Articles from the Silver Law Team on contractual matters, recent case law changes and items of interest in our sectors
April 12, 2021 | Silver Law
The aim of this article is to help people understand the tax implications that can arise from transactions involving cryptoassets. It is written to assist businesses and their professional advisers in understanding the current law relating to cryptoassets.
What Are Cryptoassets?
Cryptoassets (also referred to as ‘tokens’ or ‘cryptocurrency’) are cryptographically secured digital representations of value or contractual rights that are:
• traded electronically
The main types of cryptoasset include:
Exchange Tokens – Exchange tokens are intended to be used as a means of payment and are also becoming increasingly popular as an investment due to potential increases in value. The most well-known token, bitcoin, is an example of an exchange token.
Utility Tokens – Utility tokens provide the holder with access to particular goods or services on a platform, usually using DLT. A business or group of businesses will normally issue the tokens and commit to accepting the tokens as payment for the particular goods or services in question. In addition, utility tokens may be traded on exchanges or in peer-to-peer transactions in same way as exchange tokens.
Security Tokens – Security tokens provide the holder of a security token particular rights or interests in a business, such as ownership, repayment of a specific sum of money, or entitlement to a share in future profits.
Stablecoins – Stablecoins are another prominent type of cryptoasset. The premise is that these tokens minimise volatility as they may be pegged to something that is considered to have a stable value such as a fiat currency (government-backed, for example US dollars) or precious metals such as gold.
How Does HMRC Treat Cryptoassets?
The tax treatment of all types of tokens is dependent on the nature and use of the token and not the definition of the token.
HMRC does not consider cryptoassets to be currency or money. On its own, owning and using cryptoassets is not illegal in the UK and does not imply tax evasion or any other illegal activities.
Derivatives Over Cryptoassets
A derivative is a financial instrument where the performance is based on the movement of the price of the underlying asset. Under a derivative the holder does not hold the underlying asset. Some businesses offer the ability for individuals and companies to gain exposure to the movements in the cryptoasset market by using a derivative.
The nature of a derivative is typically very different to directly holding a cryptoasset. In particular, a derivative will give rise to contractual rights and obligations between the two parties. Where a business enters into a derivative over a cryptoasset this will typically constitute a ‘derivative contract’
Distributed Ledger Technology
Distributed Ledger Technology (DLT) is a digital system that records details of transactions in multiple places at the same time. Unlike traditional databases, distributed ledgers have no central data store or administration functionality. The ledger acts as an immutable record of all the transactions that have happened within the network previously.
Due to its secure nature, the concept of DLT is generating interest in many sectors including banking and fintech. A well-known application of DLT is the Bitcoin blockchain, which acts as a public record of all the transactions that have ever taken place
Exchanges And Exchange Fees
An exchange is an online platform where people who wish to own cryptoassets can:
• exchange their fiat (government backed) currency for a particular token;
• exchange tokens for other tokens; and/or
• convert tokens into fiat currency
There are a large number of exchanges offering a range of services. They can be:
• custodial (offering a wallet as part of their service), or
• non-custodial (not offering a wallet).
Using an exchange usually involves creating an account, which is a contractual agreement based on specific terms and conditions. Account holders can then propose/request and undertake transactions via the exchange.
The exchange will try to complete these transactions by matching the account holder’s requested transaction with the requested transactions of other account holders. The exchange may hold some tokens and/or fiat currency itself to execute transactions and act as a ‘market maker’ in a limited sense.
Exchange fees are an important area when considering a person’s tax position. It is necessary to consider the relevant tax as the rules for deductions for miscellaneous income and capital gains tax are restrictive. There are different types of exchange fees:
• Deposit fees are charged when fiat currency is deposited with the exchange. There may also be conversion fees if the fiat currency isn’t supported by the exchange.
• Trading fees are the predominant income source for exchanges. These will normally form a percentage of the trade being requested and will be payable regardless of whether the trade is to acquire or dispose of tokens.
• Withdrawal fees may be applied for withdrawing fiat currency but may also apply to the withdrawal of tokens.
A person may only be entitled to a deduction for a minority or even none of the exchange fees depending on the type of fees incurred.
Proof Of Work And Proof Of Stake
Many cryptoasset networks are not controlled by a single body or person. Typically, the network of users of a specific token play a role in verifying transactions or making technological changes.
This mechanism is often referred to as a ‘consensus’ because a sufficient proportion of the network must agree to a transaction or technological change before it can go ahead.
For example, if A wishes to send 500 tokens to B, it must first be verified that A does indeed hold that many tokens. If the network agrees that this is the case, the transaction is added to the distributed ledger.
Proof of Work – The most well-known consensus system is Proof of Work, which is used by Bitcoin (amongst others). Here, the right to add a new entry to the distributed ledger is only available to the first person to solve a randomly generated complex cryptographic puzzle. That person then creates the new entry and it is shared with all holders of the distributed ledger. The time and energy required to solve the puzzle is the proof of work, the right to add the entry is the primary reward. The person with that right will be entitled to any fees available for including transactions in that entry and they will be allocated with a quantity of new tokens that are released into circulation. This process is known as ‘mining’ and serves to maintain the network of a given cryptoasset.
