Addressing and Analyzing the CRA’s Guidance Regarding the Tax Consequences of Crypto-Asset Transactions that Occur on Decentralized Finance (DeFi) Lending Protocols

Introduction—

The article explores the uncertain income tax consequences facing Canadian taxpayers involved in the lending and borrowing of crypto assets on Decentralized Finance (DeFi) lending protocols. From a Canadian taxation perspective, crypto lending protocols offer users several innovative financial products and services that inevitably trigger taxable events and income tax consequences. Canadians engaging in crypto-asset transactions on DeFi lending protocols encounter a challenging responsibility regarding identifying and understanding their various provincial and federal tax consequences and the characterization of their particular transaction or item (the legal res of the item) from a legal perspective.

Moreover, DeFi’s technological complexity and recency are two additional factors contributing to the Canada Revenue Agency’s (CRA) failure to provide Canadians with sufficient guidance on the income taxation implications of crypto-asset transactions on DeFi lending protocols.  The CRA's guidance is urged to be upholstered and increased to mitigate against the risk that taxpayers will incorrectly report and file crypto-asset transactions. Also, incorrectly reporting crypto-asset transactions expose the taxpayer to an uncertain tax liability and renders the taxpayer in non-compliance with Canadian taxation statutes.

Road Map—

Part One of the article provides a high-level conceptual overview of DeFi. Part Two gives a theoretical overview of the technological building blocks that comprise the DeFi infrastructure.[1]  Part Three discusses how the two largest DeFi lending protocols, Aave and Compound, allow crypto-asset traders to engage in DeFi transactions that resemble margin lending. Part Four will explore the CRA’s current guidance on crypto-asset transactions, the identity of crypto-asset transactions, and the tax implications of DeFi transactions based on the current guidance of the CRA. Part Five will analyze the taxation consequences for DeFi crypto-asset lending.

Part One: What is DeFi’s Disruptive Potential?

DeFi is a catch-all phrase for the digital ecosystem built on blockchain technology. DeFi technology allows users to engage with smart contract applications and digital assets to create a self-sustaining environment for financial activity. In essence, DeFi represents a competitive marketplace for Decentralized Applications (dApps) that provide users with innovative financial services and products with the potential to disrupt traditional financial markets.[2] DApps are software applications that operate on the decentralized blockchain network and smart contract infrastructure, creating permissionless and censorship-resistant financial products and services. Since dApps inherit the novel features of their underlying technology, their participants can create a flexible organizational structure to pursue their commercial objectives.

DeFi proponents advocate that DeFi dApp protocols will create the architecture for new digitally based financial system that promotes financial inclusion, efficiency gains, and investor flexibility.[3] The new DeFi ecosystem is equitable because value accrues at the protocol level for the use and benefit of the dApps participants— the protocol’s software developers and end-users. As such, proponents believe DeFi’s removal of centralized and bureaucratic barriers substantially increases consumer access to financial products and services, democratizing finance.[4]

Within the DeFi ecosystem, dApps potential to increase and democratize omnibus access to creditor and debtor markets has attracted significant user participation across several crypto lending protocol dApps. However, it must be noted that the current structure and implementation of DeFi lending protocols do not operate to provide their users with personal and commercial credit arrangements.[5] This means that users cannot access liquidity in lending protocols to finance mortgages, student loans, and personal or commercial lines of credit. Instead, DeFi lending protocols provide users with a decentralized, transparent, and easily accessible alternative investment tool that resembles the traditional finance concept of margin trading in securities.[6] Interestingly, DeFi lending protocols offer crypto-asset holders innovative methods to leverage their crypto assets to amplify their returns. Defi’s underlying technologies—blockchain databases, smart contract applications, and the tokenization process—facilitate open, efficient, and transparent peer-to-peer lending and borrowing agreements, without the need for a third-party intermediary to facilitate the transaction.

Part Two—Conceptual Overview of DeFi’s Digital Infrastructure.

