Introduction - What Is Cryptocurrency Liquidity Mining (or Yield Farming)?
When you deposit money in a bank, you've basically lent those funds to the bank. In return, the bank pays you interest. With liquidity mining (also called "yield farming") you lend cryptocurrency to a start up cryptocurrency platform seeking to raise capital. In return, the lender will often receive interest payments or share in a cut of the platform's transaction fees.
But even more important: the lender usually receives units or tokens of the platform's native cryptocurrency. These tokens reward the lender for injecting liquidity into a budding cryptocurrency platform. Some reward tokens allow their owners to vote on the cryptocurrency platform's protocols, such as value-capture mechanisms. Of course, the reward tokens can themselves be traded. So, many liquidity providers wager their loan on the likelihood that the new platform will take hold of cryptocurrency markets, thereby causing the platform's native cryptocurrency tokens to soar in value and allowing the investor to bank a significant payoff when selling the reward tokens.
Cryptocurrency liquidity mining and yield farming trigger a number of Canadian income-tax issues. The most basic issue is: What is the character of the income that a Canadian taxpayer earns from cryptocurrency liquidity mining and yield farming? 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 liquidity miners and yield farmers 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 cryptocurrency traders and investors on the Canadian income-tax issues invoked by cryptocurrency liquidity mining and yield farming. 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 receiving interest, fees, or reward tokens from cryptocurrency liquidity mining and yield farming. This article concludes by providing pro tax tips for taxpayers engaging in cryptocurrency liquidity mining and yield farming.
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:
- 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 pertaining to capital gains are located in subdivision c.
Business income and investment income are subject to many of the same income-tax rules. Subsection 9(1), for instance, codifies the deductibility of income-earning related expenses when calculating business income and when calculating investment income. It does so by defining business income and investment income as the taxpayer's "profit" from that respective source. That is, a taxpayer's business income consists of the taxpayer's "profit from that business," and a taxpayer's investment income (which the Income Tax Act refers to as "income from property") consists of the taxpayer's "profit from that property." The starting point for each, then, is the calculation of profit or net income. As a result, business income and investment income both avail to many of the same deductions.
Still, business income and investment income are each distinct sources of income. As such, their tax treatment features some important differences. A few examples:
- Part IV tax applies only to a private corporation's investment income; business income doesn't trigger Part IV tax.
- The tax attribution rules in section 74.1 apply to investment income but not business income.
- The small-business-deduction tax credit under section 125 only applies to a Canadian-controlled private corporation's business income. The tax credit generally doesn't apply to investment income earned by the Canadian-controlled private corporation.
That said, business income and investment income receive fairly similar tax treatment overall.
The Canadian income-tax rules concerning capital gains, on the other hand, are an entirely different beast. In particular, while business income and investment income are each fully taxable, only one-half of a capital gain is included in taxable income. On the flip side, business losses and investment losses are each fully deductible against any source of income, yet only one-half of a capital loss is deductible, and the allowable portion of the capital loss may generally only be used to offset the taxable portion of a capital gain.
Characterizing Income: Is it Business Income, Investment Income, or a Capital Gain?
Investment income-that is, "income from property"-refers to the yield from property. Shares, for example, yield dividends. Bonds yield interest. Intellectual property yields royalties. Real property yields rent. And so on. In other words, investment income is passive income stemming from the mere ownership of property; it doesn't require any significant commitment of time, labour, or attention. For example, an individual can purchase public shares and earn dividends without any further effort. The dividends, then, constitute investment income.
Business income, by contrast, calls for organization, systematic effort, and a degree of activity. For example, an investment dealer can purchase and actively manage a portfolio consisting of public shares. The portfolio dealer operates an investment business, the revenues of which constitute business income. Subsection 248(1) of Canada's Income Tax Act says that a "business" includes a "profession, calling, trade, or undertaking of any kind whatever." A "business" also includes "an adventure or concern in the nature of trade." Hence, a "business" implies activity and profit motive. The representative characteristics of a business include activity, enterprise, entrepreneurship, and commercial risk. Above all, a business entails the pursuit of profit. The pursuit of profit is indeed what distinguishes a business from a mere hobby or past time (Stewart v Canada, 2002 SCC 46).
The distinction between business income and investment income therefore turns on the level of activity associated with acquiring the income. In other words, the mere use of a property doesn't by itself determine the character of the income generated by that property. For example, a taxpayer who actively manages a hotel and a taxpayer who leases a basement apartment both use a property, and both receive payments for rent. Yet the hotel manager earns business income while the homeowner earns investment income or income from property.
