In this article, we’ll look at cryptocurrency as an object of civil law and financial regulation, and how fundamentally important it is to create crypto taxation guidance.
The Nature of Cryptocurrency Taxation
Regardless of what one might think about whether it’s good or bad, blockchain technology can be viewed as a milestone and a fundamentally new stage in the development of technology and the economy. Market capitalization of decentralized digital technologies is growing steadily, and the list of types of products and services offered by relevant firms is growing in large-scale flows, as confirmed by market players. Of course, processes related to finances are always on the radar of governments, which control fiat money and establish appropriate “rules of the game” in financial markets with varying degrees of interference. This depends primarily upon the political regime in power. In the context of the wide adoption of digital money, issues related to legal regulation and taxation of cryptocurrency are about to reach the next level.
The main points to be investigated in connection with adoption of blockchain technology in financial markets include:
- identifying the tax base and taxpayers in terms of transaction anonymity
- taxation of income received as a result of mining virtual currency, and confirmation of transactions within the system.
Application of specific crypto taxation models and corresponding tax regimes has arisen in response to the evolving legal definition of virtual currency, and, as a result, the development of an approach to determining the tax basis for transactions in Bitcoin. It should be noted that approaches to the issue of cryptocurrency taxation vary depending on the legal status and the jurisdiction in which the taxation model was formed. For example, extending the value-added tax to cryptocurrency depends upon the recognition of property and currency status.
When qualifying crypto from a legal point of view, keep in mind that the foundation of crypto taxation can be found in its economic and legal definition. Today, there is no universal approach to a definition of cryptocurrency. This complicates not only the legal regulation of cryptocurrency globally but also any actual scientific discussion of this topic.
Many countries are now analyzing the possibility of recognizing cryptocurrency as equivalent to cash, foreign currency, and electronic money as an object of obligation rights. As a result, it should be accepted by legislature and law enforcement agencies as digital (virtual) currency, the creation and control of which is based upon cryptographic methods (mathematical algorithms) in relation to full decentralization (the absence of an external or internal controller in the network, which guarantees/confirms correctness in system operations, including the inability to influence participant transactions.
Note: transaction reliability is ensured in the network by blockchain technology (distributed database), the algorithms of which allow you to combine transactions into blocks and add them to the chain of existing blocks to ensure the invariability of the transaction chain via cryptography and sequential hash elements. Continuity is ensured by including the hash sum of the previous block in the current block, which does not allow changes without altering hashes in all subsequent blocks. Mathematical calculations act as a certain value in the physical world.
The key point in determining the tax/legal nature of cryptocurrency is determined by the official positions of tax authorities in states where circulation is not fundamentally prohibited. For example, the tax services of a number of countries, including Australia, Great Britain, Norway, Singapore, and the U.S., have prepared explanations for the way they formulate approaches to taxation issues in relation to Bitcoin.
Currently, with the availability of digital infrastructure, economic agents have the opportunity to engage in real economic activity involving private currencies. These are issued, as a rule, according to cryptography methods, and do not have status as legal tender in any state.
Novel Tool for Investments
Cryptocurrency is becoming a highly profitable asset. Any non-professional investor can increase his/her profit several times over since cryptocurrency is defined according to the following qualities:
- Manufacturability and ease of management
- Democratic entry into the market (valuable for beginners and those without large financial resources)
- The presence of various income-generating strategies
- The ability to create completely passive income
- Lack of reference to any specific territory
In the eyes of the community, these circumstances distinguish cryptocurrency investments from bank deposits and other classic financial instruments, the management of which requires competency, experience, and/or connections. As a result, the purchase and sale of cryptocurrency allow economic agents to increase invested capital in a short time and create a source of passive income.
Based on the supranational nature of cryptocurrency, it can be assumed that there exists a certain jurisdiction with a reasonably low tax burden within which a number of taxes cannot be levied, at least regarding the creation of new units of cryptocurrency. The anonymity of users makes crypto an analog of offshore companies, and despite its essentially different nature (crypto is attractive because of low transaction costs, and tax evasion is not a factor), the risk of erosion of the tax base due to cryptocurrency is even higher. This is due to the fact that it is not dependent on financial intermediaries or banks. Cooperation with these entities currently empowers tax authorities to collect data on capital flows.
