Taxation and Regulation of Digital Currencies

(Disponible en français : Fiscalité et réglementation des monnaies numériques)

This HillNote is the first of three on the topic of digital currencies. Part 2 of the series will deal with issues and concerns related to digital currencies and part 3 will discuss blockchain technology and its various applications.

A.        Digital Currencies

Since 2008, digital currencies have gone from an obscure computer programmer’s theory to a multibillion-dollar global industry that has caught the attention of many Canadian investors.[i] In 2017, 64% of Canadians had heard of bitcoin – the most popular digital currency – and almost 3% owned it.[ii] Globally, the total value of bitcoins in circulation reached $238 billion at the end of 2017.[iii] Many other digital currencies exist, including Ethereum, Ripple, LiteCoin and Monero.

A digital currency is an asset that only exists electronically, while a cryptocurrency is a digital currency that combines new payments systems with new assets using cryptography, which is the science of writing and breaking codes.

The financial technology (fintech) sector is comprised of companies that use blockchain, the underlying technology of many digital currencies, and other payment technologies to compete with traditional methods of providing financial services. In addition to digital currencies, fintechs provide services such as, crowdfunding, robotic financial advice and insurance. Investment in fintechs rose from $1.8 billion to $27 billion worldwide between 2010 and 2017.[iv]

Consumers can use digital currencies to purchase apps, music, travel services and other consumer goods and services. The use of digital currencies has also been linked to illegal activities such as narcotics trafficking, money laundering, terrorist financing and computer hacking.

Some believe that one day, digital currencies might replace a significant portion of currencies that governments have declared to be legal tender in their country, avoiding regulatory oversight and control.

Therefore, the challenge for governments and regulators is to develop a regulatory environment for digital currencies and fintechs that fosters responsible development of these technologies, while protecting consumers, investors, businesses and the financial system.

In Canada, legislation and/or regulations related to digital currencies exist with respect to taxation, money laundering and terrorist financing, securities and other financial regulations that affect fintechs.

B.        Taxation

One essential issue that lawmakers have had to deal with in defining how digital currencies should be taxed is that, although some digital currencies may be used to buy and sell goods and services, they are not legal tender.[v] In 2013, the Canada Revenue Agency (CRA) clarified that for the purposes of the Income Tax Act, digital currencies are treated as a commodity rather than money.

In cases where a digital currency is bought or sold as a commodity, the tax treatment is akin to buying and selling other securities such as a mutual fund or stock. Just as an investor must pay capital gains tax when he or she sells a security, a digital currency investor must pay capital gains tax when he or she sells digital currencies for more money than what he/she paid for it originally.

The use of digital currencies to pay for goods and services is treated as a barter transaction, which occurs when two individuals exchange goods or services without using money. Consequently, the fair market value of the goods or services purchased must be included in the seller’s income for tax purposes.

In cases where a taxpayer engages in the business of trading in digital currencies, gains or losses could be treated either as income or loss from business or property. According to the CRA, the frequency of transactions, period of ownership, knowledge of securities markets and the time spent trading are key factors that may affect whether the selling of digital currencies is considered income or loss from business or property. In such cases, eligible expenses may also be deducted against the taxpayer’s income generated by the transaction.

Regarding consumption taxes, CRA has stated that businesses selling goods or services in exchange for digital currencies must collect the Goods and Services Tax/Harmonized Sales Tax (GST/HST) on the fair market value of the digital currencies at the time of the sale. It is likely that, since digital currencies are not considered money, the GST/HST exemption for “the exchange, payment, issue, receipt or transfer of money” in the Excise Tax Act would not apply.

Image: Digital Currency Transactions and Taxation in Canada, Some Examples. This figure illustrates three different types of digital currency transactions. The first transaction is the selling of digital currency on an exchange. The diagram illustrates a digital currency being exchanged for a dollar bill, in which case it would be taxed as a commodity with profit or loss equal to the capital gain or loss. The second transaction is when a digital currency is used as payment for goods in services. The diagram is of two hands shaking. In this example, the exchange would be taxed as a barter transaction and the seller’s income would be equal to the fair market value of the goods or services and GST/HST would apply. The third transaction is illustrated with a picture that depicts day trading. This transaction would be one conducted by a digital currency trader, where the profit or loss from each transaction would be taxed as business income or loss.

C.        Money Laundering and Terrorist Financing

Because most digital currencies operate outside the conventional financial system, they pose regulatory challenges with respect to the control of money laundering and terrorist financing.

Money services businesses – those offering foreign exchange, money transfer and certain other financial services – must report to the Financial Transactions and Reports Analysis Centre of Canada. In 2014, the Government of Canada made legislative changes to include virtual currency services to the list of money services businesses. At the time, the legislation was the world’s first national digital currency law, but the regulations required to bring these legislative changes into force have not been published yet.

D.        Securities Laws

In August 2017, the Canadian Securities Administrators provided guidance on the applicability of Canadian securities laws to digital currency transactions and related requirements.  It also launched a “regulatory sandbox” which, on a time-limited basis, exempts fintechs from certain securities law requirements that may impede innovation, provided that investor protection is not compromised.

E.        Fintech Regulation

In August 2017, the Department of Finance Canada’s review of the federal financial sector framework sought views on whether non-banks should be permitted to use the words “bank,” “banker” and “banking.” In its first budget implementation bill of 2018, currently under consideration in Parliament, the government is proposing to allow credit unions to use these words under certain conditions, but not fintechs. This bill also proposes changes that would expand banks’ ability to do business and share information with fintechs.

Given the breakneck speed at which digital currencies and fintechs are developing, Canadian regulators will need to closely monitor future developments and, when warranted, update their regulatory framework to foster their responsible development, while at the same time protecting consumers, investors, businesses and the financial system.

[i] Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System, 2008.

[ii] Bank of Canada, Bitcoin Awareness and Usage in Canada, December 2017.

[iii] Statistica, Market capitalization of Bitcoin from 1st quarter 2012 to 1st quarter 2018 (in billion U.S. dollars), 2018.

[iv] Accenture, Global Venture Capital Investment in Fintech Industry Set Record in 2017, Driven by Surge in India, US and UK, Accenture Analysis Finds, News Release, 28 February 2018.

[v] Bank of England, The Future of Money, Speech given by Mark Carney to the inaugural Scottish Economics Conference, Edinburgh University, 2 March 2018.

Author: Brett Stuckey, Library of Parliament