The Blockchain-based Video Game with Real Tax Consequences: The Philippines Isn’t the Only Country that Taxes Axie Infinity Players – Canadian Tax Guidance from a Canadian Tax Lawyer

Introduction – Axie Infinity: What Is It?

Developed by the Vietnamese start-up, Sky Mavis, Axie Infinity is a Pokémon-like online video game allowing players raise, breed, and fight their digital pets called Axies. Like their Pokémon counterparts, Axies appear as imaginary cartoon animals with exaggerated cartoonish features—plump, egg-shaped bodies boasting goat-like horns, acorn-like tails, fish-like gills, perhaps wearing an eyepatch or sunglasses. Yet unlike Pokémon characters, which have essentially no value outside the game, each Axie is itself a non-fungible token, or NFT, which can be sold for cash or traded for cryptocurrency or another NFT.

So, what exactly is a non-fungible token? It’s basically a unique digital asset that relies on blockchain technology to track ownership. Anything digital can be converted into an NFT—e.g., a song, a tweet, this very article, or, in the case of Axie Infinity, the characters within the game. Blockchain technology allows the public to verify and track who owns a particular non-fungible token. A non-fungible token therefore allows you to buy or sell ownership of unique digital items. Because it relies on blockchain technology to track ownership, an NFT is like cryptocurrency, such as Bitcoin, Ethereum (ETH), or Litecoin (LTC). Yet unlike cryptocurrency, each NFT can be given unique characteristics. This is why non-fungible tokens are called “non-fungible.” Cryptocurrency, on the other hand, is fungible—trading one Bitcoin for another gets you exactly the same thing. A non-fungible token is more akin to an original piece of art. If you trade a Monet for a Rembrandt, you don’t end up with the same thing. The same holds true for NFTs.

Axie Infinity’s use of NFTs—as well as the game’s increasing popularity and the growing NFT market—allows Axie Infinity players to earn income. Indeed, this very income-earning opportunity reportedly prompted the Philippines’ Department of Finance and Bureau of Internal Revenue to remind local players that they must pay income tax on their Axie Infinity profits.

The same is true for Canadian taxpayers who play Axie Infinity as a source of income. Yet play-for-pay games like Axie Infinity invoke a number of Canadian income-tax issues. For example: If a Canadian taxpayer makes a profit from playing Axie Infinity, do those Axie Infinity profits constitute a tax-free windfall or taxable income? When exactly does playing the game become a “source of income” for a Canadian taxpayer? How can a Canadian taxpayer generate income from playing Axie Infinity? And do these different income-earning opportunities entail different income-tax consequences? What is the character of the income that a Canadian taxpayer earns when selling the game’s NFT Axie characters? Is it business income? Investment income? A capital gain? Or some combination of the three?

This article discusses some of the Canadian income-tax issues triggered by Axie Infinity and its related non-fungible-token market. This article first examines some of the methods by which Axie Infinity players can turn a profit from playing the game. The article then gives a general overview of the Canadian tax rules about what constitutes a source of taxable income and how to distinguish one source from another. After reviewing the legal framework, this article analyzes the Canadian income-tax implications of the methods by which Axie Infinity players can generate profit when playing the game. This article concludes by providing pro tax tips from our top Canadian tax lawyers for Canadian taxpayers who generate income by playing cryptocurrency-based, play-for-pay games like Axie Infinity.

How Do Axie Infinity Players Earn Profits from the Game?

There are a number of ways that players make money while playing Axie Infinity. Newer players will typically turn a profit by selling the game’s utility token, Small Love Potion (or SLP). Players receive SLP as a reward when their Axies win battles. The SLP tokens serve a specific in-game purpose: Without SLP tokens, a player cannot breed new Axie characters. As a result, the Small Love Potion tokens are in demand. Moreover, like any other cryptocurrency, SLP tokens can be bought, sold, and traded on the open market. So, for new players, earning and selling SLP tokens offers the most readily available means of making money in Axie Infinity.
Axie Infinity players can also trade the Axies themselves. As mentioned above, each Axie character is itself a non-fungible token, which can be sold for cash or traded for cryptocurrency or another NFT. So, players can breed Axies and sell them on the open market. In early to mid-2021, the cheapest Axies went for about $200 each. Rare Axies command higher prices, however. In August 2020, two very rare Axies sold for a total 150 ETH (worth about $68,000 back then), and, in November 2020, a single Axie went for 300 ETH, which was worth over $130,000 at the time.
Finally, some Axie owners have taken to renting out their Axies to players. A player must have at least three Axies to play Axie Infinity. If a new player cannot afford to purchase three Axies, the player can start for free by borrowing Axies from a lender (who are called “managers” in the game). In exchange for lending out their Axies, the managers take a cut of the player’s earnings. The manager may, for instance, be entitled to a portion of the SLP tokens that the player collected while using the manager’s Axies.

