Published: February 23, 2022
Last Updated: November 7, 2022
Introduction – Verifying Cryptocurrency Transactions on the Blockchain: Proof of Work (Mining) & Proof of Stake (Staking/Forging)
The various cryptocurrency platforms—such as Bitcoin (BTC), Ethereum (ETH), Tether (USDT), Solana (SOL), and Ripple (XRP)—all hinge on a decentralized-ledger technology known as a “blockchain.” A blockchain is a particular type of data structure. It stores and transmits data in packages called “blocks,” which are connected to each other in a digital “chain.” The technology allows transactions and data to be recorded and shared in a synchronized and decentralized way across network participants. As a result, transactions between network participants can be processed without involving an intermediary or central party.
Blockchains rely on consensus mechanisms to validate new cryptocurrency transactions. The two most commonly used consensus mechanisms are (i) the proof-of-work system and (ii) the proof-of-stake system.
The Proof-of-Work System (Cryptocurrency Mining)
In blockchain protocols that rely on the proof-of-work validation mechanism (e.g., the Bitcoin network), the verification process is known as “mining.” Under the proof-of-work system, the validator—i.e., the cryptocurrency miner—devotes computing power toward solving mathematical problems. By doing so, the miner verifies new cryptocurrency transactions and shares the results with other network participants by recording the verified transaction as a new block on the blockchain.
The mathematical problems in proof-of-work systems aim to make validation expensive in terms of the computing power and electricity required to solve these problems. As a result, a malicious user can falsify the blockchain only if the attacker incurs a significant cost. Experts calculate that, to falsify the blockchain, a malicious user must wield over half the total computational power deployed by all miners. And even if the malicious user garners the cooperation of other miners, the attacker requires at least 25% of the total computational power to threaten the network. Moreover, as the expected revenue from falsifying the blockchain increases, the cost of acquiring the requisite computational power to falsify blockchain transactions will increase proportionately. This essentially means that, from an economic standpoint, it’s unprofitable to attempt falsify a blockchain in a proof-of-work system.
Cryptocurrency mining occurs on a competitive basis. A reward is credited to the miner who validates the transaction first. The mining reward usually consists of new tokens in the native cryptocurrency or transaction fees (or both). (Another disincentive for malicious users is that miners lose their mining rewards if they repeatedly attempt to validate blocks that the remaining network considers invalid.)
For information about the Canadian income-tax implications of cryptocurrency mining, see our article on cryptocurrency mining.
The Proof-of-Stake System (Cryptocurrency Staking)
In blockchain protocols that rely on a proof-of-stake validation mechanism (e.g., the Cardano network, the Solana network, and the Ethereum network), the verification process is known as “staking” or “forging.” The proof-of-stake system assigns validation rights to users in accordance with their stake in the blockchain.
To participate in the validation process, the validators—called a “stakers” or “forgers”—must hold a certain minimum stake in the blockchain. The various proof-of-stake systems adopt different criteria for measuring a validator’s stake in the blockchain. In some systems, for example, a validator’s stake is measured by the quantity of native cryptocurrency that the validator owns. Other systems require the validator to put up sufficient collateral in the form of the network’s native cryptocurrency, which is held in escrow for a set period.
Thus, in contrast to the proof-of-work system, which requires every miner to wield significant computing power and bear heavy electricity costs, the proof-of-stake system selects validators who will likely act in good faith. Stakers typically either own a large quantity of the native cryptocurrency or put up the requisite collateral. In either case, the staker has an incentive to validate transactions honestly. The system aims to prevent malicious users from controlling the validation process by forcing them to invest heavily in the blockchain before gaining any ability to mount an effective attack.
Like cryptocurrency miners in the proof-of-work system, cryptocurrency stakers receive a reward in exchange for verifying transactions on the blockchain. Like the mining reward, the staking reward usually consists of new tokens in the blockchain’s native cryptocurrency or transaction fees, or both. Yet unlike a cryptocurrency miner, who can receive a mining reward without having previously owned any of the blockchain’s native tokens, a cryptocurrency staker can only receive a staking reward with respect to the staker’s prior holdings in the blockchain’s native token and in proportion to the staker’s share of cryptocurrency platform’s base.