While the use of property may give rise to either business income or investment income, subsection 9(3) of the Income Tax Act expressly distinguishes investment income from capital gains. This subsection clarifies that income from property excludes a gain arising from the disposition of the income-generating property. (It also states that a loss from property excludes a loss upon disposing of that property.) In other words, if you dispose of a property, the resulting profit isn't characterized as investment income for tax purposes; it's either a capital gain or business income.
A capital gain derives from the disposition of the investment that constitutes a "capital property." Canada's Income Tax Act recognizes only two broad sorts of property for tax purposes:
- capital property, which creates a capital gain or loss upon disposition; and
- inventory, which figures into the computation of business income.
The type of income that the property generates upon sale-that is, capital gains or business income-determines whether that property is a capital property or inventory. In other words, one starts by determining the nature of the income and then characterizes the property, not the other way around.
Canadian courts have churned out a large body of case law wrestling with the ambiguity between selling an investment, which produces a capital gain, and trading, which results in business income. Courts assess a wide range of factors when deciding whether to characterize a transaction's gains or losses as on an account of capital or income. These factors may include:
- transaction frequency-e.g., a history of extensive buying and selling of cryptocurrency or of a quick turnover of cryptocurrency units might suggest a business;
- length of ownership-e.g., brief periods of holding the cryptocurrency indicate business dealings, not capital investing;
- knowledge of cryptocurrency markets-e.g., increased knowledge of or experience with cryptocurrency markets favours a business characterization;
- relationship to the taxpayer's other work-e.g., if cryptocurrency transactions (or similar dealings) form a part of a taxpayer's employment other business, it points toward business;
- time spent-e.g., a greater likelihood of characterization as a business if a substantial part of the taxpayer's time is spent studying cryptocurrency markets and investigating potential purchases or actively managing the portfolio of cryptocurrency;
- financing-e.g., leveraged cryptocurrency transactions indicate a business; and
- advertising-e.g., increased likelihood of business characterization if the taxpayer has advertised or otherwise made it known that he deals in cryptocurrency.
Ultimately, the taxpayer's intention at the time of acquiring the property is the most important criterion that courts consider when determining whether the transaction produced a capital gain or business income. Yet to identify a taxpayer's intention, a court will focus on the objective factors surrounding both the purchase and the sale of the property. In other words, courts will determine a taxpayer's intent by evaluating the factors listed above.
In summary, depending on how a taxpayer uses it, a property can generate business income, investment income, or a capital gain, and two Canadian taxpayers with similar digital-currency portfolios may receive different tax treatment. If the property itself generates income, that income may comprise either business income or investment income (i.e., income from property). The appropriate tax characterization depends on the level of activity associated with acquiring the income: business income requires activity; investment income implies passivity. If the income stems from the disposition of the property, the profit may comprise either business income or a capital gain. In this case, the appropriate tax characterization depends on whether the taxpayer acquired the property with the intent to trade.
Canadian Tax Implications of Receiving Interest, Fees, or Reward Tokens from Cryptocurrency Liquidity Mining & Yield Farming
The takeaway from the foregoing analysis is that the character of the income determines how it is taxed under Canada's Income Tax Act. So, to determine the Canadian income-tax implications of cryptocurrency liquidity mining and yield farming, we must first ask: What is the character of the income that you earn when engaging in cryptocurrency liquidity mining and yield farming?
To answer this question, we need to distinguish between two means by which you can derive income from cryptocurrency liquidity mining and yield farming. The first is the interest, fees, or reward tokens that you may receive from the cryptocurrency platform in exchange for the cryptocurrency that you lent under the liquidity-mining or yield-farming arrangement. The second is the profit that you might enjoy from trading the reward tokens themselves.
Canadian Income-Tax Characterization of Interest, Fees & Reward Tokens from Cryptocurrency Liquidity Mining & Yield Farming
In characterizing the Canadian tax treatment of cryptocurrency liquidity mining and yield farming our knowledgeable Canadian tax lawyers start by analyzing the tax characterization of the interest, fees, or reward tokens that a liquidity miner or yield farmer receives for staking cryptocurrency. As typically described, most liquidity-mining and yield-farming arrangements take the form of a loan or investment-in particular, a loan or investment, in the form of cryptocurrency, by the liquidity miner to a cryptocurrency platform in need of capital. In exchange, the liquidity miner or yield farmer receives compensation, akin to a lender's receipt of interest payments or an investor's receipt of distributions. (For the purposes of this article, the lender/investor distinction isn't important. A lender's receipt of interest and an investor's receipt of a distribution each receive similar tax treatment. From the perspective of the liquidity miner or yield farmer, the lender/investor distinction doesn't make much difference for tax purposes.) In other words, the liquidity miner or yield farmer stakes a property-namely, the cryptocurrency that was lent to or invested in the capital-seeking cryptocurrency platform-and that property thereby generates income-in the form of interest, fees, or the platform's native cryptocurrency tokens. Hence, when a liquidity miner or yield farmer receives interest, fees, or reward tokens for staking cryptocurrency, those receipts plausibly constitute investment income (or "income from property," as it's described in the Income Tax Act).
Still, the investment-income characterization might not always fit. As mentioned above, if a taxpayer uses cryptocurrency property to generate income, the appropriate tax characterization will still turn on the level of activity associated with acquiring that income. So, your receipts may qualify as business income if you engage in cryptocurrency liquidity mining or yield farming, and your particular operation demonstrates entrepreneurship, commercial risk, and the pursuit of profit and calls for a significant commitment of time, labour, and attention-e.g., frequently researching cryptocurrency markets, pursuing a number of strategic cryptocurrency-platform targets, leveraging to fund your ventures, immediately selling or collateralizing reward tokens, etc.
Canadian Income-Tax Treatment of Interest, Fees & Reward Tokens from Cryptocurrency Liquidity Mining & Yield Farming
In any event, business income and investment income receive largely similar tax treatment overall. So, regardless of which tax characterization is ultimately correct, if you receive interest, fees, or reward tokens from cryptocurrency liquidity mining or yield farming, those receipts are fully taxable under subsection 9(1) as your profit from a business or an investment, as the case may be. If you receive interest or fees, you must include the full amount when calculating your taxable income in the year of receipt which is the calendar year for an individual or the fiscal year for a corporation. If you receive a reward token (or if your interest or fees are paid in cryptocurrency), you must include the fair-market value of the cryptocurrency when calculating your taxable income-specifically, the value, expressed in Canadian dollars, as of the time that you received the cryptocurrency.
In addition, because you've reported the value of the reward token (or other cryptocurrency) as taxable income, subsection 52(1) of the Income Tax Act allows you to increase the tax cost of the cryptocurrency accordingly. The increased tax cost prevents double tax when you ultimately dispose of the reward token or other cryptocurrency. For example, you lend cryptocurrency to a cryptocurrency platform under a liquidity-mining arrangement. In exchange, the cryptocurrency platform gives you reward tokens consisting of 2 units in its native cryptocurrency. At the time of issuance, the reward tokens are worth $400.00. Under subsection 9(1) of Canada's Income Tax Act, you report the $400.00 as business income or as investment income (depending on the appropriate tax characterization). Under subsection 52(1), your tax cost for the reward tokens is $400.00. The $400.00 tax cost will determine your taxable income upon disposing of the reward token. That is, if you later sell the reward tokens for $7,000.00 (or trade them for other cryptocurrency units worth $7,000.00), your $400.00 tax cost means that you will realize $6,600.00 in profit, which you must report as income or capital gains. The specific tax treatment of this income will again turn on the appropriate tax characterization.
Canadian Income-Tax Characterization of Profits from Disposing of Reward Tokens from Cryptocurrency Liquidity Mining & Yield Farming
We now turn to analyzing the tax characterization of a liquidity miner's profit from disposing of the reward tokens that the liquidity miner received for staking cryptocurrency. As mentioned above, income from the use of property can be characterized as investment income or business income, depending on the level of activity involved. When you dispose of a property, however, the Income Tax Act rules out characterizing the profit as investment income. As such, the resulting profit is either a capital gain or business income. Thus, when a liquidity miner turns a profit from selling the reward tokens, that profit must be reported and taxed as either business income or a capital gain.
The capital/income distinction turns on the cryptocurrency liquidity miner's intentions. The key question is whether the taxpayer engaged in cryptocurrency liquidity mining or yield farming with the intention of flipping the reward tokens for profit. If so, the profit constitutes business income. But if, by pointing to objective factors, the taxpayer can demonstrate the intent to invest (rather than to trade), the sale proceeds will be on capital account and taxed as a capital gain. For instance, taxpayer might justify capital treatment if the taxpayer can demonstrate that, say, the taxpayer wanted to control a new cryptocurrency platform and thereby sought only the liquidity-mining arrangements offering reward tokens that granted voting power over the platform's protocols. On the other hand, the taxpayer's very use of liquidity mining and yield farming might illustrate that the taxpayer possesses a certain level of sophistication and specialized knowledge in the cryptocurrency space. And this, taken together with various other factors, might suggest that the taxpayer's profits from selling the reward tokens should be characterized as business income. Keep in mind that the Income Tax Act defines a "business" as including "an adventure or concern in the nature of trade." This means that even an isolated cryptocurrency transaction may result in income treatment for the resulting profits.
Canada's income-tax jurisprudence brims with case law analyzing the numerous factors that bear on the capital/income distinction. The case law is complex, fact-specific, and sometimes inconsistent. If anything, these decisions show that the required legal analysis demands advice from a cryptocurrency-competent Canadian tax lawyer.
