UK: An Introduction To Crypto

Last Updated: 13 September 2017
Article by Stephen Banfield

Interest in cryptocurrencies has grown significantly since the inception of bitcoin in 2009. Cryptocurrencies are widely regarded as the next evolution in financial services technology. They offer the promise of increased speed and accuracy in payment processing; greater access for the unbanked; and a detachment from centralised monetary policy. Trading in cryptocurrency has historically been dominated by speculators which has contributed to notorious price volatility. Institutional investors are starting to take note as this asset class matures and gains mainstream acceptance.

The increasing trading and applications of cryptocurrencies have given rise to a number of legal and tax issues. Many of these are yet to be satisfactorily resolved and regulators around the globe have thus far struggled to keep pace with the challenges posed by these rapid advancements in technology. Change is however sure to come and it is therefore important for investors and coin issuers alike to be properly versed on the implications as they arise.

First there was bitcoin....

Bitcoin is the first cryptocurrency to have been developed. It was originally introduced as a whitepaper in October 2008 by an anonymous person (or group of persons) going by the name Satoshi Nakamoto. The bitcoin blockchain is comprised of a series of blocks which record transactions between different addresses. The entire blockchain can be downloaded from the internet and any interested party may study it as they wish. It is possible to see how much bitcoin is held within each address, though there is no way of knowing exactly who controls each address. Bitcoins can only be moved from one address to another by authorising a transaction with a private key. These private keys are often printed by holders of bitcoin on a piece of paper or electronically stored on a thumb drive or a hardware wallet. This is known as the cold storage of bitcoin and may be compared to the 'hot wallet' that is created by opening an account with an exchange.

One of the conceptual underpinnings of bitcoin is that the value of the currency is not to be devalued by simply generating more coin. There will only ever be 21 million bitcoin unlike other fiat currencies which can be devalued by government monetary policy. Bitcoin transactions are not processed by a single entity – it is designed to be decentralised putting it further out of reach of any single regulatory or government authority. Independent parties compete to process transactions on the blockchain. This is the process of 'mining' whereby racks of computer services compete to be the first to solve a cryptographic puzzle and receive a block reward. This method of validation is known as 'proof of work' and can take hours rather than seconds to complete. It is only theoretically possible for any group of persons to rewrite the blockchain and undo past transactions given the amount of computational power which is required. This makes the blockchain accurate and highly resistant to internal fraud.

The dominance of bitcoin has been gradually slipping over the past few years as different cryptocurrencies have been developed. The second most valuable cryptocurrency by total market capitalisation is ethereum. A powerful feature of ethereum is the ability to deploy 'smart contracts' on its blockchain. The ethereum blockchain is able to perform computational functions which simply can't be done on the bitcoin blockchain. The real world applications of this technology are immense. It is able to bring together payments with a computational cause and effect; including linking with physical devices which can be instructed to perform a function once a transaction in ether has been confirmed. Another key feature of ethereum is that it is moving towards 'proof of stake' as the mode of confirming transactions. This will enable must faster validation as it relies on achieving consensus through a process of wagering rather than work.

There are now over 1,000 different types of cryptocurrencies. Many of these are not actually currencies in the true sense, and are instead tokens which grant usage, governance or other rights. A good example of this is the golem network token. Golem describes itself as a market for spare computing power. Users are able to rent out their idle computer processing power in exchange for golem tokens. The golem protocol brings together all this computing power to perform tasks (such as a CGI animation) in a manner which is an alternative to centralised cloud computer services. Anyone can buy golem tokens through a cryptocurrency exchange but, speculation aside, the real value of these tokens will increase if there is customer demand for the underlying product.

A murky history....

The anonymity of cryptocurrencies has made this the payment method of choice for criminals and dark web users. This anonymity can be further enhanced by 'tumblers' which causes a mixing of cryptographic funds to further obfuscate the original source and the addresses which may be involved in a transaction.

Perhaps the most famous example of this is the Silk Road which was an online marketplace for the trade of illicit drugs and weapons. When it was shut down in 2013, the FBI seized a total of 144,000 bitcoins from the site's founder. These bitcoins were later auctioned by the US Marshals Service as the proceeds of crime. More recently victims of the WannaCry ransomware attack were instructed to make payment in bitcoin to unlock their computers.

