The popularity and use of cryptocurrency is growing extremely rapidly, reaching all-time highs in 2021. Although there are arguments both for and against cryptocurrency, it is clear that crypto is currently the next “big thing.”
Cryptocurrency (Bitcoin in particular) has demonstrated its value, and in September 2021, El Salvador became the first country in the world to adopt Bitcoin as legal tender (alongside the U.S. dollar). Many other countries are developing or considering developing, their own cryptocurrency. The cryptocurrency market’s evolution toward mainstream acceptance and stable expansion will accelerate, due to the enthusiasm of key participants, namely traders and consumers, tech developers, investors, financial institutions and regulators.
However, the framework governing cryptocurrency investing continues to evolve from a tax, regulatory, due diligence and accounting perspective and regulators all over the world are struggling to develop and implement an effective tax policy. The Organization for Economic Cooperation and Development (OECD) is encouraging regulators to form uniform and effective cryptocurrency regulations.
Against this backdrop, this three-part article will discuss the basics of cryptocurrencies and the essential role of tax and regulations in the fast-paced transition to the crypto world, review key countries’ stance on cryptocurrency and digital assets issues, and consider the OECD’s outlook and recommendations and the way forward, both for nations and for global investors.
Basics of Crypto
Cryptocurrency is a digital or virtual money in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Most of the cryptocurrency network is operated on blockchain technology, a distributed ledger technology that allows multiple copies of data to exist across numerous computers, creating a peer-to-peer network.
Essential Role of Tax and Regulations in Fast-Paced Transition to the Crypto World
Given the increasing appeal of cryptocurrency, and its rising usage, it is inevitable that governments align their regulatory and tax frameworks.
Like most financial assets, cryptocurrencies and other digital assets are prone to price volatility and market manipulation. They need to be regulated so that the underlying assets, performance, risks, potential, etc, are disclosed. Also, the number of cryptocurrencies is increasing; thousands now exist around the world. It is the responsibility of regulators to protect customers by making information available to them.
Money laundering and cybersecurity risks are other reasons for regulators to ensure a proper, clear and enforceable framework.
Cryptocurrency taxation is a somewhat contentious topic across different regions. To date, there is no global standard as to whether to treat crypto as currency or property, what stages in the lifestyle of crypto are taxable, and what are the income tax, value-added tax (VAT) and other tax consequences.
Large economies, e.g., the U.S. and Japan, already apply their existing tax laws to the nascent technology. Regulators all over the world are struggling to frame an effective tax policy for virtual currency transactions. In October, 2020 the OECD issued a report (“Taxing Virtual Currencies: An Overview of Tax Treatments and Emerging Tax Policy Issues”) providing guidance and encouraging regulators to form uniform and effective crypto tax regulations.
Most governments want to monitor, regulate, and tax this space. The basic structure of a tax on cryptocurrencies is the same across the world. Simply put, taxable events are:
Trading crypto with or for fiat currency like the U.S. dollar—
- Bitcoin → dollar
Trading one type of crypto for another—
- Bitcoin → Ethereum
Spending crypto to purchase goods or services—
- Bitcoin → Goods or services
Earning crypto as income in exchange for mining or staking, exchanging one NFT for another—
- Bitcoin → Bitcoin wallet
No taxable event gets triggered in cases of:
- buying and holding crypto;
- transferring crypto from one wallet you own to another wallet of yours (e.g. sending Ethereum from MetaMask to a hardware wallet);
- transferring the same cryptocurrency between exchanges (e.g. sending Bitcoin from Coinbase to BlockFi);
- receiving cryptocurrency as a gift (the recipient does not trigger a taxable event until the cryptocurrency is exchanged for the fiat currency, although gift tax regulations may have to be considered);
- donating cryptocurrency to a qualified charity or not-for-profit organization (subject to donations regulations).
The characterization of crypto assets is important for capital gains tax purposes, as well as how the tax treatment of borrowing and lending of digital assets may be framed in the context of local laws.
With some deviation, most tax jurisdictions treat digital assets as a form of property, an intangible asset other than goodwill, or a commodity or financial instrument. Exchanges of cryptocurrencies in payment for goods, services, or wages are also treated as a taxable event in almost all countries.
Only a few countries consider virtual currencies to be analogous to fiat currency for tax purposes, namely Belgium, Cote d’Ivoire, Italy, and Poland. Further, only a few states subject crypto asset holdings to property taxes, transfer taxes, wealth taxes, or estate taxes.
The VAT treatment of virtual currencies is more consistent across countries than their income tax treatment. Most countries mirror the approach adopted in the EU, where exchanges of virtual currencies for fiat currency/other virtual currencies are not treated as a taxable event for VAT. Where a consumer pays for goods and services with virtual currencies, the underlying supply of goods or services is subject to the normal VAT rules (i.e., EU member states do not treat the purchase of goods and services with virtual currencies as a barter event but as a taxable sale.)
The following case study (which is based on compliance with U.S. tax laws and regulations) illustrates the issues surrounding the taxability of cryptocurrency transactions.