In many countries, the first initiatives to introduce cryptocurrency in the legal field were put forward in the exact context of tax regulation and tax administration before the authorities officially recognized its status. The issue of crypto taxation in the U.S. was brought up for discussion back in 2007, and in 2013, the U.S. Audit Chamber (GAO) recommended informing taxpayers about the need to pay taxes with Bitcoin. In 2014, the IRS issued guidance regarding its regulation, and in October 2019, it addressed updates.
Gradually, the scientific community is coming to the conclusion that crypto-entrepreneurship is an income-generating and taxable business.
Conceptual Approaches to Crypto Taxation
In tax theory, it is generally accepted that the process of generating income should be taxed by direct taxes. Regarding indirect taxation, there is a trend in developed countries towards recognizing an exemption from VAT, but as for the direct taxation, there is no unanimous agreement on what the approach should be. Nevertheless, the following tax approaches to crypto have evolved:
- Issuing and receiving cryptocurrency can be recognized as receiving taxable income, which is taken into account at fair market value regardless of sales (U.S., Spain, Japan, Israel) followed by taxation of capital gains
- Establishment of a tax-free minimum for activities “for personal use” (Sweden, France, Australia)
- Recognition of the taxable object of capital gains only when exchanging cryptocurrency for fiat money and establishing benefits in case of long-term investment or small transaction volume (Germany, Singapore, Brazil). It is important to note that financial authorities have not formed a cohesive approach to taxation of cryptocurrency in countries where mining is most profitable, according to Bloomberg. This takes into account factors like the cost of electricity, ease of doing business, availability of renewable resources, average Internet speed, and the average annual temperature (Canada, China, Switzerland, Russia).
What Awaits Us in 2020?
All forecasts are based upon deep analysis of the past. If we want to know how crypto regulation activity is going to proceed, we need to look back at previous years. For now, we can say that it’s all starting to get serious. Let’s consider the cases of BitFunder and Arise Bank.
BitFunder Wallet Trap
The U.S. Securities and Exchange Commission filed a lawsuit in connection with the BitFunder case on February 21, 2018. The SEC requested that the Manhattan Federal District Court prohibit activity from this crypto exchange, and obliged its CEO, John E. Montroll, to return funds received as a result of transactions.
The SEC accused BitFunder of trading valuable securities without proper registration (which means it operated without paying taxes) and making false statements when publicly offering assets. One of the main accusations concerns failure to disclose the theft of more than 6,000 Bitcoins as a result of a cyber attack. According to a statement filed with the court, the charge of misappropriation of cryptocurrency is based upon the fact that platform users deposited crypto directly into Montroll’s crypto wallet, where they mixed with the cryptocurrency of Montroll itself. At the same time, only Montroll retained control of the crypto wallet. To maintain sufficient currency in that wallet, Montroll used the funds collected within the framework of the ICO he conducted, which, according to the SEC, was contrary to the stated fundraising goals. Also, funds from the cryptocurrency wallet were used to cover Montroll’s personal expenses.
The fact that BitFunder did not disclose the use of a “common” cryptocurrency wallet allowed Montroll to hide the cyber attack. In general, the model was beneficial for investors, since Montroll carried the risk of loss. Nevertheless, the cyberattack did not pass without a trace: The resulting cryptocurrency deficit led to difficulties in withdrawals from the wallet by users. Montroll made public statements on this subject, saying the problem was technical in nature. Through BitFunder, Montroll publicly offered tokens for sale that qualified as securities (through listing). The platform was originally created for fundraising and issued tokens secured by enterprise assets endowed with share functions.
At the same time, in the AriseBank case (see below), the SEC wasn’t stopped by the fact that investments, in the respondent’s opinion, were private. In the interpretation of Montroll, funds were a “personal loan with an investment purpose,” but this statement contradicted the fact that some of the funds were used to replenish Montroll’s crypto-wallet and satisfy his personal needs. The BitFunder case is only one special case amid general regulator concern about the security of funds transferred to crypto exchanges.
Arise Bank Case
According to a statement published on the SEC website, on January 30, 2018, the regulator received a court order for suspension of the ICO held by Arise Bank starting in November 2017. For this, it first turned to the interim measure of asset freezing. To protect investors, a manager was appointed and vested with powers extending to digital assets (primarily, cryptocurrency received from investors).