There have been some high profile cases of cryptocurrency exchanges being hacked resulting in significant losses. The Tokyo based Mt Gox exchange was the world's largest bitcoin exchange at the time it was hacked in 2014. Approximately 850,000 bitcoins were stolen which led to the exchange declaring bankruptcy. The Hong Kong based exchange Bitfinex was also hacked in 2016 losing over USD 70m of digital currency. Ethereum suffered a big setback in 2016 when ether raised by the Decentralised Ambiguous Organisation (DAO) was hacked. The DAO was established to sponsor the developments of applications to be run on the Ethereum blockchain. The transactions appropriating the funds raised by the DAO were reversed by a change to the Ethereum blockchain. Not all of the Ethereum miners agreed to the change in the blockchain (known as a hard fork) and it was effectively split into Etheruem and Ethereum Classic.

A frontier asset

The colourful history of bitcoin and other cryptocurrencies is one of the main reasons why this is still regarded as a frontier asset class. There is evidence that this is changing. There is an increasing amount of institutional investor interest and growing public awareness. It used to be the case that purchasing bitcoin required a level of computer proficiency beyond most people – generating a wallet address required downloading the blockchain and a cryptocurrency escrow provider was often used as a party to purchase transaction to prevent fraud. Now it is as simple as opening an account with one of the exchanges that will accept transfers of fiat currency.

Bitcoin has the highest level of vendor acceptance but it is still extremely low by comparison with fiat currencies. It is still many years away from being a substitute for the currency we use today. Most of the interest in cryptocurrency has come from speculators. This is a point made by the US Financial Regulatory Authority in their investor alert which carries the not-so-subtle title:_ "Bitcoin: More than a Bit Risky"._

Cryptocurrencies are renowned for extreme volatility and erratic private movements which has a lot to do with the heavy trading by speculators. The price of ether increased over 3,000% in the first half of 2017. Recently a flash crash which occurred on the GDAX exchange in which the price of ether plunged from US$320 to US$0.10 in less than a second due to a multi million dollar sell order being placed. The price of bitcoin is by comparison now fairly stable. It is akin to reserve cryptocurrency and is also used to price other cryptocurrencies. This creates a baseline level of demand and has contributed to bitcoin being seen as a store of value by investors.

Rise of the Initial Coin Offering

The rising popularity of cryptocurrency is evidenced by a rapid increase in 'initial coin offerings' (ICO). This is a funding structure whereby a new blockchain venture issues its own token to investors as opposed to traditional shares or debt. These ICOs are often structured as an exchange of ether or bitcoin for a pre-determined amount of the new token, but new and novel pricing mechanisms are starting to emerge. This includes the price discovery mechanism in the EOS ICO in which investors simply transferred ether for an unknown quantity of the EOS token. This ICO is one of the largest in history and raised USD 185m during the initial five day crowdsale.

The economic motivation behind participating in an ICO is slightly different from the purchase of debt or equity in a new venture. Investors will only realise an economic return if there is demand for the token itself which can come in the form of fevered speculation or from a real word business case. One of the reasons why the price of ether is said to have risen in recent times is the demand for investors purchasing ether to invest into ICOs.

Regulatory and tax considerations

State of cryptocurrencies

The regulatory status of bitcoin and other cryptocurrencies varies from country to country. The regulatory response tends towards a middling position – cryptocurrencies are generally not considered to be legal tender though it is also not illegal to conduct transactions using this form of payment.

The establishment and mining of cryptocurrency does not appear to run afoul of the right retained by the state to produce currency such as that found in Article 1 of the US Constitution, or existing counterfeiting laws. The US now publicly recognises a distinction between: 'convertible decentralized cryptocurrency' as opposed to currency plain and simple. A more cynical analysis would see this as an acknowledgement that the cat is well and truly out of the bag. The globally decentralized nature of cryptocurrencies makes it very difficult for these to be regulated out of existence by the unilateral action of one government alone.

The growing awareness and vendor acceptance of cryptocurrencies is leading to increased analysis of these issues by central banks and regulators. There are early signs that the pendulum seems to be swinging towards cryptocurrencies being brought within the regulatory mainstream. Earlier this year the Government of Japan amended the Banking Act to recognise bitcoin as legal tender. This brings with it a host of regulatory and compliance issues for cryptocurrency exchanges including money laundering and know your customer requirements. The desire to tackle money laundering is one of the reasons why Russia is considering recognising cryptocurrencies as a legitimate financial instrument with new regulations targeted for 2018.

