Canadian Income-Tax Implications of Cryptocurrency Airdrops – Canadian Tax Guidance from a Canadian Tax Lawyer

Introduction – Circulating a New Cryptocurrency Token: The Cryptocurrency Airdrop

When a cryptocurrency-platform developer creates a new cryptocurrency or other blockchain-based asset, one of the first steps is getting the new cryptocurrency into the hands of potential users. The cryptocurrency-platform developer has several options for circulating the new cryptocurrency tokens. For example, the new cryptocurrency platform might sell its first set of coins or tokens for fiat currency or for one of the major cryptocurrencies (e.g., Bitcoin or Ethereum) under an initial token offering (ITO) or an initial coin offering (ICO).

A cryptocurrency platform might also issue new cryptocurrency units to parties who validate transactions involving the platform’s cryptocurrency and record verified transactions on the network’s blockchain. This verification process is known as “mining” in blockchain protocols that rely on a proof-of-work validation mechanism (e.g., the Bitcoin network), and it’s known as “staking” or “forging” in blockchain protocols that rely on a proof-of-stake validation mechanism (e.g., the Cardano and Solana networks). In exchange for verifying transactions, miners, stakers, and forgers may receive transaction fees or new tokens (or both).

A cryptocurrency airdrop is yet another option for circulating the new cryptocurrency tokens. An airdrop occurs when a cryptocurrency platform sends new tokens to someone’s wallet for free. It’s basically a marketing stunt aiming to promote awareness of the new virtual currency. The platform distributes small amounts of its new cryptocurrency to the wallets of active members of the blockchain community. The recipient receives the cryptocurrency units for free or in return for a small promotional service—for example, retweeting a post by the company that issued the new tokens. Unsurprisingly, the targeted recipients typically boast a sizeable social-media following in the crypto space.

Cryptocurrency airdrops raise a number of Canadian income-tax issues. For example: If a Canadian taxpayer receives new cryptocurrency units because of an airdrop, does the receipt of those units constitute a tax-free windfall or taxable income? And if the receipt of the airdropped tokens indeed does qualify as a tax-free windfall, are your profits when you ultimately dispose of those tokens tax-free as well? Or are they taxed as business income? Investment income? A capital gain? Or some combination of the three?

This article discusses some of the Canadian income-tax issues stemming from cryptocurrency airdrops. The article first discusses the Canadian income-tax concept of an income “source.” It then examines how to distinguish one source of taxable income from another. After reviewing the legal tax framework, this article explores the Canadian income-tax treatment of acquiring new cryptocurrency units by means of an airdrop. It then reviews the Canadian income-tax consequences of disposing of airdropped tokens.  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.

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

Under subsection 2(1) of Canada’s Income Tax Act, every Canadian tax resident must pay tax on “taxable income.” A person’s “taxable income” consists of that person’s “income for the year.” (More precisely, it consists of a person’s income for the year after deducting any amounts allowed under Division C of the Income Tax Act. Division C contains 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 of Canada’s Income Tax Act describes how to compute a person’s “income for the year.” In doing so, the section identifies the following “sources” of income: (i) income from an office or employment; (ii) income from a business; (iii) income from property (that is, investment income); and (iv) capital gains. Hence, these sources of income ultimately make up a person’s taxable income.

The upshot 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 courts interpret the Income Tax Act. The fundamental concept is that a receipt constitutes income only if it comes from a productive source. This concept is codified by section 3 of the Income Tax Act which courts have interpreted as including only “income from a source” in the calculation of a taxpayer’s income for the year.

An income source typically features one or more of the following characteristics:

• It gives rise to a yield that recurs on a periodic basis;
• It demands organized effort, activity, or pursuit on the taxpayer’s part;
• It involves a marketplace exchange;
• It grants the taxpayer an enforceable claim to receive payment; and
• It comes from the taxpayer’s pursuit of profit (This characteristic is especially true for a source of business income or of investment income).

