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.
FAQs
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.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