1. Blockchain Databases

Blockchain databases are a disruptive technology that enables digital secure and transparent storage and digital exchange of information and value across the internet.[7] The databases utilize a distrusted ledger to exchange information peer-to-peer across the decentralized network to participating computers (nodes).[8]  The distributed trust and authentication architecture eliminates the need for third-party guarantors like financial intermediaries, as transactions are transparently reconciled and verified across the network’s decentralized nodes.[9]

Blockchain databases leverage novel cryptographic “private and public keys” to facilitate the encryption and authentication of new information. Since all information on the database becomes publicly auditable, validated, and saved in a tamper-resistant format, secure ownership verification throughout the transactional process is guaranteed.[10] The functionality of the underlying blockchain programming allows for diverse outputs and numerous applications.[11]

2. Smart Contracts

Smart contracts are self-executing agreements executed on top of the blockchain Database protocol, which secures relationships and agreements across a decentralized network.[12] Smart contract developers utilize a combined natural language and conditional logic statements allowing digital agreements to execute automatically once predetermined conditions are verified across a network’s nodes.[13] The autonomous execution of smart contracts offers developers and participants flexibility, programmability, and control in the performance of the parties’ specified objectives.[14]

A blockchain database’s smart contract infrastructure incorporates trusted interface devices known as “oracles” to securely import necessary data from a fluctuating external source, such as price fluctuations in commodity trading, required to execute the contract’s agreed upon terms and conditions.[15] Decentralized oracle networks enable unfamiliar parties to manage and execute contracts without needing an intermediary to ensure performance.[16] Once programmed into the database, oracles and smart contracts can communicate with each other, accessing necessary information and triggering automated notifications based on the parties’ agreed-upon event mechanisms.[17] This automation ensures a contract’s secure execution on the blockchain, reducing transaction costs and eliminating the need for intermediaries.[18]

3. Tokenization

Tokenization refers to the process of digital asset representation where software developers take an asset or bundle of assets, either real-world assets (RWAs) or digital assets, and,

1. Represent the asset on a blockchain with possible fractional ownership in the form of ERC-721 tokens; or

2. Represent that asset on a blockchain with a composite token that holds some underlying tokens in the form of ERC-20 tokens.[19]

Therefore, through secure and immutable digital representation, tokens can conform to different specifications based on the type of properties a user wants a token to have. The most popular token standards within the DeFi ecosystem include—ERC-20 tokens for non-fungible cryptocurrencies and ERC-721 for non-fungible tokens (NFTs). The ERC-20 standard token represents the fungible standard for cryptocurrency within the Ethereum DeFi ecosystem. Moreover, the ERC-20 explicitly defines how a token with non-unique units can be used interchangeably and operate across other DeFi protocols as payment tokens.[20] Alternatively, ERC-721 tokens represent the DeFi standard for non-fungible tokens. The ERC-721 defines (fractional) ownership of a unique and scarce digital asset.[21]

The Tokenization process is the product of blockchain databases and smart contract applications. On the one hand, tokenization requires blockchain databases to ensure that the token ownership and value are digitally recorded, secured, and transferred and that there is an immutable asset transfer.  On the other hand, the tokenization process leverages the Ethereum blockchain’s smart contract applications to increase the functional programmability of digital assets, allowing for automated rights management. Capitalizing on the unique and innovative qualities, digital asset holders have the secure and transparent rights of ownership, the right to participate in profit, and the right to participate in governance.