Arise Bank announced $600 million in raised funds. The SEC suspected that the organizers of the project had raised funds for fraudulent purposes. АriseBank has positioned itself as a decentralized bank that provides banking services to consumers using more than 700 cryptocurrencies. As indicated in the advertisement, the project was to create an application for automatic cryptocurrency trade. The difference in this business model was that daily income from the application was assigned to users in the form of a special cryptocurrency that was not identical to the AriseCoin cryptocurrency sold through the ICO. The SEC claims were based on the assumption that numerous AgiseBank statements made during the marketing campaign were knowingly false. Among AriseBank statements that attracted the attention of the SEC, the following should be noted:
- The project’s acquisition of a “bank with a 100-year history” in support of the fact that investor accounts would now be insured under the federal deposit insurance program. In fact, the Federal Deposit Insurance Commission had no information on bank participation in this program.
- An agreement with the VISA payment system confirming that customers would receive bank cards for this payment system (there has been no such agreement as of yet.)
- A lack of information about their criminal past in biographies of project organizers posted on the website and in the white paper. In addition, AriseBank was not authorized to conduct banking operations in Texas and was not insured by the FDIC. An important point is how AriseBank tried to defend itself against SEC claims. The company referred to the fact that it created an autonomously-functioning network of private investors, and did not raise funds from a wide audience. This thesis did not receive a rebuttal, but also did not affect the actions of the SEC. Now, two executives of the scam ICO must pay a $2.7 million penalty.
As we can see, the IRS and the SEC take regulation of the crypto industry very seriously. However, as of today, they have not provided robust guidance on how to define the cost basis of certain crypto transactions or instructions on whether their initial coin offering qualifies as a securities offering.
The process of mapping the future of crypto taxation is still underway, and in 2020, we envision some interesting trends in this area. Currently, there are 2 main bills around the topic being discussed in Congress: The Cryptocurrency Act of 2020, introduced by Congressman Paul Gosar (R-AZ) in December 2019, and the Virtual Currency Tax Fairness Act of 2020, introduced by Congresswoman Suzan Delbene of Washington and Congressman David Schweikert of Arizona. The first seeks to cover gaps in the definition of cryptocurrency and company players in the crypto market while defining which agencies are responsible for regulation and enforcement. The second aims to provide tax exemption for cryptocurrency transactions with calculated gains of less than $200. If this act is adopted, crypto owners won’t have to report their $5 cup of coffee to the IRS.
Based on these two legislative initiatives, we see a couple of trends developing in 2020:
- Further definition and categorization of cryptocurrency. The Cryptocurrency Act of 2020 defines cryptocurrencies, crypto commodities, and crypto securities.
- Clarifying which agencies are responsible for the regulation of each category, including licensing, certification, and registration required for issuing or trading or digital assets across markets. According to the Cryptocurrency Act of 2020, the Financial Crimes Enforcement Network (FinCEN) will control cryptocurrency, while the SEC will control crypto-securities. The Commodity Futures Trading Commission (CFTC) will deal with crypto-commodities.
There is a clear trend toward further refinement in terms of defining which types of transactions should and should not constitute a taxable event. In October 2019, the IRS issued new guidance in which it defined the tax status of hard forks. It looks like in 2020, there might be more news and exemptions. For example, the Virtual Currency Fairness Act of 2020 suggests exemptions for crypto transactions with calculated gains of less than $200.
Innovations have become a decisive factor, acting as an engine and incentive providing advantages to business entities that are able to correctly apply them. It is up to governments to decide whether these innovations will be beneficial for society or have a negative effect. Cryptocurrencies have a number of specific characteristics that are of interest to professional economists and stock market players.
Cryptocurrency is a revolutionary phenomenon of the digital economy that is igniting considerable interest in the private sector and serious regulatory concerns. Cryptocurrency is opening up completely new opportunities for entrepreneurial activity and investment. Its key characteristics are decentralization, anonymity, and cross-border capabilities. These qualities bring certain legal problems and risks for legal entities and individuals using Bitcoin, and also for the security of governments in general.
The trends that we see happening in 2020 mean two things for crypto investors:
- The U.S. government will continue its efforts to enforce crypto taxation, so if you haven’t filed your crypto taxes yet, do so by April 15.
- Further clarification and refinement of the rules, including new tax exemptions, will create more savings opportunities for crypto investors. However, this makes the process of crypto tax calculation more complicated: it will have to be automated to provide ease of use and reliability.
Originally published at https://medium.com on April 9, 2020.