tax aspects of bitcoin and other cryptocurrencies · 66th annual tax conference | vancouver 2014...

66th Annual Tax Conference | Vancouver 2014

Tax Aspects of Bitcoin and Other Cryptocurrencies

Olivier FournierDeloitte Tax Law, Montreal

John J. LennardDavies Ward Phillips & Vineberg LLP Montreal

December 1, 2014

66th Annual Tax Conference2


O. Fournier & J. Lennard

Bitcoin is not just digital currency. It's Napster for finance.

David Z. MorrisFortune MagazineJanuary 2014




What is a Cryptocurrency?

Digital

Cryptographic

Money




Agenda

> An introduction to decentralized finance

> How Bitcoin works

> Initial tax aspects

> Income tax

> GST/HST/QST

> What's next?


Cryptocurrency

fundamentals

An introduction to

decentralized finance




Cryptocurrency fundamentals

> All software, all digital

> No physical form or manifestation

> A trustless system

> Trust in the software protocol, as opposed to trust in a person

> Peer-to-peer (decentralized)

> No central server: each user is a "node" in the network

> Transactions are verified by a large number of nodes using proof-of-work system known as "mining"




Ex: Visa, Paypal, Bank Wire Systems

Bitcoin-based cryptocurrencies

Central Server vs. P2P


How Bitcoin works




What is Bitcoin?> The dominant cryptocurrency technology

> Launched in 2008

> Main features:

> Completely decentralized P2P network

> Supply limited to 21 million coins (divisible to 8 decimal places)

> All transactions are timestamped and published on a ledger (the "blockchain") accessible to all

> The network, as a whole, verifies the timestamping in order to prevent a "double-spending" problem

> "Wallets" are anonymous




How are bitcoins "created"?

> Bitcoins are not issued – they are "mined"

> Mining requires the use of computing power to solve a mathematical problem (called a "block")

> This computing power also serves to verify transactions

> As a reward for dedicating computing power to the network

> The first miner to solve a block is rewarded with newly issued Bitcoins

> More computing power – more likely to be rewarded

> Difficulty of the blocks increases over time as more power is devoted to the network




How Bitcoin works> "Asymmetric key cryptography"

> Public key: akin to an e-mail address

> Private key: akin to a password

> Used to verify identity and transactions

> Every "wallet" has

> A public key – for receiving units and balance verification

> A private key – to spend units

> Each user is responsible for his/her wallet

> If keys are lost, the units are lost forever




Mining and Network Security

> The computing power dedicated to mining also serves in

> Verifying Bitcoin transactions

> Effectively securing the Bitcoin network

> Transaction fee awarded for verifying Bitcoin transactions

> With each block solved, transactions since the last block are added to the "block chain"

> The block chain is continuously re-verified by miners ("consensus")

> The longest most consistent block chain serves as the most trustworthy ledger




Bitcoin as a Currency> Main advantages

> Not subject to political pressures of any one country

> No risk of inflation due to limited supply

> Significant divisibility

> Transaction fees are negligible

> Disadvantages

> Currently complex to acquire

> Usually at a premium that varies depending on the anonymity of the transaction

> Historically associated with questionable activities


Initial Tax Questions

Income Tax Aspects




Fundamental tax issue: Characterization

> Are Bitcoin and other cryptocurrencies “currencies” for tax purposes?

> Once that is determined, remaining tax issues (e.g. timing and character of gains or loss, consequences of transacting, information reporting, etc.) are more readily resolved




Income tax considerations

Statements from the Canada Revenue Agency

> Four broad points:

1. Virtual currency (such as Bitcoin) is not a foreign currency, but is instead a commodity

2. Transactions in Bitcoin assimilated to "barter" transactions (see archived IT-490 – Barter Transactions)

3. Transactions in Bitcoin may be on account of income or on account of capital, depending on the facts and circumstances

4. Normal rules on inventory valuation and recognition of losses should apply to Bitcoin mining and transactions




Income tax considerations

> Questions arise at different levels

> Bitcoin "mining"

> Do receipts from the mining of bitcoins constitute income?

