Published: February 1, 2022
What is Bitcoin and Bitcoin Mining?
Bitcoin is a decentralized cryptocurrency that records transactions in a distributed ledger system called a blockchain. The Bitcoin blockchain records the entire history of Bitcoin exchanges that takes place in its network. In this system, coins are distributed and shared among “nodes” or “peers.” The nodes or peers in this network collectively verify the legitimacy of the transactions. For example, if two parties want to transfer a certain amount of Bitcoin, the network of nodes, which contain the exact same history of transactions, must verify the transaction. If the transactions are verified, then the transfer will be recorded in the public ledger, thereby authenticating the transaction.
The blockchain records the transactions in “blocks.” Each block consists of a precedent block and an answer to a “complex” mathematical puzzle that verifies the transactions which it contains. When a block is verified and completed by other nodes or peers in the network, it connects to the most recently verified block, thus forming a chain of verified blocks. The process of solving complex mathematical puzzles that verifies Bitcoin transactions is called Bitcoin mining. To clarify, the mathematical problem is not complex per se. The work involved is essentially using computational power to be the first miner to guess the correct 64-digit hexadecimal number, also known as the hash value, that is less or equal to a target hash. In other words, the work is, in essence, guesswork.
Bitcoin Mining Process
The Bitcoin Mining process revolves around finding a hash value equal or lower to a given target value. The process of Bitcoin mining can be divided into the following: (1) a miner must join the Bitcoin network and connect to other nodes; (2) the miner must wait and listen for new blocks that are broadcasted on the network; (3) the miner must validate the new blocks by finding a nonce value that makes the block valid; (A nonce value, when hashed, results in an output hash. The miner’s job is to manipulate the nonce value until the hash output value is equal or lower to a given target hash. If the miner finds the appropriate nonce value, then it will validate the block.) (4) if the block that was mined gets validated by other miners, then the miner who worked on the block will get rewarded by way of Bitcoin allocation.
Since Bitcoin mining is the only way to record and verify transactions of Bitcoins, it is essential to the maintenance of the Bitcoin system. In other words, when a miner mines Bitcoin, that person is performing an activity that ensures the Bitcoin system’s integrity. Without miners, the Bitcoin system will be non-functional since no transactions will be verified.
Bitcoin Mining Rewards
There are two implications/results of Bitcoin mining. First, it ensures the accuracy and legitimacy of the blockchain. Miners make sure that no transactions are duplicated or recorded twice. Second, when a Bitcoin miner accurately verifies a block of Bitcoin transaction, they receive newly minted Bitcoin from the Bitcoin protocol and transaction fees, in Bitcoin, from the users involved in the transaction. In other words, the miner who validates the block will get rewarded, and the reward is two-fold: newly minted Bitcoin rewards and transaction fees.
When a Bitcoin miner accurately verifies a block, they created newly minted Bitcoin part of which they receive. This method is the only way to produce Bitcoin – Bitcoin mining is central in issuing new Bitcoin. In other words, when a miner successfully validates a block, new bitcoins get created according to the Bitcoin protocol, and a certain amount is released to the miner as a reward. In addition, as set out above, a Bitcoin miner receives transaction fees from the users involved in the transaction. Generally speaking, at present the transaction fee is approximately 1% of the block reward. As such, the Bitcoin rewards (i.e. the newly minted Bitcoin) accounts for most of the miner’s revenue as opposed to the transaction fee rewards.
However, the newly minted Bitcoin rewards will start to dwindle in the future. In particular, the block rewards are halved every four years. Initially, from January 2009 to November 2012, the block reward for mining Bitcoins was 50 Bitcoins. However, due to the Bitcoin halvings that occurred three times over more than ten years, the reward for each block is now lowered to 6.25 Bitcoins. Moreover, the total number of Bitcoin that may be mined is maxed out at 21 million Bitcoins. When Bitcoin production comes to an end, it is expected that the transaction fees will be the sole rewarding function in Bitcoin Mining. In other words, when Bitcoins are capped out, the only reward that Bitcoin miners will receive from verifying transactions are transaction fees from the users involved in the transaction.
