What is crypto rebasing?

Crypto rebasing, also known as token rebasing or elastic supply, is a mechanism used in certain cryptocurrencies such as Olympus, TempleDAO, and Snowbank, to adjust the total supply of tokens automatically. It is designed to address the problem of price volatility and maintain a stable value for the token.

In traditional cryptocurrencies like Bitcoin or Ethereum, the total supply is fixed, meaning that the number of coins in circulation remains constant (subject to new coins being mined or otherwise created). However, in rebasing cryptocurrencies, the total supply can change periodically based on predefined rules, generally intended to keep coins at a predetermined value. Examples of these predefined rules include rebase period rules, which stipulate how frequently a tokens supply will be adjusted and rebase formula rules which stipulate how the tokens supply is adjusted based on deviations from the target price.

The rebasing process typically occurs at regular intervals, such as daily or weekly, and involves adjusting the balances of all token holders proportionally. The adjustments are made by increasing or decreasing the number of tokens held by each individual, aiming to maintain a target price or price peg.

The mechanism behind rebasing involves a calculation using a specific formula that takes into account factors such as the token's current price, its target price, and the deviation from the target. If the token's price is above the target, a positive rebase occurs, resulting in an increase in the token supply held by each holder. Conversely, if the token's price is below the target, a negative rebase takes place, reducing the supply held by each holder. Adjustments in token supply during a rebase event may involve increasing or decreasing the number of tokens held by each holder. This means that after a rebase event, holders may find their wallet balances adjusted to reflect the new supply. Rebase events can also impact the amount of coins in circulation. The supply adjustments are designed to influence the overall token supply, which affects the number of tokens available to the market. Increasing the supply can expand the coins in circulation, while decreasing the supply can contract the coins in circulation. It's important to note that the specific mechanics of rebase events, including how they impact individual holders and the overall token supply, can vary depending on the token's design and the underlying protocol.

The goal of rebasing is to achieve price stability by adjusting the token supply in response to market demand. If the token's price is consistently deviating from the target, the rebasing mechanism attempts to restore balance by increasing or decreasing the supply, thus influencing the token's price toward the target. Compare this to stablecoins. The primary objective of stablecoins is to maintain a stable value, usually pegged to a specific asset or currency. Stablecoins achieve this stability by design, either through collateralization, algorithmic mechanisms, or a combination of both. On the other hand, rebase tokens do not aim for price stability in the same manner. Price stability of rebase tokens is relative to the chosen benchmark such as a fiat currency, a cryptocurrency, or an index. Rebase tokens can experience price fluctuations due to market dynamics, supply and demand factors, and the effectiveness of the rebase mechanism itself. These tokens can exhibit price volatility, especially during periods of high market activity or when the rebase mechanism encounters challenges. Unlike stablecoins, rebase tokens have an elastic supply, meaning the circulating supply adjusts accordingly to supply and demand, and the amount of tokens in each holder's wallet will change proportionally to their holdings.

What are the Canadian tax consequences of a rebasing event?

In a rebasing event where additional tokens are generated or removed from a holder's wallet, while the amount of tokens in circulation might change, the fair market value of the each token stays relatively the same since the system adjusts the number of tokens in circulation to maintain the price of the token at a specific peg. During a rebase event where the token supply is expanded, holders typically receive additional tokens in proportion to their existing holdings. For example, if the supply increases by 10% and you hold 1% of the total token supply, you would receive an additional 0.1% of the newly minted tokens. This can result in an increase in the total value of your token holdings.

For Canadian cryptocurrency tax purposes, the question is whether the retraction of tokens per the rebasing mechanism qualifies as a disposition.

On its face, it would appear to be a disposition since there are tokens leaving the holder's wallet, decreasing the overall value of the person's asset holding. When this happens with other crypto assets, there would normally be a tax disposition. On the other hand, typical crypto tokens generate unrealized gains based on the price of the coin itself increasing, rather than the number of coins in each holder's wallet increasing while the price remains relatively stable. The rebasing mechanism is then just an alternative system of generating unrealized gains/losses on the asset and should not be treated as a disposition on that basis. In reality, the token was never "disposed" of in the usual sense since users never sold their coins and withdrew their balance, rather there was a system-generated burning of their coins as an alternative way to generate unrealized gains/losses for the token without altering the token's price.

Take for example a person with 1,000 rebasing tokens in their wallet. Then, a rebasing event deletes 25 tokens from the holder's wallet. For the purposes of this example, if we assume that this disposition and all future dispositions would be a taxable event, this would mean that in a few months, a holder of a token can be tasked with tracking hundreds or thousands of acquisitions and dispositions of tokens to keep track of the adjusted cost base of their holding and pay taxes accordingly if each rebase was a taxable event. Inventory accounting can likely make this process easier, but it is always necessary to keep records and other documentation of all rebasing events.