Proof of Stake – This has developed as an alternative to Proof of Work due to the significant amount of energy and computing power that system requires. Under Proof of Stake, the ability to create a new entry is determined by a user’s wealth in the cryptoasset (or ‘stake’) rather than them having the computer power to solve a puzzle before anyone else does. Here, those verifying transactions are rewarded with fees for facilitating the transaction instead of any new tokens.
Encryption keys are a vital aspect of cryptography. They make a message, transaction or data value unreadable for an unauthorised reader or recipient, so it can only be read and processed by the intended recipient.
Exchange tokens rely on a public and private key system:
• The private key is a randomly generated string and is used to authorise a transaction involving tokens held at a public address.
• A public key is mathematically generated from the private key, linking the two keys cryptographically.
For all practical purposes, a private key cannot be generated from a public key.
The public address is shared across the Distributed Ledger (DL). Anyone who knows that address can look at the DL and see all transactions to and from the public address. Any person who knows the public and private keys can authorise transactions involving tokens held at the relevant public address.
If a private key is lost, the tokens will continue to exist at the public address. However, the ‘owner’ would be unable to undertake any transactions in respect of those tokens. If private key details were kept only on a computer which was subsequently destroyed, then the tokens would be unreachable, although they would continue to exist.
A cryptoasset wallet is a user interface where the private key is stored. There are two main types of wallet: cold wallet and hot (sometimes called ‘software’) wallet.
A cold wallet refers to a wallet that is not accessible via an internet connection. Examples of a cold wallet include:
• Hardware wallets – store key details offline on a piece of hardware such as a simple USB drive. It is possible to purchase hardware devices with the wallet already installed on them. More advanced versions of hardware wallets have additional security functions.
• Paper wallets – where the information of the private and public keys is simply printed or written on paper. This means it is always offline and its location known only by the holder.
A software wallet is one that is accessible via the internet. It can be further divided into online wallet and client-side wallets.
• Online wallets may be offered by cryptoasset exchanges as part of their services. They can be held on a server in a specific geographical location, on a cloud or the storage may be contracted out to a wallet provider. In this case the platform holds and controls the public key and private key.
• Client-side wallets are also known as desktop wallets. They are managed locally on a user’s computer or mobile device.
Some token owners memorise their keys and do not use a wallet. Some people may also only store their private key as it is possible to reproduce the public key from that private key. In essence, anything that can store data could become the wallet. Where a wallet exists, it is the ‘container’ for the keys, the wallet/keys can be duplicated and the loss of a wallet does not affect the existence of the tokens themselves.
Records You Must Keep
Cryptoasset exchanges may only keep records of transactions for a short period, or the exchange may no longer be in existence when an individual completes a tax return.
The onus is therefore on the individual to keep their own records for each cryptoasset transaction.
Records of cryptoassets can be:
• paper (cold) wallets containing the individual’s public and private keys
• electronic (hot) wallets on devices
• other records of their transactions and balances such as downloads of their wallet activity from a cryptoassets exchange
• hardware (cold) wallets looking like a USB, containing the individual’s public and private keys.
Cryptoassets are digital assets and as such all records in a wallet should show balances and transactions, either in full or via reference to a public blockchain. The individual’s access to fiat currency could come from:
• the point of deposits into a bank account; and
• use of a cryptoasset Automated Teller Machine (ATM)
These are records which should also be kept and produced for an enquiry. They form part of the audit trail from acquisition to disposal and therefore evidence of any gains made.
Cryptoasset transactions usually occur on a public blockchain (see CRYPTO10200), so can be viewed digitally and checked using records obtained from a wallet. A link to an open source blockchain transaction and acknowledgement of the individual owning the public key involved in the transaction is a record as is a download from their wallet provider or exchange.
Cryptoassets are obtained, administered, exchanged, used and linked to fiat currency electronically or digitally. It is therefore reasonable to request electronic records with full details of transactions and any supporting valuation records for the acquisition and disposal tax points.
Cryptoasset exchanges may only keep records of transactions for a short period, or the exchange may no longer be in existence when an individual completes a tax return. The onus is therefore on the individual to keep their own records for each cryptoasset transaction, and these must include:
• the type of cryptoasset
• date of the transaction
• if they were bought or sold
• number of units involved
• value of the transaction in pound sterling (as at the date of the transaction)
• cumulative total of the investment units held
• bank statements and wallet addresses, in case these are needed for an enquiry or review.
Which Taxes Apply To Businesses?