In Stewart v Canada (2002 SCC 46), the Supreme Court of Canada noted 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.” As a result, the income-tax concept of “income” excludes windfalls like amateur-gambling winnings. Amateur or casual gambling doesn’t produce a source of income. Even for habitual gamblers who repeatedly try their luck at games of chance—e.g., the lottery or roulette—the activity is a personal endeavour, not a source of income (e.g., see: Leblanc v The Queen, 2006 TCC 680).

There are exceptions, of course. Gambling winnings qualify as taxable business income in two circumstances. 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 is when a person uses his or her own expertise to earn a livelihood from betting on a game in which skill is a significant component—e.g., a pool shark who, in cold sobriety, habitually challenges inebriated players to a game for money.

Classifying Sources of Income: When is it Business Income? When is it Investment Income? When is it a Capital Gain?

Now, if the activity qualifies as 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, under Canada’s Income Tax Act, different income-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. Yet 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.

This section compares investment income (also coined “income from property”), business income, and capital gains.

Investment income refers to the yield from property. Shares, for example, pay dividends. Bonds pay interest. Intellectual property pays royalties. Real property pays rent. And so on. Investment income is passive income stemming from the mere ownership of property; the owner need not devote any significant time, labour, or attention to generate income. For example, an individual can purchase public shares and earn dividends without any further effort.

Business income, on the other hand, demands 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 broadly defines a “business” as including a “profession, calling, trade, or undertaking of any kind whatever.” But, above all, a business entails the pursuit of profit. As the Supreme Court of Canada explained in Stewart v Canada, 2002 SCC 46, the pursuit of profit is what distinguishes a business from a mere hobby or pastime.

The difference between business income and investment income depends on the level of activity required to the income. Although Canada’s Income Tax Act refers to investment income as “income from property,” the presence of a property doesn’t by itself mean that the income therefrom is investment income. The activity level is what matters. A taxpayer who actively manages a hotel and a taxpayer who leases a basement apartment each use a property, and they each receive income from that property. Yet the hotel manager earns business income while the homeowner earns investment income.

Although the use of a property might give rise to either business income or investment income, subsection 9(3) of the Income Tax Act explicitly sets apart investment income from capital gains. Under subsection 9(3), “income from property” (i.e., investment income) excludes a gain arising from that property’s disposition. Thus, if a property is sold, the resulting profit isn’t investment income for income-tax purposes. It’s either a capital gain or business income.

Over the years, Canadian tax courts have churned out an immense body of case law 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. The specific question is whether the taxpayer acquired the property with the intent to trade. To discern a taxpayer’s intention, however, a court must review the objective factors surrounding both the purchase and the sale of the property. In other words, courts will determine a taxpayer’s intent by evaluating the factors listed above. The capital/income distinction is notably ambiguous and requires guidance from an experienced Canadian tax lawyer.

Canadian Income-Tax Implications of Receiving Airdrops of New Cryptocurrency: Tax-Free Windfall or Income from a Source?

 The previous sections highlight two key lessons. First, a receipt is taxable only if it’s “income from a source.” This is why the winnings of an amateur gambler aren’t taxed. Casual gambling doesn’t produce a source of income because it’s a personal endeavour and doesn’t serve as a reliable means of generating profit. Yet if the gambling stems from another business or if the gambler earns a livelihood from a skill-based game, then the gambling qualifies as a source of business income—and the taxpayer’s winnings will be taxed as such.

The second lesson is that, depending on how it’s used, a property can generate business income, investment income, or a capital gain. If the property itself generates income, that income is either business income or investment income. The correct income-tax characterization depends on the level of activity associated with producing that income: an active venture suggests a business and thus business income; a passive undertaking implies an investment and thus investment income. If, however, the income comes from disposing of the property, the resulting profit is either business income or a capital gain. In this case, the appropriate income-tax characterization depends on whether the taxpayer acquired the property with the intent to trade.

