Published: June 25, 2021
Introduction: Taxation and The Evolving World of Cryptocurrency Trading
The explosive growth in cryptocurrency trading over the last several years has proven a substantial tax compliance headache for the Canadian tax system. The Canada Revenue Agency (CRA), as Canada’s principal tax regulator, has often struggled to keep up with the pace of economic innovation that has originated with the decentralized and unregulated cryptocurrency market. “Flash loans” represent one such recent innovation that will certainly pose trouble for both the Canada Revenue Agency and Canadian courts. If you have or are engaging in cryptocurrency trading, particularly through use of flash loans, then you should consult with one of our expert Canadian cryptocurrency tax lawyers in order to navigate the tax considerations of your activities, particularly in light of the Canada Revenue Agency’s rapidly developing views of cryptocurrency trading.
What is a Cryptocurrency Flash Loan?
It would be helpful first and foremost before delving into flash loans to analyze a close counterpart available under our modern regulated financial system. A day loan, or “daylight loan”, is a common lending tool available through banks and institutions. With a daylight loan, the principal of the loan is lent and repaid with interest accrued over the course of a single day. A daylight loan is a popular tool for organizing consecutive same-day transactions, because it provides easy access to increased capital, minimizes the cost of interest and any concerns that might attach themselves to a loan with a longer date of maturity, and all the while providing complete documentation of fund transfers for the transactions.
A flash loan is a form of uncollateralized loan. In principle, a flash loan is similar to a daylight loan in that a flash loan is intended to allow a borrower to facilitate rapid transactions with no long-term commitment. However, unlike a daylight loan, the actual payment of the loan and repayment of the loan occur simultaneously. Many cryptocurrencies operate through a public ledger system, which requires that transactions involving cryptocurrency be verified and recorded against a public record. Transactions are posted as blocks to the ledger once verified, effectively allowing for multiple transactions to occur simultaneously.
As a consequence of the ledger system, a contract that involves both an advance of cryptocurrency and a repayment of cryptocurrency can be created and executed at the same time. The decentralized nature of cryptocurrency exchanges has made flash loans a popular tool for many traders who discover price differences between currencies on exchanges. A flash loan allows a trader to leverage a significant amount of capital with minimal risk in order to engage in arbitrage or asset swapping when an opportunity presents itself.
The Significance of Canadian Tax Rules for Flash Loans
Paragraph 18(1)(b) of the Income Tax Act (the ””) prohibits a deduction from a taxpayer’s income from a business or from the use of property with respect to either “an outlay, loss or replacement of capital” or “a payment on account of capital.” Paragraph 20(1)(c) of the Tax Act, alternatively, allows for a deduction from a taxpayer’s income from a business or property with respect to interest payments made on a loan. Whether a payment is classified as ‘interest’ will therefore be significant to a taxpayer, because the interest paid may be deductible from that taxpayer’s income. The tax savings may be significant for a taxpayer, depending on the amount of interest payments made on the loan in question.
However, for these rules a flash loan presents a significant challenge. Due to how the ledger system functions, the lender in a flash loan effectively never parts with the principal amount of the loan. Generally speaking, Canadian courts found that accrual of interest on a daily basis is a fundamental element of classifying a payment, amount or right under a contract as an interest payment. The Federal Court of Appeal in Perini Estate v Minister of National Revenue,  CTC 74 (FCA) set out three requirements that, if met, would render an amount as interest for tax purposes (emphasis added):
- The amount was compensation for the borrower’s use of the money;
- The amount was ascertainable on a daily basis;
- The amount was related to the outstanding principal sum.
The simultaneous payment and repayment of a flash loan cuts completely against these principles. The repayment to the lender is calculated in direct relation to the amount borrowed and does not actually accrue over time at any point. What may be considered interest as part of a flash loan is merely a condition that must be satisfied in order for the contract to be executed. The contract could not occur unless the amounts owed were actually paid at the same time that the flash loan occurs.
That the flash loan flies in the face of basic principles of interest is cause for concern but may not be fatal to classifying part of the payment as interest. The treatment of interest by Canadian courts in precedent cases like Perini and Miller v The Queen,  2 CTC 139 (FCTD), were not completely dependant on daily accrual as a factor for classifying an amount as interest. The finding of the Supreme Court in Canada in The Queen v Melford Developments Inc.,  CTC 330 (SCC), lends support to the notion that interest cannot be classified according to a restrictive test focused on daily accrual as a core component. Therefore, it is still within the realm of possibility that the courts will revisit and re-evaluate the definition of interest to include instantaneous repayment. Canadian courts have historically condemned treating an amount as interest simply because it has been labelled so and have instead opted to analyze a transaction’s nature. Only time will tell how the courts will view the repayment of a flash loan with respect to classifying any amount as interest.
Pro Tax Tip: Flash Loan Trades May Still be Taxable
Regardless of the whether interest on flash loans is deductible, the decision to use a flash loan in order to trade cryptocurrency is likely to trigger tax obligations in and of itself. Trading cryptocurrencies in Canada is generally subject to the same rules as trading any other commodity. The trading of commodities in Canada will generally trigger tax obligations when there has been a disposition of property. The decision to employ a flash loan in order to take advantage of a market discrepancy may qualify as a disposition, where cryptocurrency rapidly changes hands. This is likely to be the case even if you simply trade one cryptocurrency for another, and do not convert your cryptocurrency into fiat currency like Canadian dollars.
It is therefore vital that you keep track of exactly what you trade, and the value of that cryptocurrency both when obtained and when disposed of. With the substantial regulatory amendments that came into effect in Canada on June 1, 2021, the reporting obligations of cryptocurrency exchanges are more onerous than ever. All cryptocurrency exchanges in Canada must now register with the Financial Transactions and Reports Analysis Centre of Canada (FinTRAC), and to record the information of parties involved in a transaction valued at over C$10,000, among others. It is not unlikely that when engaging in flash loan trades that you will be captured under these rules. With increased levels of scrutiny and surveillance over cryptocurrency traders, it is more vital than ever that you keep appropriate records of your trades and report income earned accurately. You should contact an expert Canadian tax lawyer if you are concerned about how to classify your income from cryptocurrency trades, or if you have engaged in flash loan trading and have not properly reported your income previously on your tax returns.
"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."
A flash loan is a form of uncollateralized loan, which means that the loan is not contingent on the borrower’s assets. Instead, a flash loan is a contract designed to take advantage of the ledger system employed by many Cryptocurrencies. Funds are transferred to a borrower’s account, and an amount with payment transferred from that borrower’s account in the same ledger block.
An interest payment on a loan is deductible under the Income Tax Act as long as it relates to a business or property generating income. Unlike a traditional loan, borrowing cryptocurrency and repayment of the loan are simultaneous under a flash loan. The courts generally view daily accrual of interest as a fundamental characteristic of interest for tax purposes. As a result, it is possible that no portion of payments made for use of a flash loan will be deductible against a taxpayer’s income.
Generally, trading cryptocurrency is treated the same as any other commodity for tax purposes. Selling, swapping or gifting cryptocurrency will trigger tax obligations regardless of whether the cryptocurrency is actually converted into fiat like Canadian dollars or is swapped for another cryptocurrency. What portion of your trading activity is taxable will depend on a number of facts and the nature of your cryptocurrency trading activities.