Sources of Taxable Income in Canada: Section 3 of Canada’s Income Tax Act

Subsection 2(1) of Canada’s Income Tax Act requires every Canadian tax resident to pay tax on “taxable income.”
Subsection 2(2) then explains that a taxpayer’s “taxable income” equals that taxpayer’s “income for the year” minus the deductions in Division C of the Income Tax Act. (Division C includes a number of tax subsidies, tax-relief provisions, and policy-based deductions, such as the loss-carryover rules, the lifetime-capital-gains exemption or LCGE, the part-year-resident rule, which renders offshore income non-taxable if earned while a taxpayer was a non-resident of Canada, and tax-treaty exemptions.)
Section 3 describes how to compute a taxpayer’s “income for the year.” In doing so, the section (non-exhaustively) lists the following “sources” of income:

• Office;
• Employment;
• Business;
• Property; and
• Capital gains.

Hence, these sources of income ultimately make up a person’s taxable income. The corollary is that Canadian courts have invoked the “source” concept to exclude certain receipts from a taxpayer’s income.

The notion of “income from a source” has proven influential to how Parliament drafted—and how courts interpret—the Income Tax Act. The basic idea is that a receipt constitutes income only if it comes from a productive source. Section 3 of the Income Tax Act codifies this idea by stating that only “income from a source” is included when calculating a taxpayer’s income for the year. In Stewart v Canada (2002 SCC 46), the Supreme Court of Canada explained that “whether a taxpayer has a source of income is determined by considering whether the taxpayer intends to carry on the activity for profit, and whether there is evidence to support that intention.”

• Thus, an income source typically features one or more of the following characteristics:
• It produces a yield that recurs on a periodic basis;
• It requires organized effort, activity, or pursuit on the taxpayer’s part;
• It involves a marketplace exchange;
• It gives the taxpayer an enforceable claim to receive payment; and
• It stems from the taxpayer’s pursuit of profit (in the case of a source of business income or property income).

As a result, the tax-law concept of “income” excludes windfalls, such as amateur-gambling winnings. Amateur or casual gambling doesn’t produce a source of income. Even for compulsive gamblers who continually try their luck at a game of chance—the lottery, for instance—the activity remains a personal endeavour, not a source of income (e.g., see: Leblanc v The Queen, 2006 TCC 680).

This isn’t always true, however. Gambling winnings qualify as taxable business income in two types of cases. The first is when the gambling is an adjunct or incident of a business—e.g., a casino owner who gambles in his own casino or a horse owner who trains horses, races them, and bets on the races. The second case is when a person uses his or her own expertise to earn a livelihood from a gambling game in which skill is a significant component—e.g., a pool player who, in cold sobriety, challenges inebriated pool players to a game of pool for money.

Distinguishing Sources of Income: Is it Business Income, Investment Income, or a Capital Gain?

Now, assuming that the activity constitutes a source of income, the next question is: Which source? Is it income from an office or employment? Income from business? Income from property? A capital gain?

This question is important because different tax rules apply to different sources of income. For example: While business income and investment income are each fully taxable, only one-half of a capital gain is included in taxable income. Business losses and investment losses are each fully deductible against any source of income. By contrast, only one-half of a capital loss is deductible, and the allowable portion of the capital loss may generally only be used to offset the taxable portion of a capital gain.

We’ll focus on distinguishing investment income (also called “income from property”), business income, and capital gains.

Investment income refers to the yield from property. Shares, for example, yield dividends. Bonds yield interest. Intellectual property yields royalties. Real property yields rent. And so on. In other words, investment income is passive income stemming from the mere ownership of property; it doesn’t require any significant commitment of time, labour, or attention. For example, an individual can purchase public shares and earn dividends without any further effort. The dividends, then, constitute investment income.