So, how do these two lessons bear on Canadian taxpayers who receive new cryptocurrency units by means of a cryptocurrency airdrop? Well, the first takeaway means that the receipt of the airdropped token is taxable only if airdrops constitute a source of income for the recipient taxpayer. The second takeaway means that you must understand how to properly report the income if you’re a Canadian taxpayer for whom the receipt of airdropped tokens absolutely constitutes a source of income.

As mentioned above, a receipt is non-taxable unless it comes from a source of income. A source of income possesses 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, in the case of a source of business or investment income, it stems from the taxpayer’s pursuit of profit.

So, it seems that the receipt of airdropped tokens doesn’t constitute a source of income unless the airdrop relates to a business operated by the recipient. For example, cryptocurrency airdrops might be a source of income for a social-media influencer who received the airdropped tokens for promotional services—e.g., posting or tweeting about new cryptocurrency platform or about the company that issued the new tokens. Here, the airdrop exhibits some characteristics of an income source for the recipient. For instance, it requires organized effort, activity, or pursuit on the recipient’s part. And, as someone able to spread the word about the new cryptocurrency, a social-media influencer could conceivably receive airdrops from budding cryptocurrency platforms on a periodic basis. So, in this case, a cryptocurrency airdrop is likely a source of—taxable—business income. The income-tax result is that the airdrop recipient must report the value of the airdropped token as income for the year in which the airdrop was received. (That said, the amount of the income inclusion might be negligible. Airdrops often consist of small quantities of virtual currencies that, being newly created, have little, if any, market value.)

This tax treatment won’t apply universally, however. In particular, it probably doesn’t apply to most airdrop recipients, who received the airdropped cryptocurrency tokens unprompted, for no consideration whatsoever. Indeed, cryptocurrency airdrops don’t exhibit the characteristics of an income source for most the taxpayers who receive them. In most cases, the airdrops don’t recur on a periodic basis; they require no organized effort, activity, or pursuit on the recipient’s part; and the recipients of the airdrop arguably had no enforceable claim to receive the airdropped token because the recipients don’t provide any consideration for them. So, it’s possible that, for many Canadian taxpayers who received cryptocurrency by means of airdrops, their receipt of the airdropped tokens was a tax-free windfall.

Ultimately, 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, or who’ve received cryptocurrency airdrops should learn their tax obligations by seeking tax guidance from an expert Canadian tax lawyer.

Canadian Income-Tax Implications when Disposing of Airdropped Tokens: Business Income or Capital Gains?

The previous section demonstrates that the receipt of airdropped tokens may or may not be taxable income. But to be clear: although the receipt of airdropped tokens might not be a source of income, the disposition of those tokens is. In other words, even if the acquisition of airdropped tokens isn’t a taxable event, the disposition of those tokens always is. You must report the profit or loss resulting from the disposition. The only thing up for debate is: How do you report that profit or loss?

To that end, we turn to analyzing the income-tax characterization of a taxpayer’s profit from disposing of airdropped cryptocurrency tokens. As mentioned above, income from the use of property can be characterized as investment income or business income, depending on the level of activity involved. But when you dispose of a property, subsection 9(3) of Canada’s Income Tax Act rules out the investment-income characterization. The resulting profit is either a capital gain or business income. So, when a taxpayer turns a profit from selling the cryptocurrency tokens that the taxpayer previously received by airdrop, that profit must be reported and taxed as either business income or a capital gain.

The capital/income distinction turns on the taxpayer’s intentions. The key question is whether the taxpayer engaged in cryptocurrency transactions or solicited airdrops with the intention of flipping the cryptocurrency units for profit. If so, the profit constitutes business income. If, by pointing to objective factors, the taxpayer can demonstrate the intent to invest (rather than to trade), the sale proceeds will be on capital account and taxed as a capital gain. For instance, you might justify capital treatment if you demonstrate that you, say, received the cryptocurrency airdrop unsolicited and therefore didn’t expect to receive the airdropped tokens—much less acquire them with an intent to flip them.  On the other hand, if you received the cryptocurrency airdrop because you promoted the new cryptocurrency platform that issued the airdrop, it might suggest that your profits from ultimately selling the airdropped tokens should be characterized as business income.

