Canadian Income-Tax Implications Of Cryptocurrency Hard Forks ' Canadian Tax Guidance From A Canadian Tax Lawyer

• Published date: 19 January 2022
• Subject Matter: Tax, Technology, Income Tax, Capital Gains Tax, Tax Authorities, Fin Tech
• Law Firm: Rotfleisch & Samulovitch P.C.
• Author: Mr David Rotfleisch

Introduction - Evolution of a Cryptocurrency Token: What Is a Blockchain Fork?

In 2017, the Bitcoin network underwent two hard forks. The first hard fork occurred in August 2017 and resulted in the creation of Bitcoin Cash (BCH). The second hard fork occurred in October 2017 and resulted in the creation of Bitcoin Gold (BTG). As a result of the two hard forks, Bitcoin owners received Bitcoin Cash units and Bitcoin Gold units that equalled the number of Bitcoin units that they owned at the time of the respective fork. Likewise, in 2016, after users exploited a security flaw in The DAO project's smart-contract software and made off with $50 million in Ether, the Ethereum network instituted a hard fork, thereby restoring the stolen funds. As a result, the Ethereum blockchain split into two branches, each with its own cryptocurrency: the original, unforked blockchain continued as Ethereum Classic, and the new blockchain remained as Ethereum.

So, what exactly is a blockchain fork? It basically refers to a change to the protocol underlying the cryptocurrency network. The underlying protocol of a cryptocurrency network establishes the rules governing how that cryptocurrency functions-e.g., transaction-processing speed. To alter the way that the cryptocurrency functions, you typically need to change the underlying protocol. Say, for example, that you wanted to improve transaction-processing speed (i.e., a function change). It will likely demand a protocol change such as, for instance, altering the amount of information contained in each block on the chain. These protocol changes are known as "forks."

Not every fork entails the creation of a new cryptocurrency token. Forks come in two main types: Hard forks and soft forks. A hard fork (also called a "chain split") alters the protocol code to create a new version of the blockchain alongside the old version, thereby creating a new token that operates under the rules of the amended protocol while the original token continues to operate under the existing protocol. A soft fork also updates the protocol, but no new coin is created; thus, the protocol change applies to all network users. The creation of Bitcoin Cash (BCH) and Bitcoin Gold (BTG), and the split between Ethereum and Ethereum Classic, all resulted from hard forks.

Hard forks invoke a number of Canadian income-tax issues. For example: If a Canadian taxpayer receives new cryptocurrency units because of a hard fork, does the receipt of those units constitute a tax-free windfall or taxable income? And if the receipt of a forked coin is a tax-free windfall, are your profits when you ultimately dispose of the forked coin tax-free as well? Or are they business income? Investment income? A capital gain? Or some combination of the three?

This article discusses some of the Canadian income-tax issues triggered by cryptocurrency hard forks. The article first gives a general overview of the Canadian tax rules about what constitutes a source of taxable income and how to distinguish one source from another. After reviewing the legal framework, this article analyzes the Canadian income-tax implications of receiving new cryptocurrency under a hard fork. It then analyzes the Canadian income-tax implications arising from the disposition of forked coins. This article concludes by providing pro tax tips from our top Canadian tax lawyers for Canadian taxpayers who trade or invest in cryptocurrency.

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 ultimately make up a person's taxable income. The corollary is that Canadian courts have invoked the "source" concept to exclude certain receipts from a taxpayer's income.

The notion of "income from a source" has proven influential to how Parliament drafted-and how courts interpret-the Income Tax Act. The basic idea is that a receipt constitutes income only if it comes from a productive source. Section 3 of the Income Tax Act codifies this idea by stating that only "income from a source" is included when calculating a taxpayer's income for the year. In Stewart v Canada (2002 SCC 46), the Supreme Court of Canada explained that "whether a taxpayer has a source of income is determined by considering whether the taxpayer intends to carry on the activity for profit, and whether there is evidence to support that intention."

Thus, an income source typically features one or more of the following characteristics:

• It produces a yield that recurs on a periodic basis;
• It requires organized effort, activity, or pursuit on the taxpayer's part;
• It involves a marketplace exchange;
• It gives the taxpayer an enforceable claim to receive payment and
• It stems from the taxpayer's pursuit of profit (in the case of a...