Bitcoins are not Cash – Tax and Other Issues with Bitcoin payments

Bitcoins are not Cash – Tax and Other Issues withBitcoin payments – Canadian Tax Lawyer Analysis

Although bitcoins and other digital currencies are often considered to be a cash equivalent, they are not the same as cash. This article explores severalpractical concerns arising from cryptocurrencies, such as bitcoin. In particular, itbriefly discusses some tax issues and also examineswhether rules limiting cash receipts by lawyers and paralegals apply to bitcoin and other cryptocurrencies.

The Nature of Bitcoin and Cryptocurrency Transactions

Unlike a traditional online transaction, bitcoin and cryptocurrency transactions do not rely on a third party for facilitation or security. With a traditional online transaction, a third party, usually a bank or online payment processor, approves or confirms online payments. But the bitcoin system relies on a peer-to-peer network of computers, which verifies the transaction, transfers bitcoin units, and prevents double dealing. In other words, no centralized authority, governmental or otherwise, controls the bitcoin system. As a result, cryptocurrency systems offer users a means of transacting in relative anonymity in a way similar to cash.

Tax Issues with Bitcoins and other Cryptocurrencies

The Canada Revenue Agency treats bitcoin—and digital currencies generally—as a commodity for income-tax purposes so they are very different from cash. As a result, bitcoin transactions are subject to the same rules as barter transactions—that is, transactions where one commodity is exchanged for another. Generally, this means that a gain or loss from a bitcoin transaction will be treated as either (i) income or loss from business or property or (ii) a capital gain or loss.

Cryptocurrencies raisea number of important tax issues, including:

• characterization
• valuation
• administration and enforcement

The character of income determines its tax treatment. For instance, business income is fully taxable while a capital gain is half-exempt from tax. Some bitcoin transactions may straddle the line between two different characterizations. Purchasing cryptocurrency for resale at profit may be characterized as business income, on the one hand, or a capital gain, on the other. The result depends on several factors, including: (1) frequency of transactions, (2) period of ownership, (3) knowledge of bitcoin markets, and (4) use of advertising.

Frequently, Canada’s tax rules deem certain transactions to occur at fair market value. For instance, a donor is deemed to receive fair market value in exchange for a gift. Obviously, one cannot determine the tax liability resulting from a bitcoin transaction if one cannot value the bitcoin. And, presumably, Canada Revenue Agency shall insist that taxpayers find a reliable method of recording the bitcoin’s value at the time of the transaction.

Finally, one might think that the nature of cryptocurrency makesenforcing taxation a difficult task. And—for the most part—one would be correct. The bitcoin system offers the anonymity traditionally associated with cash transactions. Still, taxing authorities have figured out ways to identify bitcoin users. The Internal Revenue Service, for instance, reportedly invested in software capable of tracing a bitcoin unit from one digital wallet to another. This software can trace the movement of a bitcoin from the moment it comes into existence—through a process called mining—to the moment that a user ultimately cashes out his or her bitcoin at an exchange.

In addition, the creation of bitcoin gives rise to interesting tax issues. Bitcoin units come into existence through a process called mining. A person mines for bitcoin by solving complex mathematical problems, which, in turn, processes bitcoin transactions and secures the bitcoin network. These complex problems require bitcoin miners to dedicate extensive computer resources to generate solutions. In essence, bitcoin miners receive bitcoins as compensation for contributing to the integrity of the bitcoin system.

A person who mines bitcoins may be thought of as either acquiring a capital property or earning business income. If thought of as acquiring a capital property, the miner’s adjusted cost base would be the bitcoin’s fair market value at the time of acquisition. Also, since bitcoin mining demands considerable computing resources, a bitcoin’s adjusted cost base would presumably include the cost of generating the computer power necessary to acquire the coin. The miner thus incurs a capital gain or loss depending on the bitcoin’s value upon disposition.