Business income, by contrast, calls for organization, systematic effort, and a degree of activity. An investment dealer, for instance, can purchase and actively manage a portfolio consisting of public shares, and a cryptocurrency trader actively seeks opportunities to purchase and flip cryptocurrency. The dealer operates an investment business, and the cryptocurrency trader operates a cryptocurrency-trading business. The revenues of each business constitute business income. Subsection 248(1) of Canada’s Income Tax Act defines a “business” as including a “profession, calling, trade, or undertaking of any kind whatever.” A “business” therefore implies activity and profit motive. The representative characteristics of a business include activity, enterprise, entrepreneurship, and commercial risk. Above all, a business entails the pursuit of profit. The pursuit of profit is indeed what distinguishes a business from a mere hobby or pastime (Stewart v Canada, 2002 SCC 46).

Hence, the distinction between business income and investment income turns on the level of activity associated with generating the income. Although Canada’s Income Tax Act refers to investment income as “income from property,” the mere use of a property doesn’t by itself guarantee that the income therefrom is investment income. It’s the activity level that matters. For example, a taxpayer who actively manages a hotel and a taxpayer who leases a basement apartment both use a property, and they both receive payments for rent. Yet the hotel manager earns business income while the homeowner earns investment (rental) income.

While the use of property may give rise to either business income or investment income, subsection 9(3) of the Income Tax Act expressly distinguishes investment income from capital gains. This subsection clarifies that income from a property (i.e., investment income) excludes a gain arising from the disposition of that property. (It also states that a loss from property excludes a loss upon disposing of that property.) In other words, if you dispose of a property, the resulting profit doesn’t qualify as investment income for tax purposes; it’s either a capital gain or business income.
A capital gain (or capital loss) arises when you dispose of an asset that qualifies as “capital property.” 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; and
• 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. Put another way: you start by determining the nature of the income, and then you characterize the property, not the other way around. Still, the determination is often unclear and requires guidance from an experienced Canadian tax lawyer.

Over the years, Canadian tax courts have churned out an immense body of case law while grappling with the ambiguity between investing, which produces a capital gain, and trading, which results in business income. Courts assess a wide range of factors when deciding whether to characterize a transaction’s gains or losses as on capital account or income account. These factors may include:

• transaction frequency;
• length of ownership;
• knowledge of the market;
• relationship or similarity to the taxpayer’s employment or other business;
• time and energy expended on the endeavour;
• the use of financing; and
• the use of advertising.

Ultimately, the taxpayer’s intention at the time of acquiring the property is the most important criterion that tax courts consider when determining whether the transaction produced a capital gain or business income. Specifically, the question is whether the taxpayer acquired the property with the intent to trade. Still, to discern a taxpayer’s intention, a court must review the objective factors surrounding both the purchase and the sale of the property. In other words, courts will deduce a taxpayer’s intent by evaluating the factors listed above.

Canadian Income-Tax Implications for Axie Infinity Players

The previous sections offer two key takeaways. First, a person’s taxable income only includes “income from a source.” This is why the winnings of an amateur gambler aren’t taxed. Amateur or casual gambling doesn’t produce a source of income because it’s generally a personal endeavour that doesn’t serve as a reliable means of profit. Gambling does, however, constitute a source of income—and its winnings taxed as business income—when the gambling stems from another business or when the gambler earns a livelihood from a skill-based game.

The second takeaway is that, depending on how a taxpayer uses it, a property can generate business income, investment income, or a capital gain. If the property itself generates income, that income may qualify as either business income or investment income (i.e., income from property). The appropriate tax characterization depends on the level of activity associated with producing the income: business income demands activity; investment income implies passivity. If the income stems from the disposition of the property, the profit may qualify as either business income or a capital gain. In this case, the appropriate tax characterization depends on whether the taxpayer acquired the property with the intent to trade.

So, how do these takeaways bear on Canadian Axie Infinity players?

First, a player’s participation in Axie Infinity may or may not constitute a source of income. On the one hand, Axie Infinity is both a skill-based game and one that promotes its play-for-pay framework. So, there’s very likely a source of—taxable—business income for the motivated player who logs significant playtime to breed Axies NFTs and sell them on the open market. On the other hand, participation might be a solely personal endeavour and thus not an income source for a casual Axie Infinity player who, say, earns SLP tokens but uses them for nothing other than their in-game purpose, or who breeds Axies NFTs yet never rents them out or sells them—no matter what their market price.

