It seems as though a day does not go by without a mention of cryptocurrencies in the news. Far from being at the fringes of our lives, and despite the recent volatility in value, they appear to be here to stay and become an integral part of our financial systems.
Not surprisingly, tax authorities are grappling with how cryptocurrencies should be taxed. The U.K. tax authority, HM Revenue & Customs (“HMRC”), has taken the bull by its horns, and published its long-awaited guidance on the taxation of individuals holding cryptocurrencies on December 19, 2018. The U.K.’s approach will be of interest to other countries that are yet to formulate their approach to the taxation of cryptocurrencies and it will be interesting to see how HMRC’s approach itself develops as cryptocurrencies evolve.
What Approach is the U.K. Taking?
HMRC’s approach to taxing cryptoassets is to use the existing tax rules and draw analogies with assets such as shares and securities, rather than introducing new bespoke legislation. The guidance provided is high level, and it is important to remember that the exact tax treatment will depend on the facts of the case.
This light touch approach is not surprising, given that the world of cryptocurrencies is evolving so rapidly. This flexible approach allows HMRC to deal with novel and difficult situations as they emerge.
Before going any further, cryptocurrencies are not considered a currency, but an asset by HMRC: it prefers to refer to them as “cryptoassets.”
A Brief Guide to Cryptoassets
For those not sure about “mining,” “forks” or “airdrops,” here is a very brief guide to cryptoassets.
These are digital representations of value or contractual obligations that are kept secure by cryptography.
They can be characterized as three different types of asset:
- exchange token—intended to be a method of payment and the value is based on its use as a means for exchange or services;
- utility tokens—owner of a token has access to goods or services;
- security tokens—the owner has an interest in a business such as a share in the profits.
Most cryptoassets use blockchain technology to keep them secure, which keeps a record of all that has happened with the asset. Cryptoassets are not subject to any government or central bank oversight.
This is where “miners” essentially verify transactions by solving complex problems. The miner gets a reward which is usually a new cryptocurrency.
This is where a token holder automatically receives additional tokens. There are many reasons for airdrops including a reward for being an early investor or as part of a marketing campaign.
A fork is an alternate version of a blockchain. Where there is a fork, two blockchains run on different paths simultaneously. There are number of reasons for a fork in a blockchain, which include fixing a bug or incorporating a new feature.
Will Buying and Selling Cryptoassets be a Trade or an Investment?
Generally, buying and selling cryptoassets will be considered a personal investment rather than a trade. Therefore, it will primarily be subject to capital gains tax (“CGT”) as opposed to income tax. HMRC will consider buying and selling cryptoassets to be a trade only in exceptional circumstances. Taxpayers will have to show a particular level of frequency, organization and sophistication in their dealing with cryptoassets to be trading.
The rules and case law surrounding trade in shares, securities and other financial products should provide a guide as to whether taxpayers are trading or investing in cryptoassets. Where there is a trade, taxpayers will primarily be subject to income tax.
Any fees received in return for mining will be subject to income tax.
Any cryptoassets that are received for successful mining will be subject to income tax on the value (in pounds sterling) at the time of the receipt. Where cryptoassets are retained and disposed of at a later stage, any gains will be subject to CGT.
Taxation of Airdrops
The taxation will depend on the circumstances of the airdrop.
Income tax may be due on the pound sterling value of the cryptoasset where:
- the taxpayer did something in return; and/or
- it was part of a trade or business involving cryptoassets or mining.
Disposal of Cryptoassets
Where there is a chargeable disposal of cryptoassets, CGT on the gains will be due. What constitutes a “disposal” is wide and includes:
- selling cryptoassets for money;
- exchanging cryptoassets for other cryptoassets;
- using cryptoassets to purchase goods or services;
- gifting cryptoassets.
There is a disposal and consequently a CGT liability from not only selling cryptoassets but also exchanging them for another currency—or buying a morning coffee with them.
When calculating the CGT due, the cost of the cryptoasset, advertising for a buyer or professional costs can be deducted. However, costs of mining activities such as electricity costs cannot be deducted.
Cryptoassets that are acquired and sold at different times can become an accounting nightmare, as is the case with shares. To simplify matters, as with shares, each type of cryptoasset that is disposed of will be pooled together for CGT purposes. This means that rather than having to undertake the difficult task of identifying exactly which cryptoasset was sold, from a number of cryptoassets purchased at different times with different base costs, the allowable costs are all pooled together. When there is a disposal of a cryptoasset, a corresponding proportion of the pooled cost will be deducted from the disposal value.
As with shares and securities, the “bed and breakfasting” rules also apply: this means that where the same cryptoassets are acquired within 30 days of disposal the original acquisition cost is used.
Finally, any losses can be used, but this has to be reported to HMRC first.
Where there is a fork and the cryptoassets are disposed of later (either the old or new tokens), the allowable costs for CGT purposes will be split on a just and reasonable basis. There is no particular method of apportionment indicated by HMRC, but it does have the power to inquire into any valuations if it does not think a valuation is just and reasonable.
Tax Implications for Losing the Key
Where a taxpayer loses the key, the corresponding cryptoasset is worthless, as it cannot be accessed. If the taxpayer can show that “there is no prospect of recovering the private key or accessing the cryptoasset,” a negligible value claim can be made. Where this claim is made, the taxpayer is treated as having disposed of and re-acquired the cryptoassets at a negligible value. The losses can then be used against other gains.
Taxation of Cryptoassets Received from an Employer
The value of the cryptoassets that are received will be subject to income tax (and where applicable) National Insurance contributions.
Unfortunately, there is no pensions relief for paying in cryptoassets to a registered pension scheme, as HMRC does not consider cryptoassets to be currency or money.
Cryptoassets are considered to be property for inheritance tax purposes.
International Element—Non U.K. Residents and Non U.K. Domiciliaries
How international individuals will be taxed is an interesting question. Where cryptoassets are located is a difficult question, that HMRC has not addressed in its guidance of December 19, 2018.
The issue of where cryptoassets are located for tax purposes is important. If the cryptoassets are situated in the U.K., they will be subject to U.K. tax even if an individual is not resident and not domiciled in the U.K. If the cryptoassets are not located in the U.K: (1) non U.K. domiciled and non U.K. resident individuals; and (2) non U.K. domiciled and U.K. resident individuals claiming the remittance basis will not be subject to U.K. tax.
- Cryptocurrencies are not considered to be a currency but an asset by HMRC and it prefers to refer to them as “cryptoassets.”
- Buying and selling cryptoassets is most likely to be subject to CGT rather than income tax as such activity will only be considered a trade (rather than an investment) in exceptional circumstances.
- A disposal for CGT purposes has a wide definition and includes selling, exchanging, using to purchase goods and services and gifting.
- Losses relating to cryptoassets can be used to offset other gains but the losses need to be reported to HMRC first.
- Cryptoassets are subject to inheritance tax.
- The difficult question of the situs of cryptoassets has not been addressed and remains an area that needs clarity.
Hilesh Chavda is an associate in the Private Wealth team at law firm Royds Withy King. He can be reached by email at: firstname.lastname@example.org