While Bitcoin continues to grab the headlines, the cryptocurrency sector now takes in literally thousands of different digital assets. Even though Bitcoin dominates the sector, making up circa 40% of the market, more than 12,000 Altcoins are available. This is a phrase used to describe cryptocurrencies other than Bitcoin, with Ethereum the most recognised Altcoin. Even though many people will be aware of the Bitcoin image (the gold coin with the B in the centre), these are digital assets and do not physically exist. Consequently, how to tax cryptoassets and cryptocurrencies is proving a challenge!
The emergence of Bitcoin
The 22nd of May 2010 will be forever etched in the history of cryptocurrencies, the first commercial transaction. This was the day when computer programmer Laszlo Hanyecz spent 10,000 of the Bitcoins he had been “mining”. He purchased two pizzas from Papa Johns for a combined value of $41, with each Bitcoin worth $0.0041. At the current price of $62,000 per Bitcoin, today, the transaction is valued at a staggering $620 million. An expensive couple of pizzas!
The price of Bitcoin has been highly volatile, currently just off its $66,000 high reached on the 21st of October 2021. It is easy to assume that Bitcoin and other cryptoassets have been around for some time, but they have only been in the public domain for just over a decade. Until recently, these currencies were effectively ignored and rejected by mainstream regulators. Consequently, governments worldwide are now playing catch-up about both taxation and regulation of the cryptoasset market.
Regulating cryptocurrency markets
While the Financial Conduct Authority (FCA), the leading financial regulator in the UK, has been monitoring cryptocurrency markets for some time, it was only recently appointed regulator to the many cryptoasset firms operating today. The FCA banned the sale of crypto derivatives to retail customers in October 2020. Then followed a dire warning in January 2021; those investing in cryptocurrencies should be prepared to “lose the full amount of their investment”. This was the beginning of a concerted campaign amongst international regulators to rein in the power of cryptocurrencies, setting the ground for future taxation.
Then crypto platforms were forced to apply for FCA approval to operate in the UK. Under the guise of money-laundering and antiterrorism regulations, all crypto platforms will need to be FCA approved going forwards. As of June 2021, only six out of dozens of firms have received FCA approval, with 64 applications recently withdrawn. It would appear that many cryptocurrency platforms don’t currently conform to international anti-money-laundering standards. We recently saw the high profile quasi-ban on the Binance crypto platform, with the FCA banning the transfer of funds from UK regulated banks to the trading platform.
First came denial, regulation and now taxation
The emergence of leading products and services has often left regulators struggling to keep pace. We saw the same process when electronic cigarettes first emerged, denial, regulation and now taxation. The first two stages have been completed for cryptoassets/cryptocurrencies, and now HMRC is taking a greater interest.
The Financial Times reported that HMRC plans to send crypto investors what are known as “nudge letters”, encouraging them to check they have paid the correct tax on their cryptoassets. Receipt of such a letter does not necessarily mean you have underpaid your tax but is a subtle warning that the authorities are watching. There is a widespread belief within HMRC that large amounts of capital gains tax and income tax, related to cryptocurrency investments, haven’t been declared.
Through a publically available Freedom of Information request, we know that HMRC is targetting cryptoasset platforms in the UK and those on the international scene. Under their existing powers, HMRC has gathered information on crypto investors for the tax years 2017/18, 2018/19 and 2019/20. The information obtained includes the names and addresses of individual investors and the value of cryptoassets they hold.
When dealing with traditional banks, details of the sender and receiver of funds are noted and recorded. Transactions in cryptoassets are traded on a peer-to-peer basis under the blockchain system which records all movements. While this creates a very secure validation system, there is an element of anonymity to these blockchain transactions. However, additional details gleaned from the cryptoasset platforms fills in the gaps. This has been one of the significant regulatory concerns, money laundering and the movement of terrorist-related funds on a quasi-anonymous basis.
Taxing cryptoasset profits
As of September 2021, it is believed that more than 2.3 million people in the UK own a cryptoasset. As these assets don’t physically exist, HMRC has been forced to issue guidance stating that cryptoassets will follow the residence of the beneficial owner. So, if you live in the UK and trade cryptoassets, no matter where these assets are “held”, you will be liable to UK taxes. However, there is a growing belief that this guidance may well be challenged in the courts. This could impact future HMRC tax income from those not domiciled in the UK for tax purposes.
As a rule of thumb, profits from the trading of cryptoassets will fall under the capital gains tax system. In certain circumstances, where HMRC recognises a “sophisticated, frequent, and organised” investment operation, this could lead to income tax liabilities. When it comes to inheritance tax, the situation is even more confusing. Under current regulations, only assets “located” in the UK are subject to inheritance tax where the deceased held a foreign domicile. However, as cryptocurrencies are not physically located in the UK, there may be some legal challenges in the future. Those domiciled in the UK will still be liable to inheritance tax on all of their assets, both UK-based and overseas.
Regulators struggling to catch up
The current regulatory structure in the UK allows the FCA to regulate those operating in the cryptoasset market, but not cryptocurrencies as such. In effect, it is the same, recently demonstrated when the FCA banned UK banks from transferring funds to the Binance cryptoasset platform.
The emergence of HMRC plans to send out “nudge letters” is a subtle reminder that cryptoassets and cryptocurrencies, in particular, are on their radar. They are effectively allowing investors to “review” recent tax returns to see whether cryptoasset profits have been included. Failure to make the relevant corrections could be deemed a form of tax evasion and lead to significant penalties. In what is effectively a two-pronged attack, international regulators are clamping down, and the tax authorities are inviting individuals and companies to “correct” any previous submissions. Subtle, but so far effective, will we see any legal challenges?