Tax Implications of Acquiring BTC by Mining: Three Alternatives
Canada has yet to enact income tax legislation dealing expressly with cryptocurrency transactions or cryptocurrency mining. (Canada, however, enacted GST/HST legislation concerning “virtual payment instrument”. In 2021, the Excise Tax Act was amended to include “virtual payment instrument” in the definition of “financial instruments”.) Moreover, the Canadian courts have yet to decide upon a tax issue regarding cryptocurrency transactions and cryptocurrency mining. Therefore, it will be interesting and important to see how the courts and the legislation will treat the taxation of cryptocurrency transactions and cryptocurrency mining.
Our view is that there are three alternatives as to the tax implications of acquiring BTC by mining. As we discuss below, the correct alternative depends not only on the nature of BTC mining itself but also on what the taxpayer does with the BTC acquired through mining.
The following three sections discuss each alternative in detail.
Alternative 1: The Hobbyist Miner
The first alternative is that the taxpayer mined Bitcoin solely as a hobby without commercial intent. In such cases, the reward from mining is not treated as a source of income. The hobbyist won’t need to report the value of the mining rewards as income upon receipt. Rather, the income inclusion (or loss realization) will occur when the hobbyist disposes of the mined Bitcoin.
The disposal of the mined Bitcoin is a separate activity from the acquisition of the mined Bitcoin. Thus, the resulting gain from the disposition of the mined Bitcoin is reportable on account of either income or capital. In other words, the tax implications of the disposition of the Bitcoin will require a separate legal analysis. To be clear, the tax cost of the mined Bitcoin by a hobbyist would be nil since the taxpayer does not report the mined Bitcoin as income. Therefore, the hobbyist miner cannot incur a loss from the disposition of the mined Bitcoin at the time of disposition. Instead, when the hobbyist disposes of the mined Bitcoin, the disposition will result in a gain. The gain will be computed as A minus B, where A equals the proceeds received upon disposition and B equals the tax cost of the disposed property. Since the tax cost of the disposed property in such case is nil, the gain will equal the proceeds received upon disposition.
Alternative 2: Mining While Operating a Cryptocurrency Trading Business
The second alternative is that the taxpayer mined Bitcoin while operating a cryptocurrency trading business with commercial intent. In such cases, acquiring Bitcoin through mining would be akin to acquiring inventory – in particular, acquiring inventory for a cryptocurrency trading business. The mining activity in this case is not itself the taxpayer’s source of income. Rather, the mining activity is incidental to the taxpayer’s source of income – which consists of selling and trading Bitcoin units acquired by mining. Therefore, a cryptocurrency trader does not recognize income when acquiring Bitcoin through mining, just as a gold dealer does not recognize income upon acquiring gold deposits from mining.
Instead, like the hobbyist miner, the cryptocurrency trader recognizes income when the mined Bitcoin rewards are disposed of. However, for the cryptocurrency trader, the resulting gain (or loss) from the disposition of mined Bitcoin rewards will necessarily be on income account. In other words, the cryptocurrency trader cannot receive capital treatment with respect to the disposition of mined Bitcoin.
It is important to stress that the inventory-acquisition model will only be appropriate if the Bitcoin miner operates the mining activities in the context of a cryptocurrency trading business. If the Bitcoin miner is not operating the mining activities in the context of a cryptocurrency trading business, then the inventory-acquisition model will not be appropriate.
Alternative 3: Mining as Services
The last alternative is that the taxpayer mined Bitcoin as a provision of services. This type of tax treatment finds support from the role that mining plays in the Bitcoin network and also from the portion of the mining rewards – the transaction fee component. To elaborate, a Bitcoin miner uses mining software to verify the validity of Bitcoin transactions. As a result of this verification work, the integrity of the Bitcoin network is maintained, and the parties involved in Bitcoin transactions are recipients of the services of miners. For compensation, the miners receive newly minted Bitcoin and transaction fees.