Cryptocurrency staking, then, exhibits characteristics of both a service and an investment. On the one hand, by validating transactions, the cryptocurrency staker might be viewed as a providing a service. Yet the cryptocurrency staker or forger cannot earn staking rewards without making a prerequisite investment in the cryptocurrency platform’s native tokens. As such, cryptocurrency staking invokes a number of Canadian income-tax issues, and Canadian cryptocurrency stakers and forgers will typically find themselves unsure about how to properly report their income to the Canada Revenue Agency without proper crypto-tax guidance from an experienced Canadian crypto-tax lawyer.
This article aims to educate cryptocurrency stakers and forgers about some of the Canadian income-tax issues stemming from cryptocurrency staking. This article concludes with pro tax tips from our top Canadian crypto-tax lawyers for Canadian taxpayers with crypto wallets who trade or invest in cryptocurrency.
Canadian Income-Tax Implications of Receiving Reward Tokens from Cryptocurrency Staking & Forging
Under Canada’s Income Tax Act, the character of the income determines how it is taxed. In other words, different income-tax rules apply to different sources of income. Business income and investment income, for instance, are each fully taxable in Canada. Yet only one-half of a capital gain is included in taxable income.
So, to determine the Canadian income-tax implications of cryptocurrency staking and forging, we must first ask: What is the character of the income that you earn when engaging in cryptocurrency staking and forging? To answer this question, we need to distinguish between two means by which you can derive income from cryptocurrency staking and forging. The first is the staking reward that you receive from the cryptocurrency platform for verifying transactions on a blockchain that employs the proof-of-stake system. The second is the profit that you might enjoy from trading the reward tokens themselves.
Tax Characterization of Staking Reward Tokens
To determine the Canadian income-tax characterization of cryptocurrency staking or forging, our knowledgeable Canadian crypto-tax lawyers start by analyzing reward tokens that a staker or forger receives for staking cryptocurrency. As mentioned above, cryptocurrency staking resembles an investment in the sense that, to earn staking rewards, the staker must first hold a sufficient interest in the cryptocurrency platform’s native tokens. In other words, the cryptocurrency staker acquires a property—namely, the requisite quantity of tokens—and, by virtue of owing that property, the staker generates income—in the form of staking rewards from the cryptocurrency platform. Hence, when a cryptocurrency staker or forger receives staking rewards, those receipts plausibly constitute investment income (or “income from property,” as it’s described in the Income Tax Act).
Yet the investment-income characterization might not always fit. As mentioned above, by validating transactions, the cryptocurrency staker might be viewed as a providing a service. Moreover, if a taxpayer uses cryptocurrency property to generate income, the appropriate tax characterization will still turn on the level of activity associated with acquiring that income. So, your staking rewards may qualify as business income if you engage in cryptocurrency staking or forging, and your particular operation demonstrates entrepreneurship, commercial risk, and the pursuit of profit, requiring a significant commitment of time, labour, and attention—e.g., frequently researching cryptocurrency markets, pursuing a number of strategic cryptocurrency-platform targets, leveraging to fund your ventures, immediately selling or collateralizing reward tokens, etc.
In any event, business income and investment income receive largely similar tax treatment overall. So, regardless of which tax characterization is ultimately correct, if you receive reward tokens from cryptocurrency staking or forging, those receipts are fully taxable under subsection 9(1) as your profit from a business or an investment, as the case may be. Thus, when calculating your taxable income, you must include the fair-market value of the cryptocurrency that you received as a staking reward—specifically, the value, expressed in Canadian dollars, as of the time that you received the cryptocurrency.
