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tax matters

My son, Win, is a budding entrepreneur. He's already asked me for money to help him start his latest venture: A cheese-sculpting business.

"Win, who in the world needs a very large sculpture made of cheese?" I asked. Evidently, thousands – according to Sarah Kaufmann, who started a thriving business with the tag line "So much cheese… so little time." My son showed me her website. Very impressive.

"Win, I'm not going to fund your business, because you've never sculpted anything."

"That's okay, Dad," he replied, "I've already started raising money online through crowdfunding. I've got $56 so far."

"Well, son, good luck with that. And by the way, we should talk about the tax implications of crowdfunding." Here's a summary of our chat.

The concept

Crowdfunding seems to be taking the world by storm. It's the idea of matching up people who want to raise capital for a particular purpose with those who are willing to provide it, using the Internet and social media to connect them. Most of the amounts contributed are small, but when you add the contributions of potentially thousands of people, it can be an effective way to raise quite a bit of money.

I've seen crowdfunding provide money for charitable causes, personal causes, music or other artistic productions, research, and to start businesses. Take Pebble Smartwatch, for example, which raised $10.27-million (U.S.) from 68,929 backers, or Oculus Rift, a virtual reality headset for gamers, that raised $2.44-million from 9,522 backers.

The models

There are four popular crowdfunding models that you'll typically find online:

-the lending model (backers offer interest-bearing loans to those looking for funding);

-the equity-based model (where investors take some ownership in the companies they choose to fund);

-the reward-based model (where backers give money to projects and get rewards in return, often in the form of a final product being produced, a discount or advance order of the product, or some other promotional reward);

-the donation model (where backers simply give altruistically to a project without anything in return – there are typically no donation receipts issued either).

The most common of these models has been the reward-based model. The equity-based model, however, is expected to have the greatest growth in the future.

In Canada, equity-based crowdfunding wasn't legal in the past, but that's changed. Today, as long as accredited investors make up the "crowd," it's possible to raise funds this way. Securities regulation is a provincial matter, and Saskatchewan was the first province to allow equity-based crowdfunding by way of a specific exemption. As an aside: If you're looking to raise funds using an equity-based model you should consult with a local securities lawyer to understand the rules in your province. Check out the National Crowdfunding Association of Canada's website for great information.

All of this raises the question: How will the Canada Revenue Agency (CRA) view the funds raised through crowdfunding?

The tax rules

The fact is, the taxman is still contemplating the taxation of crowdfunding. It's a new concept and the CRA hasn't said much about it yet, although the first guidance came last fall in the form of technical interpretations (letters to taxpayers who had asked for the taxman's views). The CRA said that each arrangement must be looked at on its own merits, but that crowdfunding receipts could be treated as a loan, capital contribution, a gift, income, or a combination of these four – depending on the arrangement.

In the end, I expect that the tax treatment will very likely depend on what the backer, or funder, gets in return, which could be nothing (a donation model), a reward of some kind, a presale or advance access to a product, equity, or debt.

In the case of reward-based models, amounts received will generally be included in the income of the recipient as income from carrying on a business (if you're in fact carrying on a business). The good news is that the recipient, in this case, will be able to deduct expenses incurred in connection with the crowdfunding campaign.

In equity-based models, the funds raised shouldn't be taxable since they are paid as capital in the company, and in the case of lending models, the funds should not be taxable because they are loans to be repaid; the interest paid on the loans should be deductible.

A donation model is less clear; I expect amounts will be taxable as with a reward-based model if a business is carried on.

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.