Taxation Of NFT Rug-Pulls: A Canadian Tax Lawyer’s Guide – Capital Gains Tax – Canada

0


Background: What is an NFT?

A non-fungible token (NFT) is a unique digital asset that is
built on top of the blockchain system. It is non-fungible in the
sense that it is unique in nature: there is only one unique,
original NFT. Cryptocurrencies (such as Bitcoin or Ethereum) or
conventional fiat currency are fungible because each coin or token
or dollar or pound is exactly the same, and therefore
interchangeable.

Further, the fact that NFTs are built on the blockchain allows
you to track ownership of the asset and verify its authenticity.
Hence, while you can screenshot an NFT of a bored ape (similar to
making a copy of a painting), the original NFT retains its value
because it is a verifiably unique and original and authentic
version.

Because it is built on the blockchain, NFTs can be bought, sold,
or transferred using cryptocurrency such as Ethereum, Bitcoin,
Solona, and Polkadot. The new-found popularity of cryptocurrency
has created an immense spike of interest in NFTs. As a result, many
artists, singers, and public figures have begun to create NFTs and
sell them, oftentimes for large sums of money.

What is a rug-pull?

With NFT’s rise in popularity, investors, speculators, and
scammers alike have flooded the market. The concept of a
“rug-pull” comes from the expression referring to
“having the rug pulled out from under you”. In essence, a
person or organization deceives the investor, thereby taking their
money.

An NFT rug pull occurs when an NFT developer sells an NFT, or
collection of NFTs, and then creates the conditions for the value
of the NFT to fall precipitously. For example, if an NFT derives
its value as being part of a community or collection, and the
developer decides to leave the community, the value of an NFT can
collapse.

Types of Rug-Pulls

There are many ways that a developer can “rug-pull”
and thereby devalue the NFT. On easy way is by simply disappearing
with investor funds before the completion of a project. Further,
let’s say an NFT is part of a collection, if the developer
disappears without completing the collection, the value of the
already sold NFTs may suffer.

Another common rug-pull technique occurs when the NFT is
purchased with a particular “scam-coin”. Usually, after
significant investment, the developers will sell all off the
“scam-coin” they have on hand, thereby devaluing the
cryptocurrency (and therefore the NFT) until its worth is a
fraction of its original purchase price. Because the developers
created the “scam-coin”, they can distribute most of the
coins or tokens to themselves. This means that any sell-action by
the developer is almost certain to capitulate the price of the
crypto, and thereby the NFT.

Other rug-pull methods include:

  • A “hard” rug-pull, in which the developer creates a
    back-door to hack the NFT,
  • Cryptocurrency liquidity stealing, in which
    developers use a smart contract to use a legitimate crypto currency
    to prop up the value of a “scam-coin” and then devaluing
    the “scam-coin”

Tax Consequences of an NFT Acquisition

However, while the value of the NFT the investor holds is a
fraction of the purchase price after a rug-pull, the investor is
likely to incur significant tax benefits after disposing the asset
at a loss. While there are no tax consequences from merely holding
an asset, when an asset is sold, the gain or loss is
“crystallized” and thereby the taxpayer incurs tax
consequences. Critically, failure to crystallize the loss through a
disposition means that a tax deduction is not available. The
Canadian Income Tax Act distinguishes between
several sources of income: employment income, business income,
property income (which includes investment income), and capital
gains. Each of these types of income has its own tax treatment.
This is why it is crucial to correctly characterize the type of
income (or loss).

The Canadian Income Tax Act generally deems a
disposition of property, including an NFT, as either capital
property or a business type of property. While selling capital
property leads to a capital gain or a capital loss, selling or
trading business property, including an adventure in the nature of
trade, leads to business income or loss. However, Canada’s
Income Tax Act works backwards: first, the Court
determines the type of income – capital gain or business income –
and then based on the nature of the income, the property is deemed
capital property or business property.

In other words, the type of income the property generates upon
sale (whether capital gains or business income) determines the
character of the property. Hence, it is critical to understand
whether the property upon sale gives rise to capital gains (or loss) or business income (or
loss).

