Canadian Income Tax Implications Of Buying & Selling Blockchain NFTs

• Published date: 27 April 2021
• Subject Matter: Intellectual Property, Tax, Technology, Copyright, Income Tax, Sales Taxes: VAT, GST, Tax Authorities, Fin Tech
• Law Firm: Rotfleisch & Samulovitch P.C.
• Author: Mr David Rotfleisch

Introduction - Blockchain Non-Fungible Tokens or NFTs: What Are They?

Lately, non-fungible tokens (or NFTs) have exploded news headlines. Artists and other personalities have been raking in millions by selling digital works of art as NFTs. In March 2021, musician and artist Grimes sold a collection of digital art as non-fungible tokens for almost $6 million. On March 11, 2021, digital artist Mike Winkelmann (also known as Beeple) cashed in on the NFT craze, selling an NFT of his work "Everydays: the First 5000 Days" at Christie's for $69 million. The billionaire co-founder of Twitter, Jack Dorsey, offered to sell his very first tweet as a non-fungible token. It sold for $2.9 million. Even the noted whistleblower Edward Snowden got in on the action, auctioning off an NFT image outlining his face with pages from the landmark 2015 US court decision about the mass-surveillance program that he had exposed. The Snowden NFT sold for over $5 million.

So, what exactly is a non-fungible token? A non-fungible token, or NFT, allows you to buy or sell ownership of unique digital items. Anything digital can be converted into an NFT-e.g., a drawing, a song, a tweet, this very article.

Blockchain technology allows the public to verify and track who owns a particular non-fungible token. (Most NFTs use the Ethereum blockchain, but other blockchains can also support their own versions of NFTs.) So, in that sense, an NFT is like cryptocurrency, such as Bitcoin, Ethereum (ETH), or Litecoin (LTC): it relies on blockchain technology to track ownership and transfers of ownership.

But non-fungible tokens are called "non-fungible" because each NFT can be given unique characteristics. Cryptocurrency, on the other hand, is fungible-trading one Bitcoin for another gets you exactly the same thing. A non-fungible token, however, is more akin to an original piece of art. If you trade a Monet for a Rembrandt, you don't end up with the same thing. The same holds true for NFTs. As such, non-fungible tokens have unsurprisingly garnered the most excitement and attention for their utility in commercializing digitized art and music.

In addition, NFTs allow an artist or musician to program a resale royalty directly into the NFT, thereby prompting commissions beyond the first point of sale. Facilitated by blockchain technology, this royalty could in principle continue forever. This enables the artist or musician to generate continuing revenue for future sales of an artistic work or song-generating even greater revenues as the art or the artist increases in popularity.

The purchase, creation, and sale of blockchain NFTs by Canadian taxpayers invoke a number of Canadian income-tax issues. Some of these issues include: Do Canadian taxpayers receive different income-tax treatment when creating NFTs for sale, on one hand, and when selling NFTs created by someone else, on the other? What is the character of the income that a Canadian taxpayer earns when selling blockchain non-fungible tokens? Is it business income? Investment income? A capital gain? Or some combination of the three? Canada's Income Tax Act contains different tax rules for each of these three sources of income. Hence, Canadian taxpayers who buy and sell blockchain NFTs will typically find themselves unsure about how to properly report their income to the Canada Revenue Agency without proper tax-planning guidance from an experienced Canadian tax lawyer.

This article aims to educate NFT creators, traders, and investors on the Canadian income-tax issues triggered by the non-fungible-token market. First, this article gives a general overview of the tax rules governing the following three sources of taxable income in Canada: business income, investment income, and capital gains. Second, this article discusses the features that distinguish these three sources of taxable income-that is, the features that allow us to discern whether a particular receipt constitutes business income, investment income, or a capital gain. After reviewing the legal framework, this article analyzes the Canadian income-tax implications of creating, buying, and selling blockchain non-fungible tokens. This article concludes by providing pro tax tips for Canadian taxpayers engaging in NFT transactions.

Sources of Taxable Income in Canada: Section 3 of Canada's Income Tax Act

Subsection 2(1) of Canada's Income Tax Act requires every Canadian tax resident to pay tax on "taxable income."

Subsection 2(2) then explains that a taxpayer's "taxable income" equals that taxpayer's "income for the year" minus the deductions in Division C of the Income Tax Act. (Division C includes a number of tax subsidies, tax-relief provisions, and policy-based deductions, such as the loss-carryover rules, the lifetime-capital-gains exemption or LCGE, the part-year-resident rule, which renders offshore income non-taxable if earned while a taxpayer was a non-resident of Canada, and tax-treaty exemptions.)

Section 3 describes how to compute a taxpayer's "income for the year." In doing so, the section (non-exhaustively) lists the following sources of income:

• Office;
• Employment;
• Business;
• Property; and
• Capital gains.

Hence, these sources of income (plus any other source that section 3 doesn't expressly name) ultimately make up a person's taxable income.

This article focuses on the last three sources-that is, income from business, income from property, and capital gains.

Overview of Canadian Income-Tax Rules Governing Business Income, Investment Income & Capital Gains

Under Canada's Income Tax Act, a different set of tax rules applies to each source of income. "Source" refers to the character or the type of the income. As mentioned above, the sources of income named in section 3 of the Income Tax Act include income from business, income from property (investment income), and capital gains. The tax rules for all three of these sources are located in Division B of Part I of Canada's Income Tax Act. But the tax rules governing business income and investment income are found in subdivision b while the tax rules...