> Trading Bitcoin for goods or services

> Are bitcoin-denominated transactions treated as barters or as foreign currency-denominated transactions?

> Operating a Bitcoin exchange

> Do transaction fees received constitute income from a source?

> Speculating in Bitcoin

> Are dispositions of bitcoins treated on income or capital account?

> Other issues

> Gifts, employment income, dividend payments




Bitcoin mining

> Set of activities consisting of inputs (i.e. computer, electricity, labour, time), processes (i.e. software), and outputs (Bitcoin)

> Hobby or commercial activity?

> Stewart v. Canada (SCC): "In order for an activity to be classified as commercial in nature, the taxpayer must have the subjective intention to profit and there must be evidence of businesslike behavior which supports that intention"




Bitcoin mining

> If done as part of a business, the act of mining bitcoins may give rise to income from that business

> But when is the income recognized?

> At the moment the bitcoin is "unearthed"?

> At the time the bitcoins are converted to a government-issued currency or transferred to a third party for goods/services?

> Qualified as inventory or capital property and taxed accordingly




Bitcoin mining

> Inventory valuation

> Necessary to determine the value of the taxpayer’s inventory for the purposes of computing a taxpayer’s income from business

> Market value of Bitcoin as at date of acquisition (i.e. mining) = cost of Bitcoin

> What is the best measure of value?




Bitcoin mining

> Consequences of loss, from theft, of Bitcoins acquired in the context of business activities?

> See IT-185

> Are Mt. Gox losses “reasonably incidental” to the activities of the business?

> Mining pool arrangements?

> Pooling of resources and sharing of processing power by miners, who split the reward equally according to the amount of work they contributed to solving a block

> Additional complexity

> Audit issues relating to anonymity




Operating a Bitcoin exchange

> Selling Bitcoin as an exchange service would clearly seem to be a commercial activity

> Proceeds derived from sale of bitcoins (transaction fees) should be included in income

> Expenses deductible

> Including cost of acquisition of bitcoin for sale

> Again, question of valuation




Trading Bitcoin for goods or services

> Barter transactions:

> Exchanging one commodity for another (i.e. without the use of "money")

> Each person considers that the value of whatever is received is at least equal to the value of whatever is given up in exchange

> Can result in income or expense, or can result in the acquisition or disposition of capital property, eligible capital property, personal-use property or inventory, depending upon the circumstances

> Can also lead to anomalous results




Barter transaction – example

> Ms. A does some renovation work for Mr. B. She would normally charge $500 this work

> Mr. B instead pays Ms. A using Bitcoin having a value, on the date the work is completed, of $550

> According to CRA, Ms. A must include $500 in her business income

> What is the deductible expense for Mr. B?

1 Bitcoin worth $550

Service worth $500

Mr. B Ms. A




Barter transactions

> In Linnett and Karoly v. MNR (85 DTC 416) the TCC held that amount to be reported in a barter transaction would be reduced where the value received on the transaction is less than the value given up.

> The court, however, did not address the situation where the amount received is higher

> In Donovan v. R (94 DTC 1143), TCC held that the value of the what is received should be based on the benefit to the recipient, and the cost to the provider is irrelevant

> Therefore:

> Income for Ms. A ≠ Expense for Mr. B

> Cost of bitcoin to Ms. A ≠ Proceeds of disposition of Bitcoin to Mr. B

> What if we viewed it as a foreign currency-denominated transaction instead?




Foreign currency-denominated transaction

1 Bitcoin

Service worth 1 Bitcoin

Mr. B Ms. A

> Transaction would occur in Bitcoin

> Bitcoin then valued in CAD terms

> Income for Ms. A = Expense for Mr. B

> Cost of Bitcoin to Ms. A = Proceeds of disposition of Bitcoin to Mr. B




Speculating in Bitcoin

> Normal rules should apply

> When bitcoins bought and sold like a commodity, disposition should give rise to income or capital gains according to whether they are traded on income, or held on capital, account.

> Where a person trades or sells bitcoins (i.e., speculates on the changes in the value of bitcoins), the resulting gain or loss likely be on account of income (same as for transactions involving other types of commodities, or even currencies)




Gifting

> According to CRA, FMV of the bitcoins themselves at the time the bitcoins are transferred that must be used in determining the eligible amount of the gift for tax purposes.

