Bitcoin is a decentralized cryptocurrency that uses a distributed ledger technology called a blockchain to store transaction data. The whole history of all transactions involving Bitcoin within its network is recorded on the blockchain. In this system, currencies are divided and dispersed among “nodes” or “peers,” who work together to confirm the legality of each transaction.

For instance, the network of nodes, which contains the exact same history of transactions, must validate the transaction if two parties want to transfer a specific amount of Bitcoin. The transfer will be noted in the public ledger and become authenticated if the transactions are confirmed.

The blockchain stores transactions in “blocks,” each of which contains an answer to a “difficult” mathematical puzzle that verifies the transactions contained inside it. When another node or peer in the network validates and completes a block, it connects to the most recently verified block, producing a chain of verified blocks. Bitcoin mining is the process of solving these complicated mathematical puzzles to verify Bitcoin transactions.

To be clear, the mathematical problem is not particularly difficult. The job entails employing computer power to be the first miner to predict the proper 64-digit hexadecimal number, commonly known as the hash value, that is less than or equal to a target hash. In other words, the work is essentially speculative.

How does Bitcoin Mining Work?

The Bitcoin mining process relies around on locating a hash value that is equal to or less than a particular target value.

The Bitcoin mining process is as follows: (1) a miner is required to join the Bitcoin network and get connected to other nodes; (2) the miner has to wait and listen for the broadcast of new blocks on the network; (3) validation of new blocks must be done by the miner by looking into the nonce value that can prove its validity; (When a nonce value is hashed, it produces an output hash. The miner’s task is to alter the nonce value until the hash output value is equal to or less than a specified target hash. If the miner discovers the correct nonce value, the block is validated.); (4) if the mined block is validated by other miners, the miner who worked on it will be paid in the form of Bitcoin allocation.

The only means to record and validate Bitcoin transactions is through mining, hence it is crucial to the ongoing operation of the Bitcoin system. In other words, a Bitcoin miner is engaging in a task that preserves the integrity of the Bitcoin network. Since no transactions will be validated without miners, the Bitcoin system won’t work.

Rewards for Bitcoin Mining

Mining for bitcoin has two consequences or outcomes. First, the blockchain’s accuracy and legitimacy are ensured. Miners check that no transaction is replicated or recorded more than once. Second, when a Bitcoin miner successfully validates a block of a Bitcoin transaction, they are rewarded with a newly minted Bitcoin by the Bitcoin protocol as well as transaction fees from the people who took part in the transaction, also paid in Bitcoin. In other words, the miner who validates the block will be paid, and the reward comes in the form of both transaction fees and newly-minted Bitcoin rewards.

An accurate block verification by a Bitcoin miner results in a portion of newly produced Bitcoin being awarded to them. Since mining is a key component of creating new Bitcoin, this is the sole way to create it. To put it another way, when a miner successfully verifies a block, new bitcoins are created in accordance with the Bitcoin protocol, and the miner gets a certain amount of bitcoins as a reward. A Bitcoin miner also receives transaction fees from the users taking part in the transaction, as stated above. In general, the transaction charge right now is about 1% of the block reward. Due to this, rather than transaction fee rewards, the Bitcoin rewards (i.e. the newly minted Bitcoin) make up most of the miner’s income.

The freshly created Bitcoin incentives, however, will eventually start to diminish. In particular, every four years the block awards are cut in half. Initially, the block reward for mining bitcoins was 50 bitcoins, which was the case from January 2009 to November 2012. But due to three Bitcoin halvings over the past ten years, the reward for each block has now been reduced to 6.25 Bitcoins. Furthermore, the total number of Bitcoins that may be mined is limited to 21 million. When Bitcoin production ceases, transaction fees are likely to be the only profitable function in Bitcoin mining. In other words, once unmined Bitcoins have been depleted, the only payment Bitcoin miners will receive for confirming transactions will be transaction fees from the users participating in the transaction.

The Tax Implications of Mining for Bitcoin: Three Options

Canada has yet to pass an income tax law that specifically addresses cryptocurrency transactions or mining. (Canada, on the other hand, implemented GST/HST legislation pertaining to “virtual payment instrument,” and the Excise Tax Act was revised in 2021 to include “virtual payment instrument” in the description of “financial instruments.”) Furthermore, the Canadian courts have yet to rule on a tax issue pertaining to transactions and the mining of cryptocurrency. As a result, it will be fascinating and crucial to see how the courts and legislation handle the tax treatment of bitcoin and cryptocurrency transactions and mining.

In terms of the tax implications of acquiring BTC through mining, we believe there are three options. As we will see later, the optimal alternative is determined not only by the nature of BTC mining but also by what the taxpayer does with the BTC obtained through mining.

The three parts that follow go into each choice in depth.

Option 1: The Hobbyist Miner

The first possibility is that the taxpayer mined Bitcoin merely for fun, with no business aim. In such circumstances, the mining incentive is not considered a source of income. The hobbyist will not be required to disclose the value of the mining incentives as income when they are received. The income inclusion (or loss realization) will be realized when the enthusiast disposes of the mined Bitcoin.

The disposal of mined Bitcoin differs from the acquisition of mined Bitcoin. As a result, the gain from the sale of mined Bitcoin is reportable as either income or capital. In other words, the tax implications of Bitcoin disposal will necessitate a distinct legal study.