Part Three— Overview of the Crypto-Asset Lending Mechanics of Compound and Aave Defi Lending Protocols

Compound and Aave are the prominent crypto-asset lending protocols in the DeFi ecosystem. They create a decentralized marketplace for ERC-20 assets. These protocols effectively augment savings accounts at banks and other financial intermediaries and provide highly competitive yields for lenders.[22] The metric measuring the value held in a protocol’s liquidity pools is the Total Value Locked (TVL).[23] The TVL represents the total value of user deposits held within the protocol.[24] As of March 12th, 2024, the Aave protocol held 13.69 billion in TVL, while the Compound protocol held 2.52 billion.[25]

The Defi protocols’ services and products share several features common to margin lending practices in traditional financial markets. First, margin lending and crypto lending require collateralized debt positions to access borrowed funds.[26] In conventional margin lending, borrowers provide securities or other assets to borrow funds from a broker. Compound and Aave platforms overcollateralize crypto assets to ensure the protection of the digital lending arrangements, removing the need for credit rating requirements.[27] Moreover, the platforms provide users with transparent collateralization ratios visible to the entire ecosystem.[28]

Second, margin lending and crypto lending require the payment of interest on borrowed assets. In both cases, borrowers are responsible for paying interest on the amount borrowed. However, the Defi lending protocols algorithmically pool and optimize interest rates.[29] The platform's interest rates outperform the suboptimal rates and inflated costs inherent to borrowing and lending transactions in traditional financial markets.[30]

Finally, in both traditional margin lending and crypto lending on DeFi platforms, there's a risk of liquidation if the value of the collateral falls below a certain threshold. In traditional margin lending, if the value of the securities being held as collateral drops below a certain level, the broker may issue a margin call and liquidate the assets to cover the loan. Similarly, in DeFi lending protocols, if the value of the crypto-asset collateral falls below a certain threshold, the collateral may be liquidated to repay the borrowed funds and avoid losses for the lenders.[31] However, in the DeFi context, asset liquidation is automated through smart contract applications. As a result, liquidation on crypto lending protocols can occur immediately without requesting an additional margin or a grace period for repayment.[32]

Part Four—Criticism of the CRA’s Guidance Relating to the Income Taxation Consequences of Crypto-Asset Transactions on DeFi Lending Protocols

The CRA has provided taxpayers and tax professionals with guidance on crypto-asset transactions through several of the CRA’s formal publications. However, the two CRA publications that are the most relevant to the current analysis of crypto-lending transactions. The first relevant publication is Information for Crypto-Asset Users and Professionals (Information for Crypto-Asset Users).[33] The Information for Crypto-Asset Users is the seminal source of the CRA’s limited administrative. It guides taxpayers on the income and sales taxation implications that flow from their crypto-asset transactions. The CRA’s compliance and enforcement publication titled Virtual Currency (Virtual Currency Guidance)[34] is the second relevant publication. The CRA’s Virtual Currency Guidance provides additional utility to the current analysis of crypto-asset transactions, as it clarifies key conceptual definitions and assists taxpayers in determining the applicability of tax rules in limited transactional contexts.

The CRA’s Information for Crypto-Asset Users creates taxation-focused crypto-asset classifications that set the conceptual foundation for taxpayers to understand and address the income tax consequences of “common commercial crypto-asset transactions.”[35] Next, the CRA directs taxpayers to apply these novel concepts to existing legal frameworks.  More specifically, the CRA suggests that taxpayers use a general principles approach when determining the source characterization of taxpayers’ crypto-asset transactions, whether the crypto assets are held as income or in a capital account.[36] The Information for Crypto-Asset Users provides additional guidance on several other matters to  crypto-asset users to understand the tax implications of their transactions. The additional issues the CRA provides guidance on include the potential events and transaction structures that trigger the taxpayer’s reporting obligations, the acceptable crypto-asset valuation methods for tax reporting, and the crypto-asset recording-keeping obligations to facilitate accurate reporting amounts.[37]

Turning to the second relevant CRA publication, the value of Virtual Currency Guidance lies in the CRA’s clarification of the conceptual distinction between virtual currencies and cryptocurrencies. In their Virtual Currency Guidance, the CRA qualifies cryptocurrencies as a subset of the larger classification of virtual currencies. Moreover, the CRA broadly construes virtual currency as “a digital asset that can be used to purchase or sell goods or services.”[38] However, because the definition is so broadly construed, the publication provides taxpayers with limited guidance on the applicable taxation rules for virtual currencies used in commercial transactions. While the CRA’s guidance clarifies the applicable tax rules for using virtual currencies in several common commercial transactions, the publication discusses one transactional context, when virtual currency is used like a commodity, relevant to the current taxation analysis of crypto lending transactions.

