Tax & Accounting January 04, 2018

The challenges of reporting income from cryptocurrencies

Cryptocurrencies and the blockchain technology that power them are beginning to disrupt how transactions take place, and I believe that they will continue to change the world in unexpected ways. For those not familiar, bitcoin is a decentralized cryptocurrency where transactions are permanently recorded a public blockchain ledger. The identity of each party to a transaction is generally unknown, since the buyer/seller is identified using an address which is merely a random assortment of characters. Until recently, there appeared to be almost guaranteed anonymity when transacting with a cryptocurrency, but more on that to follow. Sale of a Cryptocurrency: Income or Capital Account? It is a question of fact whether a gain or (dare I say) loss[1] is on account of income or capital. The CRA’s administrative position best describes the taxation of gains/losses from disposing of bitcoin: “Where a person trades or sells Bitcoins like a commodity (i.e., speculating on the changes in the value of Bitcoins), the resulting gain or loss may be on account of income or capital. Determining whether such a transaction is on account of income or capital can only be made following an assessment of all the facts relating to the particular taxpayer’s circumstances. Paragraphs 9 to 32 of Interpretation Bulletin IT-479R, “Transactions in securities”, provide general comments for purposes of determining whether transactions are income or capital in nature.”[2] The CRA considers bitcoin a commodity, not a currency. The definition of “foreign currency” under subsection 248(1) means “a currency of a country other than Canada”. Since bitcoin is not a currency of a country, it does not meet the definition of a foreign currency for tax purposes. Let’s consider the quintessential cryptocurrency speculator: a 20-something individual with little recollection of the “dot-com bubble”. It would be reasonable to assume that they are not operating a commodity trading business. If this investor sells his or her currency, is the gain or loss on account of capital or income? There has long been a framework for this determination established by the courts. The courts generally examine the taxpayer’s primary intention at the time the property is acquired. The courts also consider a taxpayer’s course of conduct in income vs. capital determinations, by examining factors including: frequency of transactions, length of ownership, time spent, and knowledge of securities markets. These factual tests are discussed in the CRA interpretation bulletin mentioned above. When applying this framework to an individual cryptocurrency speculator, the characterization of the gain or loss is subjective. For example, an investor who made a six-figure gain by betting on bitcoin can likely assume that the gain is on the account of capital. But where the investor deploys a few bitcoin mining rigs and the income from bitcoin eclipses his or her employment income, one can only speculate how the income might be characterized. Record-keeping As with any investment, record-keeping for cryptocurrencies is important for claiming a gain or loss. Taxpayers will need to retain records of each transaction. The adjusted cost base of a currency is presumably the cost incurred to acquire the currency including commissions paid to the exchange (if it was purchased from an exchange in the first place). Given that these currencies were designed to protect to the identity of the owner, it is reasonable for the CRA to expect extraordinary evidence that demonstrates that the taxpayer was in fact a party to a particular transaction. In terms of what records to keep, I believe that “everything and the kitchen sink” is a safe route to take that this time. Anonymity and Non-Compliance In a time that presumably hundreds of millions are being made by Canadians by speculating on bitcoin, the tax authorities can only wonder how much income has gone unreported. From a U.S. perspective, it was revealed that less than 1,000 U.S. citizens have reported income from their bitcoin holdings, despite Coinbase (a large bitcoin exchange in the U.S.) having more than 6 million users.[3] Coinbase was recently ordered by the IRS to reveal the information of over 14,000 of its users (transactions exceeding $20,000 USD).[4]  If the tax authorities know the personal identity that relates to a particular bitcoin address, they can potentially review all transactions on the blockchain—not completely anonymous after all. Similar cryptocurrency exchanges exist in Canada too. One particular exchange, QuadrigaCX, I observed volume of 707 bitcoins, or nearly $12 million CAD worth of trades in one day. The Canadian public has not been made aware of any enforcement activities undertaken by the CRA, or whether the CRA made any similar compliance order to any Canadian bitcoin exchanges. I also reviewed a thread on Reddit, where a Canadian asked whether they need to report cryptocurrency gains. After being told by several Redditors that Canadians are required to report their worldwide income, this was his response: “Well it's money to anonymous cryptocurrency (monero). After that you send it to another wallet and at that point it's untraceable. Yes, these exchanges are legit, they do not deal with fiat though, just pure cryptocurrencies, most likely makes a difference. But anyways, once I have my anonymous currency on an exchange I can trade all I want with nothing linking me to the trades if I take precautions. Then you take your money out by buying gift cards or something with the crypto. Obviously I'm not big time but it's almost like a second income.” Although warned by Redditors that they were committing blatant tax evasion, the user responded “obviously, lol.” Monero is another cryptocurrency that is self-proclaimed to be “secure, private, and untraceable”[5] Alternatively, speculators have resorted to using bitcoin “tumblers” to make it more difficult to trace transactions back to them.  Although the order for Coinbase to turn over information to the IRS was a win, it is clear that new methods of keeping cryptocurrency buyers and sellers completely anonymous are being introduced. If there is anything to conclude from all of this, it is that tax authorities have an uphill battle with enforcing compliance. If the unthinkable should happen and speculators suffer catastrophic losses, investors might be more incentivized to report if they have a loss to claim. That is why I wager that in the event of a price correction, tax authorities may see an uptick in cryptocurrencies being reported for tax purposes. In Conclusion:

  • There is a lot of money being made on cryptocurrencies
  • Many taxpayers are unaware of their tax reporting obligations
  • A lot of income is going unreported
  • Enforcing compliance is extremely challenging to due to the anonymous nature
  • Investors need to keep adequate records of their purchases and sales of cryptocurrencies
[1] I can’t help but listen to the voice of Benjamin Graham in my head that’s telling me that bitcoin has little to no intrinsic value as an asset, even when compared to other cryptocurrencies. There are hundreds of other cryptocurrencies out there and bitcoin has no competitive advantage apart from being the first one to exist and the most popular. [2] 2013-0514701I7 [3] [4] Ibid. [5]
Cameron Mancell
CFP®, Senior Technical Writer at Wolters Kluwer Canada
Cameron Mancell, CFP®, is a Senior Technical Writer at the Wolters Kluwer office in Toronto. Cameron contributes to Canadian Tax Reporter, Preparing Your Income Tax Returns, and Preparing Your Corporate Income Tax Returns, among several others.
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