To be clear, the tax expense of a hobbyist’s mined Bitcoin would be zero because the taxpayer does not record the min’s ed Bitcoin as income. As a result, the hobbyist miner cannot suffer a loss while disposing of the mined Bitcoin at the moment of disposition. Instead, when the enthusiast disposes of the mined Bitcoin, he or she will profit. The gain will be calculated as A minus B, where A is the disposal profits and B is the tax cost of the sold property. Because the tax expense of the disposed of the property is zero in this situation, the gain equals the revenues obtained upon disposition.

Option 2: Mining While Running a Cryptocurrency Trading Company

The second option is that the taxpayer mined Bitcoin while running an enterprise that dealt in cryptocurrencies for profit. In such circumstances, obtaining Bitcoin via mining would be comparable to obtaining inventory, particularly inventory for a cryptocurrency trading business. In this instance, the mining operation is not the taxpayer’s primary source of revenue. Instead, the mining activity is a byproduct of the taxpayer’s primary source of revenue, which is the sale and exchange of Bitcoin units obtained from mining. Therefore, just as a gold dealer does not register income upon acquiring gold deposits through mining, a cryptocurrency trader does not do so while purchasing Bitcoin through mining.

Instead, the cryptocurrency trader, like the hobbyist miner, records income when the generated Bitcoin rewards are sold. The gain (or loss) that results from the disposition of mined Bitcoin rewards must, however, be recorded on the trader’s income account. In other words, the trader of cryptocurrencies is not eligible for capital treatment with regard to the sale of Bitcoin that was mined.

It is crucial to emphasize that the inventory-acquisition model will only be suitable if the Bitcoin miner conducts mining operations inside the framework of a cryptocurrency trading business. The inventory-acquisition approach won’t work if the Bitcoin miner isn’t running their mining activities alongside a bitcoin trading operation.

Option 3: Bitcoin Mining as Services

The final option is that Bitcoin mining was done as a service provided by the taxpayer. The function that mining serves in the Bitcoin network and the portion of the mining payments known as the transaction fee component both enable this form of tax treatment. In order to confirm the legitimacy of Bitcoin transactions, a Bitcoin miner uses mining software and hardware. The parties involved in Bitcoin transactions are the recipients of miners’ services as a result of this verification work, which also helps to maintain the integrity of the Bitcoin network. The newly created Bitcoin and transaction fees serve as the miners’ compensation.

The services model assumes that the Bitcoin mining incentive is a source of revenue, in contrast to the hobbyist model and the inventory acquisition approach. As a result, in accordance with this approach, the Bitcoin miner is required to include the value of mining rewards in their yearly income reports after receiving them. The cost of the mined Bitcoin rewards will be equal to the amount reported as income by the miner, which will be the fair market value at the time of receipt.

The services model is only applicable if the Bitcoin miner does not run a cryptocurrency trading business and performs mining activities for profit. If the case is a Bitcoin miner who operates a trading business for cryptocurrency, the Bitcoin mining reward will be the acquisition of inventory with the inventory value being equal to the cost of production. However, if a Bitcoin miner does not do so with a view to making a profit, the rewards cannot be considered a source of income. Therefore, the service model should only be used in situations when the Bitcoin miner uses their mining activity for profit but does not run a cryptocurrency trading operation.

The CRA’s View on the Tax Implications of Bitcoin Mining

The CRA declared their opinion in 2019 on whether Bitcoin miners should include the value of Bitcoin rewards in their income at the moment they are mined. According to the CRA, Bitcoin miners must include Bitcoin mining rewards in their income when they are earned. The tax department’s reasoning was that Bitcoin is a commodity, and hence bitcoin mining activity is effectively a barter transaction. Furthermore, CRA says Bitcoin miners provide services and accept Bitcoin as payment.

Regardless of the CRA’s current position, it is vital to emphasize that the CRA’s interpretative pronouncements lack legal weight, and the CRA’s viewpoint is in fact contrary to the law. It is not enough to consider Bitcoin mining in isolation. The tax implications of Bitcoin mining are determined not only by the nature of Bitcoin mining but also by the conditions under which the taxpayer obtained the Bitcoin through mining. The CRA’s view ignores the taxpayer’s intentions and the context in which the mining activities were carried out. If the CRA has incorrectly assessed your Bitcoin mining income, contact one of our top Canadian tax crypto lawyers for assistance.

Tax Pro Tip: Understanding the Nature of Bitcoin Mining and the Circumstances Surrounding the Taxpayer’s Acquisition of the Bitcoin Rewards from Mining is Necessary for Determining the Correct Tax Consequences

As previously stated, the correct tax consequences of Bitcoin mining are determined not only by the nature of Bitcoin mining but also by the conditions under which the taxpayer obtained the Bitcoin through mining. Depending on the taxpayer’s circumstances, Bitcoin mining rewards may be taxable upon receipt or may not be taxable until they are eventually disposed of. The tax classification of mined Bitcoin rewards is a legal issue. As a result, if you are mining Bitcoin and have issues with the proper tax classification of your mining activity, please contact one of our experienced Toronto tax lawyers.

Disclaimer:

“This article just provides broad information. It is only up to date as of the posting date. It has not been updated and may be out of date. It does not give legal advice and should not be relied on. Every tax scenario is unique to its circumstances and will differ from the instances described in the articles. If you have specific legal questions, you should seek the advice of a Canadian crypto tax lawyer.”