Published: December 9, 2022
Introduction: Significant Cryptocurrency Crash Impacts Investors Globally
On Friday, November 11, 2022, the cryptocurrency derivatives exchange FTX Trading Ltd. revealed that it had applied for Chapter 11 bankruptcy protection in the United States. The company had previously been valued at over USD $32 billion. This signaled FTX’s collapse.
Only a week had passed since Binance, FTX’s main rival in the cryptocurrency exchange market and an investor in FTX, announced that it would be selling a sizable portion of its holdings in the native cryptocurrency tokens of FTX, or FTT, sparking widespread investor concern and speculating about FTX’s financial stability.
Concerns about FTX’s true solvency were raised as a result of FTX’s collapse, also known as the FTX crash, and a leaked balance sheet that revealed that Alameda Research, a quantitative cryptocurrency trading company linked to FTX and its CEO, Samuel Bankman-Fried, owned the majority of FTT in circulation. To the amazement of cryptocurrency investors worldwide, one of cryptocurrency’s most well-known public forces has completely collapsed following a failed bailout by Binance.
Many cryptocurrency traders who had stakes on FTX have lost access to their assets as a result of FTX’s collapse. The FTX crash has significantly reduced investor trust across the entire cryptocurrency market, which has caused a significant decline in value across almost all cryptocurrency assets. And many Canadian cryptocurrency investors have witnessed a significant decline in the value of their holdings as a result of the FTX meltdown. When disposing of any assets, care must be taken for Canadian taxpayers who invested in cryptocurrencies and want to continue their trading or investment operations.
A tax savey Canadian trader of cryptocurrencies should now take the FTX fall as a tax planning opportunity and focus on realizing losses immediately in order to maximize future tax savings on the legitimate disposal of their investment. The “stop-loss” provisions of the Canadian Income Tax Act, in particular the “superficial loss” provisions for individual taxpayers, are there to prevent just such a tax win for Canadian taxpayers.
Understanding these regulations is essential to keeping your crypto tax deductions for cryptocurrency losses intact and figuring out how to take advantage of market changes like the ones that have occurred since FTX’s collapse. Speak to one of our knowledgeable cryptocurrency tax lawyers in Canada to better understand your filing situation and options if you are a Canadian cryptocurrency investor trying to learn from the FTX crash, evaluate how to maximize your tax savings, and plan for the future.
Accrued Losses and the Application of the Canadian Income Tax Act‘s “Superficial Loss” Rules
Several restrictions in the Canadian Income Tax Act prevent Canadian taxpayers from experiencing “superficial losses” on their property. These rules are intended to stop a Canadian taxpayer from artificially realizing an incurred capital loss by selling a property and then buying it back right away in order to capture the loss. A “superficial loss” is a loss from the disposal of a specific capital asset in the following circumstances, as defined by Section 54 of the Canadian Income Tax Act:
- The taxpayer or an “affiliated” person (which includes, among other relationships, spouses, common-law partners, and controlled corporations, but excludes parents and children) acquires a substituted property that is the same property or “identical” to the previously owned property between the beginning of the period of 30 days before and the end of the period of 30 days after the disposition; and,
- The substituted property was owned by the taxpayer or an affiliated person at the conclusion of the 61-day window, or they had the option to do so.
The Canadian Income Tax Act‘s subparagraph 40(2)(g)(i) states that a taxpayer’s loss from the sale of a property, to the extent it is a superficial loss, is presumed to be zero. So, unless the taxpayer disposes of the property with a definitive intent, he or she is not permitted to deduct that loss. Additionally, the standards remain the same when a taxpayer purchases an “identical” replaced property. When determining a Canadian taxpayer’s preference, the CRA has taken the stance that “properties which are the same in all material respects, so that a prospective buyer would not prefer one as opposed to another” are included as “identical” properties for the purposes of section 54 of the Canadian Income Tax Act defining a superficial loss.
In the context of specific businesses, Subsection 18(14) offers a comparable superficial loss provision. In particular, it applies where a Canadian taxpayer sells a piece of property that is listed in the inventory of a business that is “an adventure or concern in the nature of trade.” Comparable to section 54, subsection 18(14) is applicable when the taxpayer or an affiliated person acquires the same or an identical property during the 61-day period beginning 30 days before and 30 days after the disposition, and at the end of that time, the taxpayer or affiliated person owns or has the right to the substituted property. Similar to subparagraph 40(2)(g)(i), subsection 18(15) determines the loss on disposition to be nil if it was only a superficial loss.
