Bitcoin, that child of the Internet that may be the world’s first currency not created or backed by a central government, is the subject of intense regulatory review in Canada. But questions remain: should Bitcoin should be regarded as money, a commodity or a payments system? Concerns over the potential use of Bitcoins for criminal activity also weigh heavily on regulators.

So far, responses from bodies such as the Canada Revenue Agency (CRA) and the Standing Senate Committee on Banking, Trade and Commerce indicate there is little agreement among regulators as to how this so-called “cryptocurrency” should be treated. Olivier Fournier, tax partner with Deloitte Tax Law LLP in Montreal, says technology-based innovations such as Bitcoin can pose interesting policy challenges as these innovations emerge and become more popular: “There has to be a balance between embracing them and some form of control.”

A recent report entitled Rebooting Money: The Canadian Tax Treatment of Bitcoin and Other Cryptocurrencies, which Fournier co-authored with John Lennard, lawyer with Davies Ward Philips and Vineberg LLP in Montreal, notes that existing laws sometimes are insufficient to address new paradigms, such as Bitcoin. As a result, the report states, “Significant evolution of the legal framework is required.”

Therein lies the challenge faced by regulators in dealing with Bitcoin. It has the potential to revolutionize the payment system in such a way that traditional perceptions of money or currency on which the current regulation of currencies is based are no longer appropriate.

Kyle Kemper, executive director of the Bitcoin Alliance of Canada in Ottawa and senior vice president with the Bitcoin trading platform Coinsetter, parent to Cavirtex (the Canadian Bitcoin exchange), says: “The regulators haven’t yet fully grasped what Bitcoin is.”

Kemper contends that “Bitcoin is a legitimate currency” that can be used to transact business as simple as paying for a cup of coffee. Bitcoins also can be used as an investment option whereby investors hold Bitcoins for long-term capital appreciation or even for charitable gifting.

Bitcoins also can be used in margin accounts. For example, users of Cavirtex can execute larger Bitcoin trades with up to five times leverage. And traders have the ability to short the Bitcoin price in the deliverable spot market. In addition, ARK Investment Management LLC, a New York-based exchange-traded funds issuer, has added Bitcoins to one of its portfolios.

More important, however, is the use of Bitcoins as a technology solution or payments system, otherwise described as a cryptocurrency system. Bitcoin, as the most established cryptocurrency, Kemper says, eliminates the need for a trusted third-party payment processor, such as a bank or other intermediary. In addition, there are no or low transaction costs for Bitcoins and the speed of processing is almost instantaneous. “It takes about 10 minutes to settle a Bitcoin transaction, compared with about two days for a wire transaction through a bank,” Kemper says.

One advantage of Bitcoin – perceived as a disadvantage by regulators – is that it is a completely decentralized currency with a supply that is not controlled by a central bank. Control functions are handled through open-source software that is deployed across a worldwide peer-to-peer network of computers.

Users who maintain the Bitcoin network are rewarded with new Bitcoins, or fractions thereof, for the computer power and electricity used by the network. This activity is referred to as “Bitcoin mining.”

For added security, all Bitcoin transactions are made on a public ledger – basically, a large online bulletin board written in a cryptic computer language called the “blockchain.” The public ledger, also known as “distributed ledger technology,” then broadcasts transactions to the entire network. The public ledger database is always accessible and cannot be forged or changed. Notes Kemper: “It is a permanent record of all Bitcoin transactions.”

Blockchain technology is an ingenious computer code, stored entirely by computers, that forms the underlying architecture for Bitcoin and other cryptocurrencies. Several major banks, including Royal Bank of Canada (RBC) and Toronto-Dominion Bank (TD) are examining the use of distributed ledger technology to enhance their infrastructure and settlement systems, but not for the use of Bitcoin as a currency.

In September, U.S.-based R3 Consulting Group Inc. announced that RBC and TD are among 13 global banks that are joining an effort to design and apply the technology that underpins virtual currencies such as Bitcoin to mainstream financial markets. These banks are hoping the technology can be used to make financial transactions more secure and efficient.

But while the blockchain technology used by Bitcoin appears to be gaining traction, the role of Bitcoins as money or currency remains unclear. Fournier’s and Lennard’s paper states: “Canadian regulatory authorities, like those of many other countries, have been measured in providing guidance on how the Bitcoin ought to be treated for various purposes.”

The CRA, for example, recognizes Bitcoin as a digital currency but considers it a commodity instead of a currency for Canadian tax purposes. The CRA states that speculating on the changes in the value of Bitcoins may result in a gain or loss on account of income or capital. This determination can be made only on a case-by-case basis and on the specific facts of each situation. Therefore, the income tax consequences relating to the tax treatment of gains or losses arising from the purchase and sale of Bitcoins would be the same as for transactions involving other types of commodities.

Using Bitcoins to purchase goods or services would be treated as a form of barter by the CRA. Each party to a barter transaction has received something that is equal to the value of whatever is bartered. Therefore, for Canadian tax purposes, if a business sells goods or services in exchange for Bitcoins, the business must report its income from the transaction in Canadian dollars based on the fair market value of the Bitcoins at the time of the sale. GST/HST would apply on such transactions.

If Bitcoins are transferred to a qualified recipient in a donation, the fair market value of the Bitcoins at the time of the donation must be used in determining the value of the gift for tax purposes, according to the CRA. In addition, gifts of Bitcoins received by employees may be subject to taxation depending on the Bitcoins’ status as a “voluntary payment.”

Bitcoin miners also may be taxed, depending on whether their mining activities constitute a personal activity (or hobby) or a business activity. If the activity is considered a business activity, miners must report gains and may be entitled to claim losses associated with their mining operations for tax purposes.

The CRA also extends its long-arm to Bitcoins and other digital currencies as foreign property by stating that digital currencies and an interest in a foreign partnership that holds digital currencies both may be specified foreign property if they are situated, deposited or held outside Canada.

The Bank of Canada (BoC) also does not recognize Bitcoins as money, based on the central bank’s definition of money, which includes three criteria: a generally accepted medium of exchange; being a unit of account that allows the value of goods and services to be compared; and as a store of value.

The BoC has noted that very few merchants accept Bitcoins. It also highlights the potential for criminal transactions and tax evasion, stating: “Given the private nature of Bitcoin transactions, Bitcoins could be easily used to facilitate criminal transactions and to evade taxes.”

As a store of value, the BoC suggests, the price of Bitcoins is 40 times more volatile than the relative value of the U.S. dollar – thus, Bitcoin is not a stable store of value.

The 2015 report of the Senate committee, entitled You Can’t Flip This Coin, also highlights the opportunity for criminals and terrorists to take advantage of the Bitcoin system.

Fournier also notes that the Bitcoin system facilitates user privacy: while users are identified by a string of numbers, they are difficult to trace.

Fornier’s and Lennard’s report suggests that Bitcoin should be treated like money. The report notes: “In the end, neither the CRA nor the Bank of Canada appears to have disclosed the precise legal rationale for their conclusions. This leaves the matter of how to characterize the Bitcoin open to discussion.”

Fournier suggests that Bitcoin “should be a new system of currency.”

The Senate committee report concludes that the best strategy is to monitor the situation as it evolves: “This technology requires a light regulatory touch – almost a hands-off approach.

In other words: not necessarily regulation, but regulation as necessary.”

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