Canadian Tax Courts have often been tasked
with distinguishing between capital gains and business income, and
thereby Canadian tax law has amassed a plethora of case law on the
matter. Normally, trading produces business income while investing
produces capital gains. The Courts have listed a number of factors
that help distinguish between them. There is no one factor that is
determinative and all relevant factors have to be examined,
including:

intention when acquiring the asset. This is generally one of the
most important factors;

  • Length of ownership – brief ownership of NFTs
    typically indicates a trading purpose and therefore business
    income;
  • Transaction frequency – extensive buying and selling of NFTs typically indicates
    a trading purpose and therefore business income;
  • Background knowledge – advanced knowledge of
    NFT markets typically indicates business income;
  • Time spent – spending a substantial amount of
    time studying NFTs and the NFT market, as well as managing a
    portfolio typically indicates business income;
  • Financing – debt-back investment typically
    indicates business income, and
  • Advertising – if the taxpayer makes known that
    they deal in or an expert in NFTs, that will typically indicate
    business income.

However, as stated above, the most important factor in this
analysis is the taxpayer’s intention when purchasing the
non-fungible token. While the intention of the taxpayer is key, the
Court can use objective factors – such as the ones listed above –
to verify and examine this intention. In Macdonald v
Canada
, the Supreme Court of Canada stated that the intention
of the taxpayer cannot overwhelm the objective analysis. Simply
put, if the objective factors heavily favor one type of income, the
stated intention of the taxpayer will not (on its own) be enough to
prove otherwise.

Tax Consequences of an NFT Rug-Pull

In the context of a NFT rug-pull, the taxpayer’s property
will be heavily devalued. While there are no tax consequences for
merely owning an asset that has decreased in value, there are tax
consequences when the taxpayer disposes of the asset. Critically,
the determination of whether the disposition results in a capital
loss or business loss will determine the tax consequences. If the
factors point towards investment, the result will be a capital
loss. If the factors point toward trading, or an isolated adventure
in the nature of trade, the result will be a business loss.

Because of the nature of capital and business losses, a taxpayer
will usually prefer to incur business losses when possible.
Similarly, a taxpayer will usually prefer capital gains. This is
because capital gains and losses have a 50% inclusion rate meaning
that only half of the gain or loss is taxable. Hence, while
business losses would be fully deductible against one’s income,
capital losses would not be.

Pro Tax Tip: The first step in being able to deduct a loss as to
dispose of the NFT.

Then the most important factor in evaluating whether the sale of
an NFT creates a capital loss or business loss is the intention of
the taxpayer at the time of purchase. For more advice on the
distinction between business income and capital income, contact our
expert Canadian tax lawyers who can analyse your
Cryptocurrency or NFT portfolio and advise as to the appropriate
tax treatment or tax saving strategies including loss
crystallization.

FAQ:

1. What is an NFT (non-fungible token)
rug-pull?

A NFT rug-pull is when the developer or creator of the NFT or
NFT community sells an NFT and then creates the conditions for the
price of the NFT to drop sharply. This leaves the investor with an
NFT worth a fraction of the purchase price.

2. Can I claim the loss without selling the
NFT?

In order to incur a loss, the Income Tax Act requires a
disposition. A disposition occurs when you sell or trade the NFT.
After a rug-pull, it is necessary to dispose of the NFT in order to
incur a loss in order to receive the tax deduction associated with
the loss.

3. How do I know if I have capital or business
loss?

It is critical to evaluate what the intention of your purchase
was, as well as utilizing the factors: length of ownership,
transaction frequency, background knowledge, time spent, financing,
and advertisement to assess. Our lawyers are experts in crypto tax in Canada and have assisted
numerous taxpayers in assessing the type of income

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.



Read More: Taxation Of NFT Rug-Pulls: A Canadian Tax Lawyer’s Guide – Capital Gains Tax – Canada

Subscribe
Notify of
guest
0 Comments
Inline Feedbacks
View all comments