If a company or business is carrying out activities which involve exchange tokens, they are liable to pay tax on them. Such activities include:
• buying and selling exchange tokens
• exchanging tokens for other assets (including other types of cryptoassets)
• providing goods or services in return for exchange tokens
The type of tax will depend on who is involved in the business and the activities it carries out (including whether these activities count as a trade). It is likely they will be liable to pay one or more of the following:
• Capital Gains Tax (CGT)
• Corporation Tax (CT)
• Corporation Tax on Chargeable Gains (CTCG)
• Income Tax (IT)
• National Insurance Contributions
• Stamp Taxes
The amount of tax a business must pay will depend on its income, expenditure, profits and gains. These must be declared annually to HMRC on either a:
• self-assessment tax return (for individuals); or
• company tax return (for companies).
HMRC will consider each case on the basis of its own facts and circumstances. It will apply the relevant legislation and case law to determine the correct tax treatment (including where relevant, the contractual terms regulating the exchange tokens).
Use Of Bitcoins For Acquiring Goods Or Services
Out Of Scope: No VAT should be levied on the value of the bitcoins themselves.
Supplies Of Goods Or Services, Subject To VAT, Remunerated InBbitcoins
Taxable: The supply of goods and services, subject to VAT and remunerated by way of Bitcoin, would for VAT purposes be treated in the same way as any other supply. VAT should therefore be levied on the goods or services provided.
Services Supplied By Digital Wallets
Out of scope: A large majority of the services supplied by digital wallet providers are free of charge, which sees these transactions falling outside the scope of VAT.
Taxable: If, however, some digital wallet providers ask for payment of fees in exchange for their services, it seems that the transaction would be taxable.
Exempt: Such services could however be seen as exempt pursuant to Article 135(1)(e) of the VAT Directive, on the grounds of them being transactions directly concerning currency.
Not exempt: It seems that services supplied by digital wallet providers could not be exempt pursuant to Article 135(1)(d) of the VAT Directive.
Out of scope: The fact that the payment of a transaction fee by a Bitcoin user is not a necessary condition for successfully sending bitcoins (and thus for receiving a verification service supplied by the miner) may be indicative of there not being a direct link between the consideration and the service.
Besides, the provision of a mining service does not create for the miner the right to receive a consideration in exchange, which could imply the non-existence of a legal synallagmatic relationship between him and the recipient of the verification services (the user whose transaction request the miner has validated).
Taxable: New bitcoins received automatically by the miner from the Bitcoin system every time that a verification service is supplied could possibly be seen as constituting a consideration for a taxable service.
Despite the fact that Bitcoin transactions carried out for free are in theory possible, in practice Bitcoin users pay fees (used as a default by most digital wallets); and it seems almost impossible to imagine users would be willing to wait days or weeks, before a transaction is verified (which could be the case if no fee is paid).
Exempt: Mining activities could be seen as exempt pursuant to Article 135(1)(e) of the VAT Directive, on the grounds of them being services directly concerning currency.
Exempt: Mining activities could be treated as exempt pursuant to Article 135(1)(d) of the VAT Directive on the basis of them fulfilling in effect the specific, essential functions of an exempt supply (the transfer of bitcoins itself).
Services Related To Intermediation Supplied By Exchange Platforms
Taxable: Services for consideration supplied by exchange platforms acting as intermediaries would be taxable.
Not exempt: Exchange services could not be seen as exempt pursuant to Article 135(1)(e) of the VAT Directive.
Which Taxes Apply To Individuals?
In the vast majority of cases, individuals hold cryptoassets as a personal investment, usually for capital appreciation or to make particular purchases. They will be liable to pay Capital Gains Tax when they dispose of their cryptoassets.
Individuals will be liable to pay Income Tax and National Insurance contributions on cryptoassets which they receive from:
• their employer as a form of non-cash payment
• mining, transaction confirmation or airdrops
There may be cases where the individual is running a business which is carrying on a financial trade in cryptoassets and they will therefore have taxable trading profits. This is likely to be unusual, but in such cases Income Tax rules would take priority over the Capital Gains Tax rules.
Buying And Selling Is Not Gambling
HMRC does not consider the buying and selling of cryptoassets to be the same as gambling. The term ‘gambling’ is not defined in the Income Tax or Corporation Tax Acts, or in the Taxation of Chargeable Gains Act 1992.
Whether a transaction can be characterised as betting or gambling is a question of fact. It will be down to the caseworker to consider the particular facts of any transaction involving cryptoassets and conclude whether that transaction had the character of betting or gambling.
Author Monty Jivraj is Head of Tax Disputes and Investigations and has worked with individuals and business in the UK for twenty years to help them understand tax laws and save millions of pounds. His business operations background allows him to quickly understand your business model and how the UK and EU tax laws apply to you.
Through extensive work with Her Majesty’s Revenue and Customs (HMRC), he can easily translate and advise on complex HMRC policies, public notices, decisions to deny input tax, fraud investigations and tax assessments.
At Silver Shemmings Ash, we provide seminars and training alongside our core activities in contentious and non-contentious matters. The purpose of these is to facilitate a greater knowledge and understanding of construction and property law. There remains a considerable lack of training in such areas for companies and this is an issue which we are looking to address
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