In addition, because you’ve reported the value of the staking-reward cryptocurrency as taxable income, subsection 52(1) of the Income Tax Act allows you to increase the tax cost of that cryptocurrency accordingly. The increased tax cost prevents double tax when you ultimately dispose of the cryptocurrency that you received as a staking reward.
Say, for example, that you validate transactions for a cryptocurrency platform that relies on the proof-of-stake model, and you thereby stake sufficiently many units of the platform’s native cryptocurrency. For this, you receive a staking reward consisting of new 2 units in the platform’s cryptocurrency. At the time of their issuance, those 2 units are worth $400. Under subsection 9(1) of Canada’s Income Tax Act, you report the $400 as business income or as investment income (depending on the appropriate tax characterization). Under subsection 52(1), your tax cost for the staking-reward units is $400. The $400 tax cost will determine your taxable income when you ultimately dispose of the staking-reward units. For example, if you later sell the staking-reward units for $7,000 (or trade them for other cryptocurrency tokens worth $7,000), your $400 tax cost means that you will realize $6,600 in profit, which you must report as income or capital gains.
The specific tax treatment of the income resulting from the disposition will again turn on the appropriate tax characterization. In particular, when you dispose of a property, the resulting profit is either a capital gain or business income. Thus, when a cryptocurrency staker or forger turns a profit from selling the staking-reward tokens, that profit must be reported and taxed, either at 100% as business income or at 50% as a capital gain.
The capital/income distinction turns on the cryptocurrency staker’s intentions. The key question is whether the taxpayer engaged in cryptocurrency staking with the intention of flipping the staking-reward tokens for profit. If so, the profit constitutes business income. But if, by pointing to objective factors, the taxpayer can demonstrate some other intention—e.g., the intent to invest rather than to trade—the sale proceeds will be on capital account and taxed as a capital gain.
A taxpayer might justify capital treatment if the taxpayer can demonstrate that, say, the taxpayer wanted to control a cryptocurrency platform and thereby sought only the cryptocurrency-staking arrangements offering reward tokens that granted voting power over the platform’s protocols. On the other hand, the taxpayer’s very participation in cryptocurrency staking might illustrate that the taxpayer possesses a certain level of sophistication and specialized knowledge in the cryptocurrency space. And this, taken together with various other factors, might suggest that the taxpayer’s profits from selling the staking-reward tokens should be characterized as business income. Keep in mind that the Income Tax Act defines a “business” as including “an adventure or concern in the nature of trade.” This means that the profits resulting from even an isolated cryptocurrency transaction may attract income treatment.
The bottom line is that Canadian taxpayers must understand that no single tax-law analysis will cover every case. The income-tax implications depend on each taxpayer’s specific set of facts. This means that Canadian taxpayers who trade cryptocurrency, who invest in cryptocurrency, who develop cryptocurrency, and who stake cryptocurrency should all learn their tax obligations by seeking tax guidance from an expert Canadian crypto-tax lawyer.
Pro Tax Tips: Tax-Law Analysis of Proper Cryptocurrency Tax Reporting & Voluntary Disclosures Program for Unreported Income from Cryptocurrency Transactions
Canadian taxpayers who trade cryptocurrency, who invest in cryptocurrency, and who stake cryptocurrency will typically benefit from a tax memorandum examining whether their earnings should be reported as business income, as capital gains, or as a blend of the two. The distinctive features of various proof-of-stake systems means that Canadian taxpayers who’ve staked cryptocurrency will require competent and expert Canadian tax guidance. Our experienced Certified Specialist in Taxation Canadian crypto-tax lawyer has assisted numerous clients with correctly reporting their cryptocurrency transactions and other blockchain-related arrangements.