The second takeaway bears on Canadian taxpayers for whom playing Axie Infinity absolutely constitutes a source of income. For them, the issue is how to properly report that income. As mentioned above, a property can generate business income, investment income, or a capital gain. It all depends on how that property is used. And to be clear: the Income Tax Act’s definition of “property” includes intangible property, such as cryptocurrency and non-fungible tokens. So, for income-tax purposes, when Axie Infinity players sell or trade their Small Love Potion tokens, or when players breed, sell, or trade their NFT-based Axie characters, or when managers rent out their Axie characters for a cut of player proceeds, they’ve all used a property to, in one way or another, earn income. And the character of that income depends on the manner in which the property was used. For instance, the manager who rents out Axie characters may be earning investment income or business income—depending on the scale of the operation and the activity level it entailed. The sale of an Axie might generate business income for a player who breeds Axies specifically to sell them. Yet for a manager who used the Axie as an income-earning property for years beforehand, the sale of an Axie might result in a capital gain.

Ultimately, however, Canadian Axie Infinity players should understand that no single tax-law analysis will cover every case. The tax implications will turn on each taxpayer’s specific set of facts. This means that Canadian taxpayers who generate income by playing cryptocurrency-based, play-for-pay games like Axie Infinity should learn their tax obligations by seeking expert tax guidance from a Canadian tax lawyer.

Pro Tax Tips: Legal Opinion on Proper Tax Reporting of Axie Infinity Income & Voluntary Disclosures Program for Unreported Income from Cryptocurrency-Based, Play-for-Pay Gaming

Canadian taxpayers who generate income by playing cryptocurrency-based, play-for-pay games like Axie Infinity will typically benefit from a tax memorandum examining whether their earnings constitute a source of income and, if so, whether those earnings should be reported as investment income, as business income, as capital gains, or as a blend of all three. The novelty of NFT-based, play-for-pay games means that participating Canadian taxpayers will require competent and expert Canadian tax guidance on several unsettled issues. For example, if the tax cost of your aggregate holdings in SLP tokens and NFT-based Axies exceeds $100,000, you might be required to file a T1135 form. Moreover, while this article focuses on Canadian income-tax issues, you should be aware that NFT transactions—like trading Axies—might give rise to GST/HST obligations. Fungible cryptocurrency, like Bitcoin, Ethereum, or Chainlink, arguably meets the definition of “money” in Canada’s Excise Tax Act. Yet non-fungible tokens don’t readily meet that definition. So, while a cryptocurrency-trading business might constitute a supply of financial services, which is exempt from GST/HST, an NFT-trading business might qualify as a taxable supply. If so, and if an NFT-trading business generates over $30,000 in annual revenue, the business must register for a GST/HST number, charge GST/HST on sales, collect GST/HST from clients, and remit that GST/HST to the Canada Revenue Agency.

If you’ve generated profits by playing Axie Infinity or any other blockchain-based, play-for-pay game, consult a top Canadian tax lawyer for advice. Our experienced Certified Specialist in Taxation Canadian tax lawyer has assisted numerous clients with issues concerning the proper characterization and reporting of cryptocurrency transactions, NFT transactions, and other blockchain-based transactions.
The advances and cooperative efforts of international tax authorities signal the end of the anonymity that cryptocurrency users thought they once enjoyed. This should definitely concern Canadian taxpayers with unreported profits from cryptocurrency transactions. And while blockchain non-fungible tokens are relatively novel, taxpayers engaging in any blockchain-based transactions, such as those involving NFTs, should be equally concerned. If you filed Canadian tax returns that omitted or underreported your cryptocurrency profits or your profits from non-fungible tokens, you risk facing not only civil monetary penalties, such as gross-negligence penalties, but also criminal liability for tax evasion. And if you failed to file T1135 forms for your NFT holdings, the standard late-filing penalty can be upwards of $2,500.00 per unfiled form, and the gross-negligence penalty can be upwards of $12,000.00 per unfiled form.
You may qualify for relief under the CRA’s Voluntary Disclosures Program. If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). But your voluntary-disclosure 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 voluntary-disclosure application before the Canada Revenue Agency contacts you about the non-compliance you seek to disclose.

See also

Tax Implications of QuadrigaCX Lost Cryptocurrency Keys – A Canadian Tax Lawyer Analysis

Our expert Certified Specialist in Taxation Canadian tax lawyer has assisted numerous Canadian taxpayers with unreported cryptocurrency and blockchain transactions. We can carefully plan and promptly prepare your voluntary-disclosure application. A properly prepared disclosure application 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 your voluntary-disclosure application.  To determine whether you qualify for the Canada Revenue Agency’s Voluntary Disclosures Program, schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers.

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About the Author

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David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch