Introduction – Blockchain or Cryptocurrency Liquidity Mining and Yield Farming
Blockchain or cryptocurrency liquidity mining (also called cryptocurrency yield farming) is an arrangement whereby you lend cryptocurrency to a start-up cryptocurrency platform seeking to raise capital. In return, the cryptocurrency platform usually gives you units or tokens of the platform’s native cryptocurrency. These tokens serve as a reward or as consideration for injecting liquidity into a budding cryptocurrency platform. (Instead of, or in addition to, issuing reward tokens, the cryptocurrency platform might pay you interest.)
Hence, liquidity-mining and yield-farming arrangements generally take the form of a loan to a cryptocurrency platform or an investment in a cryptocurrency platform. This article examines the tax consequences for the lender or investor if the cryptocurrency platform repays the principal on the loan or returns the investor’s capital.
This article assumes that the reader understands the background Canadian tax issues invoked by cryptocurrency liquidity mining and yield farming. For a detailed discussion about the central tax issues, see our article entitled “Taxation of Cryptocurrency Liquidity Mining & Yield Farming in Canada – Canadian Tax Guidance from a Canadian Tax Lawyer”
Cryptocurrency Liquidity Mining & Yield Farming: Return of Capital & Repayment of Loans
As mentioned above, most liquidity-mining and yield-farming arrangements fit the characterization of either a loan to a cryptocurrency platform or an investment in a cryptocurrency platform. This raises the question of what are the tax consequences for the lender or investor if the cryptocurrency platform repays the principal on the loan or returns the investor’s capital? (Granted, the extent to which this actually occurs in practice is currently unclear.)
Canadian Tax Consequences of Receiving a Return of Capital or Repayment on a Loan: General Treatment
If you make a loan or investment, the funds should in principle come from your after-tax savings or from corporate retained earnings. (Of course, in practice, many Canadian taxpayers, whether intentionally or unwittingly, fail to report income relating to cryptocurrency transactions. So, when using cryptocurrency to make a loan or investment, they in fact aren’t using after-tax savings. This is a separate issue altogether. And this non-compliance should be addressed through the Canada Revenue Agency’s Voluntary Disclosures Program. For detailed Canadian tax guidance on the CRA’s Voluntary Disclosures Program, see our article entitled “Correcting Your Taxes Errors or Omissions & The Voluntary Disclosures Program – Canadian Tax Lawyer Analysis”) Because you use after-tax savings when making a loan or investment, a repayment of the loan principal or a return of the investment capital isn’t taxable income.
The caveat, however, is that you’ll incur capital-gains tax on any amount that you receive in excess of the principal that you lent or the capital that you invested. When you make a loan or an investment, you acquire certain rights—for instance, the right of a lender to receive repayment under a loan agreement or the right of an investor to share in the net proceeds upon winding up the investment vehicle. And a right constitutes a “property” under Canada’s Income Tax Act. So, when you discharge this right—for instance, by releasing a debt obligation upon repayment of the loan principal—you thereby dispose of a property and trigger a potentially taxable transaction. In many cases, when discharging such a right, you’ll receive an amount that equals your tax cost for acquiring the right—namely, the amount that you lent or invested. But if you receive more, you’ve realized a capital gain, which is taxable. If, on the other hand, you receive less, you incur a capital loss, which you may use to offset a capital gain that you realized on another disposition.
Canadian Tax Consequences of Receiving a Return of Capital or Repayment on a Loan: As Applied to Blockchain or Cryptocurrency Liquidity Mining and Yield Farming
The income-tax consequences of receiving a return of capital or a repayment on a loan reflect the income-tax consequences for a Canadian taxpayer engaging in blockchain or cryptocurrency liquidity mining and yield farming. If you lend cryptocurrency to a new platform, you seemingly acquire some sort of right under the liquidity-mining or yield-farming arrangement. The nature of this right has yet to be clearly delineated. It will typically vary from one liquidity-mining arrangement to another and will depend on the specific terms and conditions of the arrangement, which will typically be set out by the cryptocurrency platform. But by keeping the cryptocurrency platform liquid through your loan or advance, you apparently acquire some sort of right or interest—in particular, the right or interest that motivates the blockchain-smart-contract programming by which you receive automated distributions of interest payments, fees, or reward tokens from the platform. If so, then you thereby acquired a “property” for Canadian tax purposes.
And just as a lender’s right to repayment may trigger a taxable transaction when discharged, so too can the right that you acquire when lending cryptocurrency under a liquidity-mining arrangement. If you extract the cryptocurrency that you contributed or lent to the platform, you realize a taxable capital gain should the value of the tokens at the time of withdrawal exceed their value at the time of contribution. The corollary is that you incur a capital loss if the value of the tokens upon withdrawal is less than their value upon contribution.
Claiming Capital Losses on Bad Debts from Cryptocurrency Liquidity Mining & Yield Farming: The Subsection 50(1) Election
Another possible situation is that the blockchain or cryptocurrency platform might fail, and, as a result, you cannot recover the cryptocurrency that you lent to the platform. In this case, you may trigger a capital loss by electing under subsection 50(1). The subsection 50(1) election deems you to have disposed of the bad debt for nil proceeds, and the deemed disposition takes effect as of the end of the tax year for which you made the election.
The subsection 50(1) election also deems you to have reacquired the bad debt for a nil tax cost as of the beginning of the tax year following the year for which you made the election. This means that you’ll realize a capital gain on any amount that you subsequently recover after you’ve elected to write off the debt as a capital loss.
For example: In 2020, you lent tokens worth $500,000 to a cryptocurrency platform under a liquidity-mining arrangement. In 2021, the cryptocurrency platform fails, and you cannot recover your $500,000 cryptocurrency loan. So, you elect under subsection 50(1) in your 2021 income-tax return. As a result, at the end of 2021, you are deemed to dispose of the loan for nil proceeds, thereby incurring a capital loss of $500,000—i.e., a $250,000 allowable capital loss. In addition, you are deemed to have reacquired the loan for nil tax cost at the beginning of 2022. If, in 2022, you manage to somehow recover some payment on the cryptocurrency loan that you wrote off in 2021, you’ll realize a capital gain in the amount of that payment, and you’ll need to report that gain on your 2022 income-tax return.
Subsection 50(1) requires that you make the election “in” your income-tax return. So, a paper-filed return should include a letter stating that you have elected under subsection 50(1). An individual who electronically files a T1 income-tax return must submit the election to the CRA in writing (see: RC4018 Electronic Filers Manual). A corporation, however, has the option of electronically filing the subsection 50(1) election as an attachment to its T2 corporate income-tax return.
Furthermore, you qualify for the bad-debt election under subsection 50(1) only if you establish that the debt has become a bad debt. To determine whether a debt has become a bad debt, courts—and the Canada Revenue Agency—evaluate a number of factors, such as:
- the history and age of the debt;
- the financial position of the debtor, its revenues and expenses, whether it is earning income or incurring losses, its cash flow and its assets, liabilities and liquidity;
- changes in total sales as compared with prior years;
- the debtor’s cash, accounts receivable and other current assets at the relevant time and as compared with prior years;
- the debtor’s accounts payable and other current liabilities at the relevant time and as compared with prior years;
- the general business conditions in the country, the community of the debtor, and in the debtor’s line of business; and
- the past experience of the taxpayer with writing off bad debts.
This list isn’t exhaustive, and different factors may prove more significant in different circumstances. If you cannot establish that your cryptocurrency loan has become uncollectible, the Canada Revenue Agency will disallow your bad-debt election.
Pro Tax Tips: Voluntary Disclosures Program for Unreported Cryptocurrency Income, Subsection 50(1) Election to Write Off Bad Cryptocurrency Loans as Capital Losses & Incorporating a Cryptocurrency Trading Business
While cryptocurrency liquidity mining and yield farming are relatively novel, taxpayers engaging in cryptocurrency liquidity mining and yield farming should be concerned about the advances and cooperative efforts of tax authorities, which signal the end of the anonymity that cryptocurrency users believed they once enjoyed. If you filed Canadian tax returns that omitted or underreported your blockchain or 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 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 top Canadian tax lawyer. Your communications with an accountant, however, remain unprotected. So, if you seek Canadian 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.
A subsection 50(1) election allows you to claim a capital loss on unrecoverable cryptocurrency loans. But the CRA will disallow your claim unless you can establish that your cryptocurrency loan is uncollectible. If you incurred a loss when engaging in cryptocurrency liquidity mining and yield farming, consult one of our experienced Canadian tax lawyers to discuss whether you qualify for the subsection 50(1) election. Likewise, if the Canada Revenue Agency has denied your subsection 50(1) election, our Canadian tax lawyers can dispute the decision by filing a notice of objection to the CRA’s Appeals Division or a notice of appeal to the Tax Court of Canada.
A Canadian-controlled private corporation (CCPC) enjoys a reduced tax rate on its first $500,000 of active business income, and its individual shareholders can defer shareholder-level tax to the extent that retained earnings are left in the corporation. So, you may benefit from incorporating your cryptocurrency portfolio if you operate a cryptocurrency-trading business and thereby earn fully taxable business income (as opposed to half taxable capital gains). The same is true if you generate business income from cryptocurrency liquidity mining or yield farming. For advice on cryptocurrency tax-planning involving incorporation, contact one of our knowledgeable Canadian tax lawyers today.