Regulatory Issues

The general consensus position has been that a cryptocurrency token is not a 'security' for securities law purposes. This is particularly true for utility tokens which provide a network usage right, as compared to those which enable a share in the profits of the coin issuer. ICOs have to date been being conducted with comparatively light informational disclosures and none of the investor protection mechanisms which are common for a standard IPO or debt issue. The US SEC and the MAS in Singapore have however both recently stated that the issue of a token may come within existing securities law. Chinese regulators have also indicated an intention to regulate ICOs.

The trend toward government intervention is an investor protection response. There are many risks and information asymmetries for an investor participating in an ICO. It is common for sponsors to pre-mine a significant amount of the tokens which are issued and retain these as part of their incentive. Outside of a self-imposed escrow mechanism, there is nothing the sponsor of an ICO embarking on a pump-and-dump once the token is listed on a public cryptocurrency exchange (which can happen within days of an ICO). There is also the potential for price manipulation and trading on asymmetric information in a manner which would be insider trading if the tokens were securities.

In the immediate wake of the statements made by the US, Singapore and Chinese authorities, issuers are now starting to exclude investors from these jurisdictions participating in an ICO. There are a number of methods which are used. These include the creation of investor whitelists (some of which require proof of identification documentation) and geoblocking participants from these countries during the ICO itself. Issuers are also changing the features of their tokens so that they are less likely to be considered securities. Many of the large cryptocurrency exchanges are based in the US and they will not list a token for trading if in their view it is a security. An inability to list on major exchanges hampers liquidity and consequently the price of the token itself.

Income tax issues

There are a significant number of tax issues associated with the trading of cryptocurrencies. The United States Internal Revenue Service (IRS) issued guidance in 2014 addressing the treatment of cryptocurrency for US federal tax purposes. Cryptocurrency is considered "property" under the Internal Revenue Code, therefore transactions involving cryptocurrency have potential income tax, capital gains, and employment tax implications as well as possible information reporting obligations.

The IRS guidance highlights the following potential issues:

  • A taxpayer who receives cryptocurrency as payment for goods or services must include the fair market value of the cryptocurrency in his or her gross income.
  • Cryptocurrency will have a basis equal to the fair market value of the currency on the date of receipt. Therefore, upon a future exchange of the cryptocurrency for other property, the taxpayer may have a taxable gain or loss. The character of the gain or loss, and thus the rate at which it is taxed, depends on whether the taxpayer held such cryptocurrency as a capital asset (e.g. as an investment) or as inventory or other property held mainly for sale to customers, which is not considered a capital asset.
  • A taxpayer who "mines" cryptocurrency will include the fair market value of such mined currency in his or her gross income. If such mining constitutes a trade or business, the net earnings resulting from the mining activities may constitute self-employment income, subject to the self-employment tax. Similarly, cryptocurrency paid by an employer will be considered wages for employment tax purposes.
  • All IRS information reporting requirements related to property ownership, transfer, receipt, etc. apply to virtual currencies just as otherwise required for other property.
  • Penalties can potentially be incurred, including accuracy-related penalties and penalties for failure to timely or correctly report cryptocurrency transactions when require. However, relief may be available if such failures are shown to be due to reasonable cause.

A broadly similar position applies in the United Kingdom. Businesses that accept payment in cryptocurrencies are subject to corporate tax and income tax in the same manner as if the amount was paid in fiat currency. Capital gains taxes are chargeable if an individual makes a gains on the disposal of cryptocurrencies. Similarly, companies are liable to pay corporate tax on trading gains.

The position of traders who are not subject to a worldwide basis of taxation also requires close analysis. A trader who is based in Singapore may be able to take a position that their frequent trades are not subject to local taxation as capital gains. This argument is potentially open given the current administrative position of the IRAS in relation to share trading gains made by individuals. If however they choose to buy and sell cryptocurrency on a Hong Kong based exchange, will the territorial basis of taxation in apply to subject any gains to profits tax? A comprehensive double tax agreement is not in place between Singapore and Hong Kong and so there is no ability for the trader to assert they do not have a permanent establishment in Hong Kong and are not subject to tax on that basis.

