Cryptocurrency-Trading Businesses in Canada
Canadian cryptocurrency-trading businesses face unique challenges. The mostly unregulated market brings higher risk of fraud and cyber-crime. The volatile markets may bleed profits. And some cryptocurrency traders don’t even realize that they’re carrying on a business, misreporting their profits as capital gains.
Is Your Cryptocurrency Inventory? Trading vs. Investing
Canada’s Income Tax Act recognizes only two broad sorts of property for tax purposes:
- capital property, which creates a capital gain or loss upon disposition;
- inventory, which figures into the computation of business income.
The type of income that the property generates upon sale-that is, capital gains or business income-determines whether that property is a capital property or inventory. In other words, one starts by determining the nature of the income and then characterizes the property, not the other way around. Hence, your profits from a cryptocurrency transaction will be treated as either (i) business income or (ii) a capital gain, and, if they are characterized as business income, your cryptocurrency units constitute inventory.
The income/capital distinction also comes with important tax implications. The full amount of business or property income is taxable, while only one-half of a capital gain is taxable. On the flip side, while only one-half of capital losses are deductible, one may fully deduct losses and expenses associated with business or investment activity.
Some cryptocurrency transactions straddle the line between income and capital. Canadian courts have indeed churned out a large body of case law wrestling with the ambiguity between investing, which produces a capital gain or loss, and trading, which results in business income or expenses. Courts assess a wide range of factors when deciding whether to characterize a transaction’s gains or losses as on an account of capital or income. Applied to cryptocurrency transactions, these factors may include:
- transaction frequency-e.g., a history of extensive buying and selling of cryptocurrency or of a quick turnover of cryptocurrency units might suggest a business;
- length of ownership-e.g., brief periods of holding the cryptocurrency indicate business dealings, not capital investing;
- knowledge of cryptocurrency markets-e.g., increased knowledge of or experience with cryptocurrency markets favours a business characterization;
- relationship to the taxpayer’s other work-e.g., if cryptocurrency transactions (or similar dealings) form a part of a taxpayer’s employment other business, it points toward business;
- time spent-e.g., a greater likelihood of characterization as a business if a substantial part of the taxpayer’s time is spent studying cryptocurrency markets and investigating potential purchases;
- financing-e.g., leveraged cryptocurrency transactions indicate a business; and
- advertising-e.g., increased likelihood of business characterization if the taxpayer has advertised or otherwise made it known that he deals in cryptocurrency.
Ultimately, the taxpayer’s motive or intent at the time of acquiring the cryptocurrency is the most important criterion that courts consider when determining whether the transaction produced a capital gain or business income. Still, to discern a taxpayer’s intention, courts will focus on the objective factors surrounding both the purchase and the sale of the cryptocurrency. In other words, courts will determine a taxpayer’s intent by evaluating the factors listed above.
Computing & Claiming Costs of Cryptocurrency Inventory for Income-Tax Purposes
Subsection 9(1) of Canada’s Income Tax Act codifies the deductibility of inventory costs by defining a taxpayer’s business income as the taxpayer’s “profit from that business.” When evaluating how a taxpayer went about computing profit, a court may ask whether a particular deduction agrees with generally accepted accounting principles (GAAP). But for income-tax purposes, the determination of a taxpayer’s profit is ultimately a legal question. In other words, while accounting principles and commercial practices may influence a court’s determination of whether a deduction was proper, those norms don’t comprise the operative legal criteria. In many cases, the Income Tax Act expressly ousts the use of otherwise acceptable accounting practices. So too have the courts.
That said, on the issue of computing inventory costs, Canada’s income-tax law mainly defers to commercial practice and generally accepted accounting principles (GAAP). For instance, commercial practice stipulates the use of accrual accounting for most businesses-especially those with high inventory turnover. As such, cryptocurrency-trading business will recognize inventory costs on an accrual basis, which means that the business doesn’t deduct the cost of cryptocurrency as an expense for the fiscal period in which the cryptocurrency was purchased. Instead, the business recognizes the inventory cost as an expense for the fiscal period in which the cryptocurrency was sold (i.e., cost of goods sold). For any cryptocurrency remaining on hand at the end of the fiscal period, the inventory at cost is recorded as an asset on the balance sheet for that period.
Cryptocurrency-trading businesses typically feature substantial inventory turnover. Thus, it’s neither possible nor desirable to keep a running tally of the cost of goods sold on a daily basis. So, the only feasible way of determining the cost of goods sold is to (i) determine the sum of the value of inventory on hand at the beginning of the tax year and the cost of the inventory purchased during the year and then (ii) subtract the value of the inventory on hand at the end of the year.
This accounting exercise gives us the following formula:
Cost of Goods Sold = Opening Inventory + Acquisitions – Closing Inventory
If inventory costs remain stable, the formula presents little trouble. If prices fluctuate, problems arise. For example: At the beginning of the year, a cryptocurrency-trading business has on hand 10,000 units of a particular coin with a current price of $1.00 per coin. At the end of the year, the business has on hand 10,000 units of the same coin with a current price of $4.00 per coin. During the year, the business traded 100,000 cryptocurrency units in the same coin, the price of which steadily increased as the business bought and sold cryptocurrency units each month. It’s impossible to say whether the 10,000 units in closing inventory are the same units as those in the opening inventory, or whether some or none from the opening inventory remain.
Hence, the computation of cost of goods sold involves two steps: The first is valuation, the second tracing.
Valuation refers to the method by which you assign an overall cost (or value) to the opening inventory and the closing inventory. Canada’s Income Tax Act permits two general methods of valuing inventory:
- valuation at the lower of cost and fair market value for each item of inventory;
- valuation of the entire inventory at fair market value.
A taxpayer may choose between these two methods and must use it consistently thereafter. (If the taxpayer wishes to switch, the Canada Revenue Agency must first give its permission.) Moreover, the Income Tax Act requires that the value of a business’s opening inventory equal the value of the business’s closing inventory from the immediately preceding year. So, the value of a taxpayer’s closing inventory determines the value of the taxpayer’s opening inventory for the following year.
Tracing refers to the method by which you determine which goods comprise the closing inventory and how much those goods cost. Canada’s income-tax law permits two methods of tracing: (1) averaging and (2) first in, first out (FIFO). Averaging assumes that the cost of each unit in closing inventory and of goods sold during the year equals the average cost of all units in opening inventory and of all units purchased during the year. FIFO allocates the most recent costs to closing inventory and the oldest costs to goods sold during the year. The assumption is that the goods sold were those first purchased-hence, first in, first out.
A third tracing GAAP method-last in, first out (LIFO)-also exists. LIFO makes the opposite assumption as that made by FIFO, and it thus allocates the oldest costs to closing inventory and the most recent costs to goods sold during the year. Canadian courts have rejected its legitimacy, however. Thus, Canadian cryptocurrency-trading businesses cannot use LIFO for income-tax purposes. This is an example of Canada’s income-tax law expressly ousting the use of otherwise acceptable accounting practices.
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