both the loan's repayment and real payment happen at the same time. A public ledger system, used by several cryptocurrencies, necessitates the verification and recording of cryptocurrency transactions against a public record. When a transaction has been confirmed, it is added as a block to the ledger, enabling many transactions to take place concurrently.
Because of the ledger system, a contract that calls for both a cryptocurrency advance, and a cryptocurrency payback may be created and carried out simultaneously. Because cryptocurrency exchanges are decentralized, traders that find price discrepancies between currencies on exchanges frequently use flash loans as a strategy. With the use of a flash loan, a trader may leverage a sizeable amount of cash with little risk to partake in arbitrage or asset swapping when the right time comes.
The Importance of Canadian Tax Laws for Flash Loans
In accordance with paragraph 18(1)(b) of the Income Tax Act (the "), a taxpayer may not deduct "an outlay, loss, replacement of capital" or "a payment on account of capital" from their income from a trade or enterprise or from the use of the property. An option is provided under paragraph 20(1)(c) of the Tax Act, which permits a taxpayer to deduct loan interest payments from their income from a business or property. In light of the possibility that the interest paid may be deducted from the taxpayer's income, the classification of payment as "interest" will thus be important to a taxpayer. Depending on the number of interest payments made on the loan in issue, a taxpayer may see sizable tax savings.
A flash loan, however, poses a big difficulty under these laws. Due to the way the ledger system works, the lender in a flash loan essentially never gives up the loan's principle. In general, Canadian courts determined that the daily accrual of interest is a crucial component in determining whether a payment, amount, or contractual right qualifies as an interest payment. Three conditions must be completed in order for a sum to qualify as interest for tax purposes, according to the Federal Court of Appeal in Perini Estate v. Minister of National Revenue,  CTC 74 (FCA) (emphasis added):
- The amount was a reimbursement for the borrower's usage of the funds.
- The amount was determinable every day.
- The amount was connected to the outstanding main amount.
Flash loans entirely break these standards because they are paid off and repaid at the same time. It is not truly accrued over time at any point; rather, the lender's payback is determined in exact proportion to the amount borrowed. A condition that must be met in order for the contract to be implemented, which may be regarded as interest as part of a flash loan, is all that is required. If the debts were not paid in full at the same time as the flash loan, the contract could not be fulfilled.
Although it is troubling that the flash loan breaches fundamental concepts of interest, it could still be possible to qualify a portion of the payment as interest. In earlier instances like Perini and Miller v. The Queen,  2 CTC 139 (FCTD), the classification of interest by Canadian courts did not entirely depend on daily accrual as a criterion for identifying an amount as interest. The conclusion reached by the Supreme Court of Canada in The Queen v. Melford Developments Inc.,  CTC 330 (SCC), supports the idea that interest cannot be categorized using a limitation test that places a primary emphasis on daily accrual. Therefore, it is still possible that the courts will review and reassess the meaning of interest to include immediate payback. In the past, Canadian courts have disapproved of recognizing an amount as interest only because it bears that name and instead has chosen to consider the substance of a transaction. It will take some time for the courts to decide whether or not to designate any amount as interest when a flash loan is repaid.
Tax Pro Tip: Trades in Flash Loans May Still Be Taxable
Using a flash loan in order to trade cryptocurrencies will result in Canadian crypto tax responsibilities regardless of whether the interest on those loans is deductible. In Canada, buying and selling cryptocurrencies is largely governed by the same laws that apply to trading traditional commodities. If there has been a property disposition, trading in commodities in Canada typically results in tax obligations. To qualify as a disposition, when cryptocurrency is quickly transferred between hands, the choice to use a flash loan to profit from a market anomaly must be made. This is probably true even if all you do is exchange one cryptocurrency for another, never converting your holdings into fiat money like Canadian dollars.
As a result, it's crucial that you keep account of exactly what you trade and its worth both when you acquire it and when you dispose of it. The reporting requirements for cryptocurrency exchanges are stricter than ever because of the significant legal changes that took effect in Canada on June 1, 2021. Every cryptocurrency exchange in Canada is now required to register with the Financial Transactions and Reports Analysis Centre of Canada (FinTRAC), as well as to keep track of the details of the parties involved in any transactions that exceed $10,000 Cdn. It is possible that if you engage in flash loan trades, you will be subject to these regulations. Since cryptocurrency traders are now subject to greater degrees of scrutiny and monitoring, it is crucial more than ever that you maintain proper records of your trades and accurately disclose any revenue generated. If you have questions about how to categorize your cryptocurrency trading revenue or if you have engaged in flash loan trading but have not previously disclosed your crypto income on your tax returns, you should speak with a knowledgeable Canadian crypto tax lawyer.
"Only general information is provided in this article. Only as of the publishing date is it current. It hasn't been updated; therefore, it might no longer be relevant. It cannot or ought not to be relied upon because it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should contact a lawyer if you have specific legal inquiries."