Although the Federal government has attempted to address the gaps in its guidance and clarify certain ambiguities, much work still needs to be done to solidify

the underlying crypto-asset tax regime.[39] The aforementioned CRA publications provided taxpayers engaged in crypto-asset transactions on DeFi protocols with insufficient and ambiguous guidance on the tax consequences of their transactions. The sources of gaps and ambiguities in the CRA guidance are two-fold.

First, the CRA guidance only covers a limited number of common crypto-asset transactions. The CRA’s restricted position creates a huge gap that fails to address the income tax consequences for most of DeFi’s innovative financial products and services.

Second, the CRA attempts to force novel crypto-asset transactions into ambiguous administrative positions and thin legislative frameworks to confront the income taxation resulting from complex digital transactions that the drafting legislators never anticipated. Both publications direct taxpayers to paragraphs 9 to 32 of Interpretation Bulletin IT-479R—Transactions in Securities[40]—for general information relating to the determination of whether their crypto-asset transactions result in income or capital gains.[41]

Problematically, taxpayer activities related to DeFi may not be legally categorized as participating in the acquisition and disposition of securities, instead, taxpayer activities related to DeFi may be legally categorized as engaging in a creditor and debtor relationship for investment purposes, earning interest income. Turning back to the paragraphs 9 to 32 of Interpretation Bulletin IT-479R—Transactions in Securities, the mentioned interpretation bulletin is strictly relating to transactions in securities, and not related to a creditor and debtor legal relationship.

Part Five— Selected Income Tax Consequences for DeFi Crypto-Asset Lending Transactions

The crux of the CRA’s guidance for crypto-asset transactions addresses the source characterization of the crypto-asset transactions as “income” or “capital.” The Income Tax Act does not clearly define the distinguishing features of a gain or loss on account of income or capital.[42] Therefore, the legal distinction between “capital gains” and “income” derives from the case law or jurisprudence.[43]

At the heart of the distinction is the concept of “investment”; an investment in property represents capital, and the flow from the investment presents income.[44] The United States courts analogized the income relationship in Eisner v.  Macomber, with capital being analogized as a tree and income to the fruit.[45] Therefore, determining whether a taxpayer has an income gain, or a capital gain hinges on identifying whether the taxpayer has traded assets or sold an investment.[46]

An “investment” is an asset or property that one acquires with the intention of holding or using to produce income.[47] The distinction between an investment and trading inventory depends not upon the taxpayer’s nature but upon the taxpayer’s intention to acquire it.[48] Therefore, where a taxpayer acquires property with an intention to trade — that is, to purchase and resell the property at a profit — any gain or loss from the trade is business income or loss. Alternatively, if the taxpayer acquires the investment with the intention to hold the property, any gain or loss occurs on the taxpayer’s capital account.

In DeFi crypto lending transactions, the distinction between capital gains and income involves the assessment of the taxpayer’s intention. Canadian taxpayers engaging in crypto-asset transactions on DeFi protocols must apply their transaction’s specific facts and circumstances to the factors listed in the CRA’s Technical Information Bulletin IT 479R—Transactions in Securities. If the facts and circumstances of the transactions demonstrate the asset holder’s intention is to hold the asset for investment purposes, then under s.39 of the Income Tax Act, the transaction should be characterized as a capital gain or loss.