> If bitcoins are used to acquire property and the acquired property is donated, the FMV of the acquired property determines the eligible amount




Employment income

> In CRA's view, remuneration paid in Bitcoin must be valued and reported in CAD and included under s. 5 or s. 6

> What about source deductions and withholdings? How will an employer withhold and remit amounts from wages paid in bitcoins?

> Service providers now exist: Canadian taxes are taken out of the wages before the Bitcoin payment is made, and the remaining funds are sent to an existing Bitcoin address or wallet service at the market rate




Dividends

> If not currency, treated as in-kind dividends?

> Subs. 52(2) ITA: shareholder deemed to acquire property at cost equal to FMV, and corporation deemed to have disposed for proceeds equal to FMV

> Fairness issues for corporations (and their shareholders) who mainly use Bitcoin for payment purposes?




International tax treatment of Bitcoin

Commodity Money/currency

Canada United Kingdom (foreign currency rules apply)

United States Germany (technically classified as a "unit of account", or "private

money")

Australia

Denmark

Brazil

Norway


Initial Tax Questions

GST/HST/QST Aspects




GST/HST/QST Considerations

> Statements from the Canada Revenue Agency

> Published positions on Bitcoins only

> Unclear if the acquisition of Bitcoins is subject to GST/HST

> Unclear if Bitcoins are considered "money" for GST/HST purposes

> Bitcoin transactions are clearly defined as "barters"

> In the supply of goods and services

> So far no explicit position on the acquisition of bitcoins for cash

> It may be inferred that the acquisition of bitcoins for cash is a barter and a taxable supply

> If it were “money” under s.123 ETA, it would a financial service




GST/HST/QST Considerations> Practical issues

> Mining has no identifiable "recipient“

> Mining could be the supply of a service as part of a commercial activity

> Transaction fees are akin to a financial service

> The difficult line between barters and financial services

> Proposed solution: treat Bitcoin-based transactions as foreign currency transactions

> The acquisition of Bitcoins for cash is not “value-added”

> Taxing it would lead to double-tax on the consumer

> Bitcoins may well be "money" for GST/QST purposes




Double-Tax Example – GST/QST

• 1 Bitcoin acquired for $500

• ATM located in Toronto

• Includes a premium

• Subject to GST/HST?

• If such taxes are paid by a consumer, no ITC




Double-Tax Example – GST/QST

• Bitcoins then used to purchase taxable goods

• Store located in Toronto

• Purchase is subject to GST/HST

• If tax is payable on purchase of Bitcoin: double-taxation on the consumer




What if bitcoins are money?

“money” includes any currency, cheque, promissory note, letter of credit, draft, traveller's cheque, bill of exchange, postal note, money

order, postal remittance and other similar instrument, whether Canadian or foreign, but does not include currency the fair market

value of which exceeds its stated value as legal tender in the country of issuance or currency that is supplied or held for its numismatic

value;




What if bitcoins are money?

“financial service” means

(a) the exchange, payment, issue, receipt or transfer of money, whether effected by the exchange of currency, by crediting or debiting

accounts or otherwise




Bank of Canada Backgrounder (July 2012)

> What is money?

> Means of exchange

> Unit of measurement

> A store of value for future use

> Perishable goods – not a good store of value

> Intrinsic store of value ≠ low volatility ≠ low inflation

> Volatility is relative to other goods

> An inflationary dollar loses value over time




Bitcoins may well be money

> Transaction fees would be exempt

> ATM operations would be financial services

> Consumers would not be subject to a double tax levy

> If a single country adopted Bitcoin as its currency, it may be money in any event


What’s next?




Where do we stand?

> Some key tax issues remain to be addressed

> Canada may wish to reassess its position in light of more recent pronouncements from other countries (e.g. Germany, United Kingdom)

> Framework needs to be clear, fair, internally-consistent and reflecting of modern realities

tax aspects of bitcoin and other cryptocurrencies · 66th annual tax conference | vancouver 2014...

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