As opposed to the hobbyist model and the inventory acquisition model, the services model entails that the Bitcoin mining reward is a source of income. As such, under this model, the Bitcoin miner must report the value of the mining rewards as part of their income for the year of acquisition upon receipt. The cost of the mined Bitcoin rewards will equal to the amount that the miner reports as income.
The services model will only be appropriate if the Bitcoin miner does not operate a cryptocurrency trading business and if the Bitcoin miner carries out the mining activities with commercial intent. If the Bitcoin miner operates a cryptocurrency trading business, then the Bitcoin rewards from mining will be acquisition of inventory. On the other hand, if the Bitcoin miner does not carry out the mining activities with commercial intent, the rewards cannot be viewed as a source of income. Therefore, the service model should be reserved for cases in which the Bitcoin miner mines Bitcoin with commercial intent yet does not operate a cryptocurrency trading business.
The CRA’s Position on the Tax Consequences of Bitcoin Mining
In 2019, the CRA stated their position on whether Bitcoin miners should include the value of the Bitcoin rewards in income at the time they are mined. CRA indicated that Bitcoin miners must include the Bitcoin mining rewards in their income at the time they are earned. The tax department’s rationale for this position was that a cryptocurrency is a commodity and, as such, bitcoin mining activity is essentially a barter transaction. CRA says that Bitcoin miners are providing services and that they are receiving Bitcoin as payment.
Despite what the CRA’s current position is, it is important to note that the CRA’s interpretative publications do not have the force of law, and the CRA’s view is indeed contrary to the law. It does not suffice to look at Bitcoin mining in a vacuum. The tax consequences of Bitcoin mining depend not only on the nature of Bitcoin mining itself, but also on the circumstances of which the taxpayer acquired the Bitcoin through mining. The CRA’s position fails to consider the taxpayer’s intentions and the context in which the taxpayer performed the mining activities. If you have been wrongly assessed by the CRA for bitcoin mining income contact one of our expert Canadian tax crypto lawyers for assistance.
Tax Pro Tip: Correct Tax Consequence Requires Analyzing the Nature of Bitcoin Mining and the Circumstances in Which the Taxpayer Acquired the Bitcoin Rewards From Mining
As discussed, the correct tax consequences of Bitcoin mining depend not only on the nature of Bitcoin mining itself, but also on the circumstances in which the taxpayer acquired the Bitcoin through mining. Depending on the circumstances of the taxpayer, the Bitcoin mining rewards may be taxable upon receipt, or they may not be taxable until they are ultimately disposed. The tax characterization of the mined Bitcoin rewards is a question of law. Therefore, if you are mining Bitcoin and have questions about the appropriate tax characterization of your mining activities, please consider contacting one of our knowledgeable Toronto tax lawyers.
"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."
It depends. If the factual circumstances suggest that a Bitcoin miner is a hobbyist miner or that a Bitcoin miner is operating a cryptocurrency trading business, then the Bitcoin rewards will not be taxable upon receipt. However, if the factual circumstances suggest that a Bitcoin miner mines Bitcoin with commercial intent yet does not operate a cryptocurrency trading business, then the Bitcoin rewards will have to be reported in the tax year upon receipt.
Yes. If your application meets the voluntary disclosure application requirements (mainly: voluntariness, completeness, tax owing, one year past due, and payment of estimated tax included), then the CRA will provide you a chance to correct your taxes. The Voluntary Disclosure Program gives taxpayers a chance to correct inaccurate and/or incomplete information. If the application is accepted, the benefits are that the CRA will refrain from prosecuting criminally and will provide certain penalty relief. The CRA may even provide partial interest relief as well as greater penalty relief depending on which track the application qualifies. Our experienced Toronto tax lawyers have prepared literally hundreds of voluntary disclosure applications on varies issues including cryptocurrency related issues. If you would like to know more about the Voluntary Disclosure Program and whether this would be an appropriate action for you, please contact our Canadian tax law firm.