Conversely, suppose the facts and circumstances of the transactions demonstrate that the taxpayer intended to hold the asset as part of an active trading business, or an adventure or concern in that nature of trade related to crypto-asset trading. In that case, any realizable gain on the transaction will be treated as business income. When crypto-asset lending transactions are treated as income, taxpayers and tax professionals must remain aware of the potential applicability of interest expense deductions on money borrowed to purchase investments under ss.20 (1). s.20(1)(c) states,

20 (1) Notwithstanding paragraphs 18(1)(a), 18(1)(b) and 18(1)(h), in computing a taxpayer’s income for a taxation year from a business or property, there may be deducted such of the following amounts as are wholly applicable to that source or such part of the following amounts as may reasonably be regarded as applicable thereto

Interest

(c) an amount paid in the year or payable in respect of the year (depending on the method regularly followed by the taxpayer in computing the taxpayer’s income), pursuant to a legal obligation to pay interest on

(i) borrowed money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy),

(ii) an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business (other than property the income from which would be exempt or property that is an interest in a life insurance policy),

The interest will be deducted under paragraph 20(1)(c), and the interest must be paid pursuant to a legal obligation to pay interest on,

1.  Money used for the purpose of earning income from a business or property (other than borrowed money used to acquire property the income from which would be exempt or to acquire a life insurance policy);

2. an amount payable for property acquired for the purpose of gaining or producing income from the property or for the purpose of gaining or producing income from a business (unless the income would be exempt, or the property is an interest in a life insurance policy).[49]

Access to paragraph 20 (1)(c) deductions allows taxpayers to reduce their income tax liability. While the provisions as mentioned above are relevant to the current income tax analysis, taxpayers and tax professionals must remain aware of potential implications arising from additional income and sales tax obligations that can impact DeFi crypto-asset lending transactions.

Throughout the above, it is demonstrated that the proverbial ‘bucket’ of DeFi transactions captures transactions that may not be security transactions, and may instead, be debtor-creditor transactions, generating strictly interest, and a repayment of the principal amount of debt lent. Thus, guidance and advisory concerning Canadian taxpayers engaging in DeFi transactions must be rendered holistically and remain cognizant of the developing law related to DeFi transactions. Regulators and lawmakers are encouraged to provide clear guidance that can foster innovation, safeguard investor confidence, and increase Canadian competitiveness in this area.

Recommendations:

The CRA should consider incorporating the CSA’s conceptual clarification of crypto-asset transactions into its current crypto-asset transaction taxation guidance. The CSA’s classification of crypto-asset transactions as a security, derivative, or crypto contract captures the complexities of DeFi transactions far better than the CRA’s current crypto-asset taxonomy. Moreover, with these definitions, the CRA will be better equipped, providing narrower guidance on the income and sales tax implications of DeFi crypto-asset transactions.

CSA Staff Notice 21-327 Guidance on the Application of Securities Legislation to Entitles Facilitating the Trading of Crypto Assets establishes that crypto-asset transactions will be subject to Canadian Securities regulations were any of the following conditions are satisfied:

1. the crypto-asset itself is a security, such as a token that carries rights traditionally attached to common shares, such as voting rights and rights to receive dividends;

2. the crypto-asset is a derivative, such as a token that provides an option to acquire an asset in the future; or

3. the crypto-asset is not itself a security or a derivative, but the transaction occurs on a Crypto Trading Platform that merely provides its users with a contractual right to an underlying crypto-asset (rather than immediately delivering the crypto-asset to the users of the platform).[50]

As Colin Romano accurately observes, the contractual right referred to in the third point is now known in Canadian Securities law as a “crypto-contract.”[51] The concept of crypto contracts allows the CSA to assert jurisdiction over transactions involving crypto assets where the underlying crypto assets are viewed as commodities. However, the CSA holds that crypto contracts may be derivatives or services without taking a position on each.[52]

Conclusion:

The CRA’s guidance on the tax consequences of crypto-asset transactions should provide further definitional clarity on the myriad of innovative crypto-asset transactions occurring within the DeFi ecosystem. The foregoing analysis of the income tax consequences of crypto-asset transitions on DeFi demonstrates the practical necessity for further definitional and conceptual clarity. One potential solution borrows from the Canadian Securities Administrators' (CSA) guidance on when crypto-asset transactions would be subject to security legislation.

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