Alternatively, if thought of as earning business income, the miner’s income is the bitcoin’s fair market value at the time that the miner uncovered the unit. If the miner later sells the uncovered bitcoin for an amount greater than its value on discovery, the excess is also included in business income. Recall, however, that bitcoin mining requires one to devote extensive computing resources to the endeavour. Presumably, these costs should constitute deductible business expenses.

Ultimately, 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 bitcoin transactions, these factors may include:

• frequency of transactions – a history of extensive buying and selling of bitcoins or of a quick turnover of properties;
• period of ownership – the bitcoins are usually owned only for a short period of time;
• knowledge of bitcoin markets – the taxpayer has some knowledge of or experience in the bitcoin markets;
• relationship to the taxpayer’s other work – bitcoin transactions form a part of a taxpayer’s ordinary business;
• time spent – a substantial part of the taxpayer’s time is spent studying the bitcoin markets and investigating potential purchases;
• financing – bitcoin purchases are financed by some form of debt; and
• advertising – the taxpayer has advertised or otherwise made it known that he is willing to purchase bitcoins.

The Law Society’s restrictions on ca sh receipts by lawyers and paralegals

The Law Society of Upper Canada (“LSUC”) imposes a general restriction on the amount of cash that a lawyer or paralegal may accept. In particular, undersubsection 4(1) of the LSUC’s By-law 9, for any single file, a lawyer or paralegal cannot accept a cash payment of $7,500 or more. This rule allows for various exceptions—receiving cash under the terms of a court order, for instance.

This rule aims to combat the potential for lawyers and paralegals to be used as a vehicle for money laundering. Generally, one “launders” money by concealing the true—i.e., illicit—source of those funds. Typically, cash-intensive businesses prove most apt for laundering money. For instance, a money launderer might include and report illicit cash as part of a business’s legitimate income. Restricting a business’s cash receipts therefore undermines that business’s usefulness in a money-laundering scheme.

Bitcoins and cryptocurrencies are not “cash” for the purpose ofLaw Society By-Law 9

Subsection 4(1)’s restriction on payments applies to “cash” receipts. Subsection 1(1) of By-law 9 defines “cash” as either:

• current coin within the meaning of the Currency Act,
• notes intended for circulation in Canada issued by the Bank of Canada under the Bank of Canada Act, and
• current coin and bank notes of countries other than Canada.

The Law Society’s Practice Management Helpline confirmed that—despite the misleading nomenclature—cryptocurrency falls into none of these categories. So, a lawyer or paralegal can generally accept bitcoin or cryptocurrency in excess of $7,500.

The caveat: the duty to not be a dupe

One might find it odd that subsection 4(1)—a rule designed to combat money laundering—doesn’t apply to an instrument seemingly perfect for money laundering.

But other professional obligations pick up the slack. For instances,lawyers and paralegals cannot knowingly assist in another’s dishonesty, fraud, crime, or illegal conduct. Moreover, lawyers and paralegals must make efforts to ascertain a client’s objectives. In short, the legal practitioner must “guard against becoming the tool or dupe of an unscrupulous client or persons associated with such a client or any other person”(Commentary [1] of Rule 3.2-7, Law Society of Upper Canada, Rules of Professional Conduct).

To this end, a lawyer or paralegal must ensure that he or she does not, when accepting bitcoin as payment, thereby further another person’s dishonest intentions.

Tax Tips

First, don’t fool yourself into thinking that cryptocurrency transactions offer a way to avoid tax. Tax authorities show that they can occasionally adapt to a challenge. If you have unreported income in the form of bitcoin or other cryptocurrency, consult one of our experienced Canadian tax lawyers today.

Second, due to their ambiguous characterization and difficult valuation, bitcoinsoffer the Canada Revenue Agency multiple ways to over-assess your taxable income. As a result, if you deal in bitcoin or cryptocurrency, you may wish to consider pre-empting these problems by visiting our Canadian tax lawyers for advance tax planning.

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