Is NFT trading income taxable in Canada?

When: September 2023

In March 2023, Israeli tax authorities announced the arrest of two Israeli citizens suspected of tax evasion for allegedly receiving more than $2 million in unreported income from NFT transactions. NFTs essentially represent unique digital assets and are indivisible digital tokens. The token ownership of each NFT is recorded on a digital ledger, typically using the Ethereum blockchain and smart contracts to link the token to specific data, which can be art or any other collectible. Usually this data is hosted on a cloud-based service and is accessible to NFT holders. Meanwhile, NFT content creators use public keys as proof of their authenticity and provenance.

According to the Jerusalem Post and the Israel Tax Authority, the two are the creators of the Holy Rock NFT project that seeks to create unique NFTs that represent each stone in Jerusalem's Western Wall and intends to sell them to digital collectors. They then sold the NFTs generated by the project in exchange for ETH. They further transfer these ETH to different cryptocurrency wallets, making the traceability of these transactions on the public ledger more complex. Allegedly, the two alleged individuals did not report any profits they generated from the sale of NFTs for ETH.

The rapid adoption of blockchain technology, including cryptocurrencies and NFTs, has raised concerns among law enforcement and tax authorities around the world. They are concerned that these digital assets may achieve tax evasion by masking the nature of taxable transactions. This concern stems from the inherent anonymity that blockchain technology provides to digital asset traders. While blockchain transactions are public in nature, a unique wallet address associated with a digital ledger does not reveal the true identity of the wallet holder. In response to these concerns, regulators such as the Israel Revenue Agency and the Canada Revenue Agency have taken strict steps to crack down on the use of crypto assets as a means of concealing unreported income.

Although the Canada Revenue Agency has not issued any compliance or enforcement notices for the global NFT market, it has taken practical action in the context of virtual currencies and cryptocurrencies. Although the Holy Rock NFT project is primarily associated with Israel, it can serve as an interesting case study to explore the Canada Revenue Agency's investigative powers regarding tax evasion issues and the potential civil and criminal consequences for tax evaders. This article will first delve into the basic principles of taxing NFTs in Canada's cryptocurrency tax system. Subsequently, the approach employed by the Canada Revenue Agency in investigating alleged tax evasion incidents will be clarified, as well as a range of penalties that may be imposed on taxpayers who intentionally or unintentionally engage in crypto tax evasion. Finally, we will provide some cryptocurrency tax tips.

Why are NFT disposals taxable in Canada? **

According to Section 3 of the Canadian Income Tax Act, the taxable income of a Canadian taxpayer includes all income generated both domestically and abroad. This includes revenue generated by the business or assets, which essentially covers the sale of NFTs. In the Canadian tax framework, whenever an asset is disposed of, the gain or loss arising from the transaction must be calculated, reported, and taxed in the year of disposal. This tax applies regardless of whether the asset is sold or exchanged for other assets in fiat or cryptocurrency. Therefore, whenever an NFT is sold for fiat currency or traded for another asset, such as a cryptocurrency or other NFT, the Canadian tax system considers such sale or transaction to be a taxable event, so it is necessary to calculate and report crypto gains or losses due to the disposal during the year.

The tax implications of NFT disposal for Canadian taxpayers are obvious. The key point or technical difficulty is whether such a disposal should be classified as a capital gain or income from the business (this can include a one-time disposal). This is important for cryptocurrency tax planning purposes because, unlike business income, only half of a taxpayer's capital gains are considered taxable income for the year of disposal. Conversely, if the disposal results in a loss of capital, only half of that loss can be deducted and can only be deducted from the capital gain. Given the volatility of the global NFT market, distinguishing between capital gains and business income could have a significant impact on Canadian taxpayers in determining their tax liability.

Determining whether profits or losses arising from the disposal of property should be considered capital or income has been the subject of extensive concern in the Canadian Tax Court. Although the Canada Tax Court has yet to hear a case regarding the sale of an NFT, it is reasonable to expect that these principles will continue to apply to the characterization of proceeds from the disposal of NFTs. It is important to recognize that no single factor alone determines the appropriate classification of proceeds from the disposal of property. The assessment should be made on the basis of the unique circumstances of each case. However, Canadian courts have consistently outlined specific objective criteria to be considered in determining whether the disposition of property is distinguished as capital or income. In the context of NFTs, these factors may include:

NFT transaction frequency: For example, if taxpayers frequently engage in NFT buying and selling or have a high NFT turnover rate, it may indicate that it is a commercial activity and not a capital investment; Term of ownership: If taxpayers tend to hold NFTs for a short period of time, this may indicate that it is a commercial activity rather than a long-term capital investment; Expertise in NFT marketplaces: A taxpayer's extensive expertise in the NFT marketplace may indicate that it is a commercial activity; Relationship with the taxpayer's other occupation: Preference for business activity classification if NFT trading or similar activity is related to the taxpayer's primary occupation or other business; Time invested in NFTs: If a significant portion of the taxpayer's time is devoted to researching potential NFT acquisitions, analyzing the NFT market, or actively managing an NFT portfolio, this indicates the existence of commercial operations; Financial support: Leveraged NFT purchases and transactions indicate the existence of commercial operations; Advertising: If a taxpayer advertises their NFT campaign as a business or publicly advertises their participation in NFTs, it increases the likelihood of being classified as a commercial activity.