The need for this complex analysis is potentially partially negated by the superficial loss rule, which states that if you sell an investment at a loss and repurchase substantially identical securities within 30 days before or after the sale capital loss you incur on the sale will be denied for tax purposes, and instead, it will be added to the cost basis of the repurchased securities. This means that in the case of rebase tokens, the constant adding and subtracting of tokens from one's wallet may be categorized as a superficial loss depending on if the asset is considered capital property or inventory, and will affect the adjusted cost base of the tokens but will not be a taxable event at the time that it occurs. The holder would then need to pay taxes on tokens that were disposed of by a rebase event and not replaced by another rebase event within 30 days, if rebasing events are taxable in the first place.

If we assume that a rebasing event is not a disposition, then this gain/loss will only crystalize when the holder of the tokens sells the asset, at which point they will be liable for any taxes payable in the same way as when they dispose of a traditional cryptocurrency like bitcoin. This would approach is more logical, and much more simple and would save taxpayers many hours of accounting work. Since crypto rebasing is such a new phenomenon, there is no tax law to support any position on the matter. However, this does not mean that investors are free to choose whichever approach is more convenient.

A heightened degree of record keeping may be essential for the holders of rebasing tokens to minimize the risks of running into taxation issues. Due to the evolving nature of cryptocurrency taxation and the lack of specific guidelines on the matter, it is recommended to consult with a qualified tax professional or seek advice from a top Canadian crypto tax lawyer to ensure compliance with tax laws and regulations.

Pro Tax Tip: The eligibility to claim a superficial loss on rebase tokens will be a fact-specific analysis

When it comes to claiming tax losses in Canada, correctly classifying an asset as either capital property or inventory is of great importance. This classification has a significant impact on whether you can claim a superficial loss and potentially offset capital gains for tax purposes. The analysis centres on whether the asset is capital property or inventory and in the nature of trade.

Capital property generally refers to assets held for investment purposes, such as stocks, bonds, real estate, or certain personal use assets. A superficial loss occurs when you dispose of a capital property at a loss and repurchase the same or identical property (or an equivalent property) within a specified period. In such cases, the loss is denied for tax purposes.

Inventory refers to assets held primarily for sale in the ordinary course of business, such as goods held by retailers, wholesalers, or manufacturers. Superficial loss rules do not apply to inventory. If you dispose of inventory at a loss and subsequently repurchase the same or similar inventory, you can generally claim the loss for tax purposes. This allows you to offset the loss against your business income, potentially reducing your taxable income.

Determining whether an asset is considered inventory held "in the nature of trade" involves assessing the specific facts and circumstances of the situation, as well as applicable tax laws and regulations. It is always recommended to consult with a Canadian crypto tax lawyer who can provide advice on the matter and prepare documents that will minimize the chances of the CRA recharacterizing the disposition.

FAQ

I have unreported income from crypto dispositions. What should I do now?

If you have income from disposition of crypto that you have not reported, a voluntary disclosure application will allow you to correct that mistake and bring your returns up-to-date. To be eligible, the taxpayer must meet the five prerequisites. Once accepted, the taxpayer may be granted relief from penalties and partial interest.

Who determines the correct Canadian tax treatment of rebase tokens?

The correct tax treatment is determined by looking to the relevant provisions in the Canadian Income Tax Act. Currently, this Act does not contain any provisions relating specifically to crypto and rebase tokens. To determine the correct tax treatment, it is essential to consult a Canadian crypto tax lawyer so that the lawyer can draft a memorandum ensuring that you are not offside any regulations set out by the ITA and apply the most relevant provisions to determine the tax treatment.

How do rebase tokens calculate the distribution/removal of tokens during a rebase event?

The most common method is the proportional distribution method described in the article above. There are also additional methods such as the:

  1. Snapshot Mechanism: Some rebase tokens employ a snapshot mechanism. Before the rebase event, a snapshot is taken of the token holdings of all users. The additional tokens are then distributed based on the snapshot data, ensuring that the distribution accurately reflects each user's holdings at that specific moment.
  2. Weighted Distribution: In certain cases, rebase tokens may employ a weighted distribution mechanism. This approach factors in additional variables, such as time held or a user's activity level within the protocol. The weight assigned to each user influences the amount of tokens the user receives during the rebase event.

To obtain more information about specific rebasing cryptocurrencies, it is recommended to research the project's documentation, whitepapers, official websites, or join community forums dedicated to the particular token or project. Due to the lack of regulation in the crypto space compared to other financial spaces, it is highly recommended to research crypto projects and seek advice from an experienced Canadian crypto tax professional when there is a tax matter that arises through investment in a crypto project. A memorandum prepared by a top Canadian crypto tax lawyer can be a means of demonstrating due diligence and reducing exposure to gross-negligence penalties. This memorandum will also help preserve the statute barred period for which the CRA can reassess a taxpayer. The three year limitation period cannot be extended unless the CRA proves fraud, wilful blindness/neglect, or wilful negligence on the part of the taxpayer. A memorandum prepared by a top Canadian crypto tax lawyer will help refute these claims by the CRA and disallow reassessments outside the three year-period