The advances and cooperative efforts of international tax authorities should worry Canadian taxpayers with unreported profits from cryptocurrency transactions. If you filed Canadian income-tax returns that omitted or underreported your cryptocurrency profits, you risk facing not only civil monetary penalties, like gross-negligence penalties, but also criminal liability for tax evasion. And if you failed to file T1135 forms reporting your cryptocurrency holdings, your non-fungible token (NFT) holdings, or your holdings in other blockchain-based assets, the standard late-filing penalty can be upwards of $2,500 per unfiled form, and the T1135 gross-negligence penalty can be upwards of $12,000 per unfiled form.
The CRA’s Voluntary Disclosures Program (VDP) may offer relief for both unreported income and unfiled T 1135’s. If your VDP application qualifies, the Canada Revenue Agency will abandon criminal prosecution and waive gross-negligence penalties (and may cancel or waive interest).
But a VDP application is time sensitive. The CRA’s Voluntary Disclosures Program will reject an application—therefore denying any relief—unless the application is “voluntary.” This essentially means that the Voluntary Disclosures Program must receive your VDP application before the Canada Revenue Agency contacts you about any of the non-compliance you seek to disclose. For more information about qualifying for relief under the VDP, see our article on the CRA Voluntary Disclosures Program.
Our expert Canadian crypto-tax lawyers have assisted numerous Canadian taxpayers with unreported cryptocurrency profits and blockchain transactions. We will prepare a memorandum to analyse your crypto transactions to determine the appropriate reporting methodology—that is, income or capital gains or both—and we will in parallel prepare a VDP application that not only increases the odds 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 unfairly deny relief.
To determine whether you qualify for the Canada Revenue Agency’s Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our knowledgeable Canadian tax lawyers. The Canada Revenue Agency cannot compel the production of information protected by solicitor-client privilege. Solicitor-client privilege prevents the CRA from learning about the confidential legal advice that you receive from our tax lawyers. No such privilege exists for accountants, so your communications with an accountant remain unprotected. As a result, if you seek tax advice but want to keep that information away from the Canada Revenue Agency, you should first approach our Canadian tax lawyers. If you also require the assistance of an accountant, we can take measures to extend our solicitor-client privilege to communications involving the accountant.
Disclaimer:
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
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Frequently Asked Questions
Cryptocurrency staking (or cryptocurrency forging) refers to the transaction-validation process in blockchain protocols that rely on a proof-of-stake validation mechanism. The proof-of-stake system assigns validation rights to users in accordance with their stake in the blockchain. To participate in the validation process, the validators—called a “stakers” or “forgers”—must hold a certain minimum stake in the blockchain. This typically requires the staker to put up sufficient collateral in the form of the network’s native cryptocurrency, which is held in escrow for a set period. The staker then receives a reward in exchange for verifying transactions on the blockchain. The staking reward usually consists of new tokens in the blockchain’s native cryptocurrency, transaction fees, or both.
Cryptocurrency staking exhibits characteristics of both a service and an investment. On the one hand, by validating transactions, the cryptocurrency staker might be viewed as a providing a service. Yet the cryptocurrency staker or forger cannot earn staking rewards without making a prerequisite investment in the cryptocurrency platform’s native tokens. Still, business income and investment income receive largely similar income-tax treatment overall. So, regardless of which income-tax characterization is ultimately correct, if you receive reward tokens from cryptocurrency staking or forging, those receipts are fully taxable under subsection 9(1) as your profit from a business or an investment, as the case may be. When calculating your taxable income, you must therefore include the fair-market value of the cryptocurrency that you received as a staking reward—specifically, the value, expressed in Canadian dollars, as of the time that you received the cryptocurrency.
You might qualify for relief under the Canada Revenue Agency’s Voluntary Disclosures Program (VDP). If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). For more information about qualifying for relief under the VDP, see our article on the CRA Voluntary Disclosures Program.
The VDP will grant relief only if your VDP application satisfies various conditions. For example, the CRA’s Voluntary Disclosures Program will reject an application—and thus deny any relief—unless the application is “voluntary.” This essentially means that the VDP must receive your voluntary-disclosure application before the CRA contacts you about the non-compliance you sought to disclose. To determine whether you qualify for the Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers.