The definition of “business” in subsection 248(1) of the Canadian Income Tax Act includes “an adventure or concern in the nature of trade.” It follows that while a business must necessarily be an adventure or a concern in business, the opposite is not always true. Generally speaking, a business exists when a Canadian taxpayer continually engages in a trade or profession with the intent to profit. An “adventure or concern in the nature of trade” usually refers to a single transaction or series of transactions in which a Canadian taxpayer purchases property with the goal of reselling it for a profit. Analyses will be extremely fact-driven when determining whether a Canadian taxpayer is running a legitimate business, an adventure or concern in the nature of trade.
In general, income losses are not subject to the laws governing superficial losses. Thus, a taxpayer is not prevented from crystallizing a loss on the non-capital property in the absence of the application of these superficial loss rules or any other superficial loss rules that may apply under the Canadian Income Tax Act. While crystallizing operational losses from that trading business, a cryptocurrency trader functioning as a pure trading business may be able to sell and repurchase inventory without triggering the superficial loss restrictions.
Whether this crystallization is feasible will be totally dependent on whether a cryptocurrency trader’s activities are classified as a business, in which case crystallization is possible, or an adventure in the nature of trade or an investment, in which case the superficial loss rules will be applicable. In these situations, the taxpayer will suffer because the disposition will set off the superficial loss rules. This might be the case if a Canadian taxpayer invests in cryptocurrency hedge funds and investment portfolios rather than actively trading cryptocurrency assets, or if the taxpayer holds cryptocurrency tokens as long-term investments.
The Taxation of Cryptocurrency Tokens Dispositions: As a Business or Capital Investment?
The type of income earned affects the type of asset disposed of under the Canadian Income Tax Act. In order to characterize the sort of income earned or loss incurred, the analysis starts there. No Canadian court has issued a clear ruling on the taxation of cryptocurrencies, and the Canada Revenue Agency has not issued any cogent guidelines of its own on how to classify cryptocurrencies for Canadian tax purposes.
However, the body of Canadian case law addressing the classification of business and investment income, as well as capital gains, offers some fundamental guidelines for assessing the classification of a Canadian taxpayer’s cryptocurrency transactions. Although the courts have not recognized a single aspect as being conclusive, important considerations for establishing whether a property transaction is being done for capital or as a component of a business include:
- The type of sold property.
- The duration of taxpayer’s ownership.
- The number or regularity of other similar transactions by the taxpayer.
- The time spent working on or in relation to the property realized.
- The events that led to the sale; and,
- The motive for both the taxpayer’s purchase of the property and its selling is crucial for cryptocurrency holders.
As a result, the tax treatment of a Canadian taxpayer’s acquisition and sale of a cryptocurrency token will depend on a number of factual factors. Your reasons for trading and investing in different cryptocurrencies, as well as your reasons for selling your holdings, will all be taken into account when determining whether the proceeds from the sale of your holdings will be taxed as capital gains or as business income.
Tax Pro Tip – Beware Against Getting Complacent. Keep Thorough Records and Obtain a Written Legal Opinion Before Filing.
When confronted with the potential application of the superficial loss regulations under the Canadian Income Tax Act, a Canadian taxpayer should always take a cautious approach. This is particularly true if you take the stance that your losses were from a business and not the sale of capital property. A business loss has much more tax benefits than a capital loss. One may deduct all losses and costs related to business or investment activity, but only half of the capital losses are fully deductible.
Therefore, the best defenses you have against a reassessment by CRA following a tax audit are caution and diligence. Even while you may believe that your transactions classify your proceeds and losses as coming from a business, it’s always possible that the CRA and Canadian courts would hold a different opinion, and disputing those views can be an expensive undertaking.
Consequently, it’s essential to keep proper records of your cryptocurrency trading activities to prevent the harshest tax enforcement actions. You should always keep your own trading records and never rely on cryptocurrency exchanges to keep track of your transactions. In addition to other previous cryptocurrency exchanges like QuadrigaCX, the FTX catastrophe is the ideal illustration of what may go wrong if you don’t conduct your own due diligence. That is, you might be required to act quickly to gather the proof you need to refute an unfair CRA tax audit or reassessment, and the onus will be on you to refute their presumptions.