Canadian Income-Tax Treatment of Profits from Disposing of Reward Tokens from Cryptocurrency Liquidity Mining & Yield Farming
Canada's Income Tax Act sets out two entirely different tax regimes for business income, on the one hand, and for capital gains, on the other. If you trade reward tokens and thereby earn business income, your reward tokens constitute inventory, and your cryptocurrency-trading profits are fully taxable. If your reward token qualifies as capital property because you acquired it for investment purposes, then you include only one-half of the gain when computing your taxable income for the year in which you disposed of that reward token.
Pro Tax Tips: Record-Keeping for Taxpayers Engaging in Cryptocurrency Liquidity Mining or Yield Farming, Legal Opinion on Proper Cryptocurrency Tax Reporting & Voluntary Disclosures Program for Unreported Cryptocurrency Income
A cryptocurrency liquidity miner who lacks proper records will fare poorly if selected by a Canada Revenue Agency for a cryptocurrency tax audit (which is becoming far more prevalent). Taxpayers engaging in cryptocurrency liquidity mining and yield farming must keep records not only of their cryptocurrency contributions but also of the interest, fees, and reward tokens that they receive from cryptocurrency platforms.
Taxpayers engaging in cryptocurrency liquidity mining and yield farming should periodically download and export their transaction information to avoid losing it. They should also maintain the following records about any cryptocurrency transactions:
- The date of each transaction;
- Any receipts for purchasing or transferring cryptocurrency;
- The value of the cryptocurrency in Canadian dollars at the time of the transaction;
- The digital-wallet records and cryptocurrency addresses;
- A description of the transaction and of the other party (e.g., the other party's cryptocurrency address);
- The exchange records;
- Legal terms and conditions of the arrangement;
- Records relating to any accounting and legal costs; and
- Records relating to any software costs for managing your cryptocurrency and tax affairs.
Our Certified Specialist Canadian tax lawyer can provide advice about record-keeping and proper reporting of your cryptocurrency profits to ensure that CRA doesn't fault you for misrepresenting the information in your tax returns and charge you with gross-negligence penalties-or, even worse, prosecute you for tax evasion.
Taxpayers engaging in cryptocurrency liquidity mining and yield farming, in particular, may benefit from a tax memorandum examining whether the interest, fees, and reward tokens that they receive from cryptocurrency platforms should be reported as investment income, as business income, or as a blend of both. And if they've traded their reward tokens, they'll face a similar issue as to whether their profits should be reported as business income, as capital gains, or as a blend of the two.
The advances and cooperative efforts of tax authorities signal the end of the anonymity that cryptocurrency users thought they once enjoyed. This should definitely concern Canadian taxpayers with unreported profits from cryptocurrency transactions. And while cryptocurrency liquidity mining and yield farming are relatively novel, taxpayers engaging in cryptocurrency liquidity mining and yield farming should be equally concerned. If you filed Canadian tax returns that omitted or underreported your cryptocurrency profits, you risk facing not only civil monetary penalties, such as gross-negligence penalties, but also criminal liability for tax evasion.
You may qualify for relief under the CRA's Voluntary Disclosures Program (VDP). If your VDP application qualifies, the CRA will renounce criminal prosecution and waive gross-negligence penalties (and may reduce interest). A voluntary-disclosure application is time-sensitive, however. The CRA's Voluntary Disclosures Program will reject an application-and thus deny any relief-unless the application is "voluntary." This essentially means that the Voluntary Disclosures Program must receive your voluntary-disclosure or tax-amnesty application before the CRA contacts you about the non-compliance you seek to disclose. Our experienced Canadian tax lawyers have drafted numerous memoranda characterizing cryptocurrency trading as either business income or capital gains and have assisted numerous Canadian taxpayers with unreported cryptocurrency transactions. We can carefully plan and promptly prepare your voluntary-disclosure application. A properly prepared disclosure application not only increases the odds that the CRA will grant tax amnesty but also lays the groundwork for a judicial-review application to the Federal Court should the Canada Revenue Agency unfairly deny your voluntary-disclosure application.
To determine whether you qualify for the VDP, schedule a confidential and privileged consultation with one of our expert Canadian tax lawyers. The Canada Revenue Agency cannot compel the production of information protected by solicitor-client privilege. In other words, solicitor-client privilege prevents the CRA from learning about the legal advice that you received from your tax lawyer. Your communications with an accountant, however, remain unprotected. So, if you seek tax advice but want to keep that information away from the CRA, you should first approach our Canadian tax lawyers. If you require an accountant, we can retain the accountant on your behalf and extend solicitor-client privilege.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.