Published: March 10, 2022
Last Updated: March 10, 2022
Introduction – loss of cryptocurrency or NFT due to theft, fraud, embezzlement or robbery.
Recently a US couple was arrested for stealing $US3.6 Billion of cryptocurrency from 2016 by hacking a cryptocurrency exchange. This news showed that although blockchain and cryptocurrency is considered by many to be a revolutionary technology, cryptocurrency can be stolen by sophisticated hackers.
Cryptocurrency or NFTs can also be lost through fraud or embezzlement. In 2021, cryptocurrency losses from scams totaled $US7.8 billion worth of cryptocurrency.
There were even instances that cryptocurrency’s holder’s real-life identity was discovered by nefarious criminal and the cryptocurrency holder would be robbed at gun point. https://www.fastcompany.com/40509102/1-8-million-worth-of-cryptocurrency-stolen-at-gunpoint
In this article, we will address the Canadian tax implication of lost cryptocurrency due to theft, fraud, embezzlement, or robbery.
Income Tax Act Characterization of Cryptocurrency
Cryptocurrency may be characterized as either generating business income through an actual business or an adventure in the nature of trade or capital properties generating capital gains. While there has been no case law that directly deals with the characterization of cryptocurrency profit as capital gains or income, much of the existing case law on the income vs capital gains can still apply. Please see our article here for a detailed breakdown on the law regarding capital gains vs income for Cryptocurrency.
Involuntarily Disposed Capital Property
When a taxpayer received compensation for his or her lost capital property in the form of either direct compensation from the party responsible for the theft, fraud, embezzlement or robbery, or received compensation from an insurance company, the Income Tax Act deems there to be an involuntarily disposition of the taxpayer’s former property. Subsections 13(4) and 44(1) of the Income Tax Act operates to defer this deemed disposition for two years if replacement property is acquired within two years.
However, if the taxpayer in the above situation did not receive actual proceeds and compensations for his or her involuntarily disposed property, a capital loss will result, as we will discuss below.
What is Replacement Property
The Income Tax Act defines replacement property as properties where it must be reasonable to conclude that the property was acquired by the taxpayer to replace the former property whereby the replacement property was used for a similar purpose as the former property. In the case of cryptocurrency, the replacement property may be generalized widely as any investment instrument that can carry out the purpose of generating business income.
When the replacement property was purchased within 2 years, the taxpayer may only pay tax to the extend the proceed of the involuntary disposition exceed the adjusted cost base of the replacement property.
Capital Loss when The Involuntary Loss Was not Compensated
When the Taxpayer did not receive any compensation for his or her capital property loss through theft, fraud, embezzlement or robbery, the taxpayer may claim a capital loss under section 40 of the Income Tax Act. This capital loss can be carried forward indefinitely or carried back 3 years
On the other hand, inventories, including Cryptocurrency, that were lost through theft, fraud, embezzlement or robbery can be deducted as business losses according to the general principle of deduction for business expenses alongside with the enumerated limitations contained in paragraph 18(1)(a) of the Income Tax Act. However, for the general principle to apply, the taxpayer must demonstrate that:
- such losses are an inherent risk of carrying on the business;
- and the loss is reasonably incidental to the normal income-earning activities of the business.
Many complex and novel questions need to be posed and answered in order to apply the general principle of deducting inventory losses to cryptocurrency traders. Furthermore, these would likely vary on a case-to-case basis based on the behaviors and strategies of the trader as well as how the trader’s cryptocurrency inventory came to be lost via theft, fraud, embezzlement or robbery. It is best to consult an experienced Canadian crypto tax lawyer to answer your questions about the specific details if you lost cryptocurrency due to theft, fraud, embezzlement or robbery.
Any insurance payout or other forms of compensation for inventory lost to theft, fraud, embezzlement or robbery would be included as business income.
Pro Tax Tip – Keep Records and Books on Your Cryptocurrency Transactions
Theft, fraud, embezzlement or robbery of cryptocurrency asset is a constant risk facing all cryptocurrency holders. It is important to keep good records of your past cryptocurrency transactions and consult with experienced Toronto crypto tax lawyers to see how your losses can be deducted to minimize unnecessary tax consequences in an already stressful and unfortunate situation.
"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."
Capital losses can only be deducted against capital gains. Non-capital losses, that is to say business losses, can be deducted against any business income. This means while capital gains treatment is preferrable compared to business income because it is taxed at 50% compared to regular business income which is fully taxable, a non-capital loss is more attractive as it can be used to reduce business income.
The Income Tax Act considers the day of the loss to be the start of the two-year replacement property rule period. This can fall on a different day than your tax year end.
A simple loss of cryptocurrency key may be considered a bad debt. This is addressed further in our article here