Additionally, getting a tax memo on how to characterize your proceeds and losses from cryptocurrency dispositions could be beneficial to you. In the event that you are ever subject to a CRA tax audit over your cryptocurrency dispositions, obtaining a tax memorandum is a significant piece of evidence proving that you exercised due diligence while calculating your correct Canadian income tax filing position. Furthermore, there may still be ways to consolidate your losses if your cryptocurrency holdings may be considered capital assets.
Since two cryptocurrencies do not qualify as equivalent properties, disposing of one and buying another right away (like trading Bitcoin for Ethereum) should prevent the superficial loss rules from being applied. For cryptocurrency investors, this gives a very potent option for tax planning, although this approach will be strongly influenced by the investor’s specific facts and circumstances. In order to guard against CRA overreach and the denial of your valid business losses, our competent Canadian cryptocurrency tax lawyers can offer more formative advice on how to keep your records and provide you with legally-justified opinions on the proper reporting position of your cryptocurrency dispositions.
What Does FTX Mean in Crypto?
The Bahamas-based cryptocurrency exchange FTX specialized in leveraged products and derivatives. By enabling users to connect with their crypto wallets, exchange cryptocurrencies and NFTS, trade, and more, the FTX cryptocurrency exchange supported the liquidation and transfers of coins and tokens. Additionally, it promoted collectibles transactions. Due to current cryptocurrency restrictions, US citizens were not allowed to trade on its platform; however, customers from other countries were able to use it up until the company filed for bankruptcy and investigations started, which caused the FTX crash.
What Exactly Does FTX Mean?
Another example of the effects of cryptocurrency crashes is the cryptocurrency trading company known by the full name Futures Exchange (FTX), which has since experienced a collapse.
What happened in the FTX Crash?
FTX Trading Ltd., the second-largest cryptocurrency derivatives exchange in the world at the time, filed for Chapter 11 bankruptcy in the United States in November 2022. The abrupt liquidation of FTX’s native cryptocurrency token FTT by Binance, its closest competitor, served as the catalyst for the company’s downfall. Binance’s failed attempt to acquire FTX after it fell into a freefall also contributed to the collapse of FTX. A significant decline in the value of cryptocurrency tokens was caused by the market crisis brought on by the FTX crash, which affected almost all cryptocurrency investors and portfolios.
A “Superficial Loss” is What?
A “superficial loss” occurs under the various provisions of the Income Tax Act when a Canadian taxpayer disposes of qualifying property and, within the period beginning 30 days before and 30 days after the disposition, the taxpayer or a person with whom he or she is affiliated acquires an “identical” or the same to the property being disposed of. The taxpayer’s loss from the disposition, to the extent it is deemed superficial, shall be considered to be nothing if the taxpayer or an affiliated person holds the property at the conclusion of the 61-day period. The Canadian Income Tax Act‘s rules on superficial losses are intended to stop Canadian taxpayers from artificially realizing accrued losses for tax planning purposes when there isn’t actually a sense of finality to the disposition.
What Does “Crystallize” My Tax Losses Mean?
When a piece of property is disposed of, a gain or loss is realized for tax purposes. Theoretically, a taxpayer may sell an asset when its value is low and then buy it back right away to assure access to the losses for tax planning purposes. However, the Canadian Income Tax Act contains a number of complex regulations that discourage improper tax planning by inducing “superficial losses.” To make sure these regulations do not apply to deny you those losses, every attempt to crystallize your losses should be reviewed and overseen by an experienced Canadian crypto tax lawyer.
In cases where your cryptocurrency holdings qualify as capital assets, an expert Canadian crypto tax lawyer can also assist in determining what tax planning opportunities exist to crystallize your losses. These opportunities include planning the repurchase of the same cryptocurrencies after the superficial loss limitation period has expired as well as swapping your cryptocurrency holdings for other cryptocurrencies that do not qualify as identical properties.
How Are Superficial Loss Rules Differently Applicable to Business Losses and Capital Losses from Cryptocurrency Transactions?
A Canadian taxpayer with holdings of cryptocurrency tokens treated as a long term investment may receive proceeds of disposition as a capital gain or from a business, as an adventure or concern in trade, which is an income transaction rather than a capital gain. In these situations, the Canadian Income Tax Act‘s superficial loss regulations will restrict the Canadian taxpayer from selling and buying cryptocurrency tokens again to realize cumulative losses. The lesson we can learn from FTX’s collapse is that the superficial loss rules may be inapplicable to a disposition or reacquisition if a Canadian taxpayer is actively engaged in a trading business, and only for tax planning purposes, such a Canadian taxpayer is allowed to crystallize operating losses.
"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."