Canada’s Income Tax Act sets out entirely different tax regimes for business income, on the one hand, and for capital gains, on the other. If your profits from cryptocurrency transactions qualify as business income, those profits are fully taxable. If, however, your profits from cryptocurrency transactions qualify as capital gains, then you include only one-half of the gain when computing your taxable income for the year in which you disposed of the cryptocurrency.  In either case, the profit is calculated by subtracting your tax cost (i.e.., adjusted cost base) from your proceeds of disposition. Your tax cost for an airdropped token will depend on whether the receipt was itself a source of income. If the receipt of the airdropped token was a tax-free windfall, you acquire the token for a nil tax cost because you needn’t report the value of the receipt as income. If the cryptocurrency airdrop was a source of income, and you therefore reported the value of the airdropped tokens as taxable income for the year of acquisition, then your tax cost for those airdropped tokens equals the amount that you reported as income due to the receipt.

Over the years, the Tax Court of Canada, the Federal Court of Appeal, and the Supreme Court of Canada have produced a massive body of case law analyzing the numerous factors that bear on the capital/income distinction. The case law is complex, fact-specific, and sometimes inconsistent. If anything, these decisions show that the required legal analysis demands advice from a Canadian tax lawyer who is experienced with tax issues involving cryptocurrency, non-fungible tokens, and other blockchain-based assets.

Pro Tax Tips: Legal Tax Analysis of Proper Cryptocurrency Tax Reporting & Voluntary Disclosures Program for Unreported Income from Cryptocurrency Transactions

Canadian taxpayers who trade cryptocurrency, who invest in cryptocurrency, or who’ve received cryptocurrency by airdrop 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 business income, as capital gains, or as a blend of the two. The distinctiveness of cryptocurrency airdrops means that Canadian taxpayers who’ve received airdrops will require competent and expert Canadian tax guidance on several unsettled issues. Our experienced Certified Specialist in Taxation Canadian crypto tax lawyer has assisted numerous clients with issues concerning the proper characterization and reporting of their cryptocurrency transactions and other blockchain-based transactions. We can also provide advice about record-keeping to ensure that the Canada Revenue Agency doesn’t fault you for misrepresenting the information in your tax returns and charge you with gross-negligence penalties—or, even worse, prosecute you for tax evasion.

The advances and cooperative efforts of international tax authorities signal the end of the anonymity that cryptocurrency users believed that they’d once enjoyed. This should trouble Canadian taxpayers with unreported profits from cryptocurrency transactions. If you filed Canadian 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 for your cryptocurrency holdings, your non-fungible token 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.

See also

Recent cra guideline regarding cryptocurrency - A Toronto Tax lawyer analysis

You may qualify for relief under the CRA’s Voluntary Disclosures Program (VDP). If your VDP application qualifies, the Canada Revenue Agency will abandon criminal prosecution and waive gross-negligence penalties (and may cancel or waive interest). 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 tax lawyers have assisted numerous Canadian taxpayers with unreported cryptocurrency profits and blockchain transactions. We can carefully plan and promptly prepare your VDP application. A properly prepared voluntary-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 VDP 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 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 your tax lawyer. 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, you should first approach our Canadian tax lawyers. If you require an accountant, we can retain the accountant on your behalf and extend our solicitor-client privilege.

See also

Canada Revenue Agency Makes Good on its Promise to Audit Bitcoin & Cryptocurrency Investors & Traders – A Canadian Tax Lawyer’s Analysis

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About the Author

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Kevin Persaud

Kevin Persaud is a tax lawyer and Senior Associate at Rotfleisch & Samulovitch. He has assisted start-up businesses, resident and non-resident business owners, corporations, and cryptocurrency traders with tax planning, will and estate planning, voluntary disclosures, and tax disputes, including tax audits, tax objections, and tax litigation.

Learn more about Kevin Persaud