In addition to the taxation of gains realised by traders, there is also the question about the application of withholding tax to cryptocurrency lending transactions. Many cryptocurrency exchanges enable the lending of cryptocurrency on a short term basis. This is essentially peer-to-peer lending though little – if anything – is known about the party or parties to whom the currency is lent. It is facilitated by the exchange which will automatically liquidate the position of the borrower if there is an adverse price event through the equivalent of a margin call. It is not clear in these lending structures who is the withholding agent and even the source of the interest income that is derived. The taxation character of "airdropped" tokens which are issued for no consideration and the proceeds of coin sharing remain to be considered.

Value added tax

The application of value added tax regimes to cryptocurrencies is another area of complexity. The Australian Tax Office (ATO) classify transactions paid for using cryptocurrency as a barter trade. The disposal of cryptocurrency is therefore the supply of a good which attracts Australian goods and services tax (GST) of 10% if the disposing party is GST registered. Up until very recently it was possible for GST to be imposed twice on the holder of cryptocurrency – once when the currency was initially bought using fiat currency (assuming this occurred on an Australian exchange), and a secondly when the cryptocurrency was used to purchase goods and services. This position has now changed and GST will not be paid on the purchase of cryptocurrencies up to AUD$10,000.

A similar position applies in Singapore. The IRAS regards the supply of cryptocurrency as a supply of services. If cryptocurrency is used as a mode of payment to a foreign supplier, the supply of the cryptocurrency is zero-rated. Because the annual registration requirement is SGD 1m in Singapore, the risk of a double GST hit should only be of concern to frequent or high value traders. In both Australia, Singapore and other jurisdictions where these issues arise, it is necessary to consider core propositions such as whether a trader is carrying on a business of trading in cryptocurrency, and whether they have a sufficient jurisdictional nexus for indirect taxes to apply. The outcome is typically highly fact dependent.

Estate tax

It is clear that cryptocurrency is an asset in the hands of the owner, and so estate tax implications need to be carefully considered. An individual who is subject to the imposition of estate tax on a worldwide basis due to domicile, or the equivalent jurisdictional nexus, will likely need to treat cryptocurrency as part of their estate. It will need to be included as part of any planning which takes place prior to their death.

A more nuanced analysis is however required for the cryptocurrency which may be held by a foreign person in a hot wallet kept with an exchange that is based in a jurisdiction which imposes estate tax. A prime example of this is the United States which is home to many leading exchanges including Coinbase. Poloniex and Kraken.

Common reporting standard

The common reporting standard (CRS) is an international initiative for the automatic exchange of financial account information. It is modelled on the US Government's Foreign Account Tax compliance Act and requires the reporting of account information by a financial institution to the country of tax residency of an account holder. This information flow is intended to ease the detection of offshore financial accounts by tax authorities and thus encourage higher levels of disclosure of offshore funds by taxpayers.

An immediate question is whether the CRS reporting will apply to cryptocurrency exchanges. This ultimately depends upon whether a participating country regards these exchanges as financial institutions. The analysis is potentially more difficult for those exchanges which don't accept deposits of fiat currency – those which do would likely be regarded as depositary institutions. Assuming that a exchange is treated as financial institution the next question is whether it reports just the value of the fiat currency which is held by an account holder or the value of cryptocurrency in their hot wallet as well? The intuitive answer would be the entire value of holdings of both fiat and cryptocurrency though the analytical pathway to reach this conclusion is not clear.

Perhaps the most troubling gap is that there is no way for CRS to cause a reporting of cryptocurrency which is already held outside of the financial system. The bulk of bitcoin is held in cold storage where ownership is established through the possession of the private keys. These funds remain undetectable until such time as they are converted into fiat currency on an exchange or by way of an OTC trade where funds are settled into a bank account. With this in mind it is then little wonder that exchanges are now coming under increased scrutiny from an AML and KYC perspective.

What to do

For those who decide to invest into cryptocurrencies, it is important to remain up to date on the regulatory and tax developments as they unfold. One of the key decisions which needs to be made is which exchange cryptocurrency is to be bought and sold. The jurisdiction in which that exchange operates may represent a touch point sufficient to create a taxable nexus. This could lead to a range of potential disclosure, withholding and other tax related implications.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.