To determine taxability, the very first step is to know if you owned or used or traded crypto during the year. If you simply own it, there are no tax implications as such. It is like stock that one buys and holds. Similarly, if you do not exchange the cryptocurrency for something else, you have not realized a gain or loss; hence no taxability. Typical taxable transactions include:
- cashing out of cryptocurrency, i.e., exchanging cryptocurrency for fiat money;
- paying for goods or services;
- exchanging one cryptocurrency for another cryptocurrency;
- trading in a similar way to stocks;
- receiving mined or forked cryptocurrencies.
For example: A has a cryptocurrency (say Bitcoin) that it purchased when it was worth $10,000 and is now trading at $15,000.
- If A cashes out the cryptocurrency for fiat money (say U.S. dollars) the difference between the price realized on the sale and the purchase price is taxable as a capital gain. In this case, $5,000 will be the capital gain. It will be taxed as a short-term capital gain if the virtual currency was held for one year or less (before it was sold or exchanged), or as a long-term capital gain if it was held for more than one year. The holding period begins on the day after the virtual currency is acquired and ends on the day it is sold or exchanged.
- If A buys a laptop worth $3,000 with its cryptocurrency, then the excess of the price paid for the laptop over the base price of the Bitcoin will be taxable. Here, if we assume the base price corresponding to this payment is $2,000, then the excess of $1,000 will be a capital gain (short-term or long-term). Furthermore, any taxpayer who receives cryptocurrency as payment for goods or services must include the fair market value (FMV) of the cryptocurrency in its reported taxable income. So, for the seller of the laptop, it would be recognized as business/ordinary income.
- If A buys Ethereum with the Bitcoin, then it is effectively selling Bitcoin. A will be taxable on the difference between Bitcoin’s price (i.e., the purchase price) and what A paid to buy the Ethereum. In this case, a new cryptocurrency, Ethereum, is added whose base price (relevant for future transactions) will be the purchase price paid on this date.
- If A trades in cryptocurrency and engages in multiple transactions during the year then one of its biggest challenges will be working out its tax position. It can be surprisingly onerous to track base costs, note effective realized price, and then compute taxes. Stockbrokers are required to issue Form 1099 statement for stocks, interest and other payments, but cryptocurrency brokers are not required to issue Form 1099s to their clients. Traders are still required to disclose all transactions to the Internal Revenue Service (IRS) or face tax evasion charges. Many exchanges or platforms (such as TrustVerse, Bitcoin.tax) help crypto traders keep all this information organized by offering to export all trading data, record and categorize it appropriately, and highlight relevant points of tax interest. Practically, however, it is not as simple as it sounds to determine their tax burden. The IRS mandates information regarding investment description, quantity of investment, date and price of purchase, date and price of sale, holding period, FMV of the virtual currency, as well as the gain (or loss). Downloading the data from the cryptocurrency platform and aggregating it into the required reporting format with the income tax return requires real expertise.
- Mining is a different story. If a taxpayer successfully mines a cryptocurrency, the FMV of the coins mined (on the day awarded on the blockchain) is included in its gross income. This amount also becomes the base price of the coins going forward and is used to calculate the miner’s future gains and losses. Furthermore, an individual whose mining operations constitute a trade or business (i.e., they can be described as work with the term “proof of work”), may be able to deduct the expenses incurred in the course of running the mining operations.
A few points to note:
- A de minimis election exempting small transactions: If the tax code has a de minimis election which allows the exclusion of certain amounts per transaction for personal purchases, etc., that needs to be considered carefully, especially if A is constantly trading crypto and also using it to buy goods and services.
- For cryptocurrency which is not traded on any cryptocurrency exchange and does not have a published value, the FMV of the cryptocurrency received is equal to the FMV of the property or services exchanged for the cryptocurrency when the transaction occurs. Nonetheless, more guidance is required for valuation issues regarding ascertaining the FMV at the time of the transaction and then subsequently tracking it.
- Losses: Losses need to be declared carefully. If a loss is to be carried forward as either long term or short term, the workings for prior years and future returns and losses need to be documented accordingly. Also, it is not clear if taxpayers can deduct virtual currencies in cases of theft/loss. As with the theft of other financial assets, if the virtual currency was acquired in a transaction entered into for profit, a theft/loss would be deductible if other requirements are met. Similarly, if a taxpayer has misplaced the private key or lost the password, there needs to be clarity about its deductibility as causality loss or if there is a loss due to failure of the cryptocurrency.
- Record: Determining which coins were used to buy the laptop, their base price and gains, and then repeating this for every purchase only gets more complicated if the buyer also trades coins frequently. It is therefore crucial to remember to keep all transaction information for each digital wallet and cryptocurrency.
- Holding periods are crucial and at times may be difficult to calculate. The IRS normally recommends specific identification methodology (sales need to be specifically traced to the purchases to determine holding period) or using a first-in-first-out (FIFO) methodology.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Anshu Khanna is a partner with Nangia Andersen LLP, a member firm of Andersen Global.
The author may be contacted at: email@example.com