In general, the most important factor in determining whether the sale of a property will result in capital gains or business income is the taxpayer's intention at the time of purchase of the property. The Canadian courts and the Inland Revenue Service will thoroughly review the objective circumstances regarding the acquisition and sale of property in conjunction with the previously mentioned factors to determine the fundamental purpose for which the taxpayer acquired the property. It is worth noting that the definition of "business" in section 248(1) of the Canada Income Tax Act includes "adventure or concern of a trade nature". This interpretation means that even a single acquisition and sale of property can be classified as operating income if this characteristic is confirmed.

Consequences of Insufficient Tax Reporting of NFT Disposition

Taxpayers may face severe civil or even criminal penalties for tax evasion, depending on the extent of their misconduct. Section 239(1) of the Canada Income Tax Act outlines various circumstances in which Canadian taxpayers may face significant fines and potential imprisonment for knowingly making false statements on tax returns, engaging in such actions, or intentionally manipulating or destroying financial records to conceal tax obligations. A conviction under section 239(1) is punishable by a penalty of 50% to 200% of the amount of tax evasion or imprisonment for up to two years.

The determinant of potential criminal liability in tax evasion cases is the psychology of the taxpayer when he commits the relevant act. In addition, section 163(2) provides a civil framework for punishing taxpayers who intentionally or with gross negligence make false statements or omissions on their tax returns (these are commonly referred to as "gross negligence penalties"). Under Section 163(2), taxpayers may be held liable for misrepresentation or omission, whichever is higher: (1) $100; (2) 50% of the total amount of tax payable by the taxpayer.

The anonymity provided by digital ledgers to NFT traders poses a challenge for the IRD to initiate cryptocurrency tax audits of Canadian NFT traders suspected of tax evasion. The IRD's existing authority to collect Canadian taxpayer information during tax audits has limited use in specifically investigating taxpayers involved in wallet-to-wallet transactions. However, the growing importance of digital asset exchanges as facilitators of NFT transactions provides a key avenue for the tax office to conduct tax audits of Canadian NFT traders. Section 231.2 of the Canadian Income Tax Act gives tax auditors and investigators the power to compel individuals to provide documents or information necessary for tax investigations. This power is particularly broad and has historically allowed the tax office to require banks and other third-party financial institutions to cooperate in the production of statements and records. The IRD does not hesitate to use this power to compel the digital asset market to provide information about Canadian cryptocurrency and NFT traders.

In 2020, the IRD successfully obtained a federal court order forcing Toronto-based cryptocurrency platform Coinsquare Ltd. to disclose confidential tax information related to the trading activities and cryptocurrency holdings of Canadian users. Therefore, despite the anonymity provided by the digital ledger, the tax office reserves the means to conduct audits of NFT traders who use trading platforms and marketplaces for trading activities.

If the IRD finds evidence during a tax audit that may bring criminal charges against a taxpayer, the case will be transferred to the Department of Justice for prosecution under Canadian criminal law. While there are no restrictions on the IRD's ability to share information collected during civil tax audits with the Ministry of Justice, IRD's investigative powers over civil tax audits cannot be used to assist in criminal investigations. When the primary purpose of the IRD's tax audit shifts to investigating criminal or quasi-criminal activity, Section 7 of the Canadian Charter of Rights and Freedoms provides for a taxpayer's constitutionally protected right against self-incrimination. In addition, taxpayer rights under Section 8 of the Canadian Charter of Rights and Freedoms protect taxpayers from unreasonable searches and seizures by the State. This invalidates the power of the IRD to compel the provision of documentation for such investigations under Section 231.2. While both the tax office and the Ministry of Justice have a duty to notify taxpayers when a tax audit becomes a criminal or quasi-criminal investigation, if they fail to do so, taxpayers have a duty to challenge the improper use of the tax office's powers to gather evidence in criminal cases. This requires taxpayers to prove that the primary purpose of the information collected by the tax office during a tax audit is for criminal investigation and not a civil tax audit, which is a huge challenge for any taxpayer.

Tax Expert Tip – Minimize the Risk of Criminal Liability by Utilizing Voluntary Disclosure Schemes

The IRD's Voluntary Disclosures Program (VDP) provides an important avenue to avoid potential criminal prosecution related to cryptocurrency tax evasion, including cases involving unreported NFT disposals. With VDP, Canadian taxpayers can proactively disclose any tax violations to the IRS before initiating an investigation. If a taxpayer meets the IRD's relief criteria, they may be eligible for a number of benefits, including exemption from penalties for non-compliance, such as gross negligence penalties, partial interest relief for unpaid taxes, and, in particular, immunity from criminal prosecution.

Timely and effective voluntary disclosure requests are important. To be eligible for relief through VDP, the disclosure submitted must meet certain criteria. First, it must be truly voluntary, meaning it precedes any enforcement action taken by the tax office on the non-compliance under consideration.

Second, disclosure must be comprehensive. This requires not only including all relevant information related to a particular tax breach, but also addressing any other violations for which you are liable. So, if you find yourself facing unreported taxes arising from NFT disposals, as well as undisclosed income from other sources, securing VDP eligibility depends on disclosing and correcting both forms of irregularities.

In addition, in addition to increasing the likelihood that the IRD will grant a tax amnesty, a well-crafted disclosure application can serve as the basis for an application for judicial review in federal court in the event that the Canada Revenue Agency unfairly refuses a voluntary disclosure submission.