Cryptocurrencies and taxing the leading edge of change

5 September 2017
Cryptocurrencies and taxing the leading edge of change

We’re going to hear a lot more about cryptocurrencies and blockchain technology as they move (very rapidly) into the mainstream. As Professor Alex Sims pointed out recently regulators are struggling to keep up with both the pace of change and the likely implications.

Inland Revenue like many other tax authorities around the world is still figuring out the income tax and GST implications of cryptocurrencies. Other than noting in 2014 that cryptocurrencies received in exchange for goods and services are taxable, Inland Revenue has not yet released any guidance on the tax treatment of cryptocurrencies.

So, what is the income tax treatment of cryptocurrencies? When I was first asked this a few weeks ago my initial reaction was that cryptocurrencies might represent financial arrangements. If so, investors holding more than one million dollars in cryptocurrency may already have incurred substantial income tax liabilities, even if they have yet not sold the cryptocurrency and realised a gain. This is because the financial arrangements regime operates on an “accrual” basis. Fortunately, Inland Revenue have informally advised that it does not consider cryptocurrencies represent financial arrangements. Instead, it views cryptocurrencies as property.

Treating cryptocurrency as property will bring within income tax those clearly trading in cryptocurrencies in the manner of a share trader. For other investors in cryptocurrency, it’s not clear. The best current interpretation would be that disposals of cryptocurrency will be taxable if the disposals are either part of a profit-making venture, or the cryptocurrency was acquired with a dominant purpose or intent of disposal This is therefore dependent on determining a person’s intention, a highly subjective matter at the best of times, more so when potentially substantial sums of tax are involved.

However, a draft “Question we’ve been asked” (QWBA) from 2016 about whether the proceeds from the sale of gold are taxable might provide an indication of Inland Revenue’s thinking on “intention”.

Inland Revenue’s conclusion was that the proceeds from the sale of gold bullion bought as an investment would be income. A key factor in this conclusion was the nature of bullion itself: “The very nature of the asset leads to the conclusion that it was acquired for the purpose of ultimately disposing of it. Such a commodity does not provide annual returns or income while being held and has use or value only in its ability to be realised.”

The draft QWBA also notes that it is irrelevant why a taxpayer decided to acquire property for disposal in due course. Describing bullion as an investment or some form of hedge does not mean it was not acquired for the purpose of disposal. In Inland Revenue’s view bullion can only be acquired for ultimate disposal as it has no other use.

Although the initial question was about gold bullion, the QWBA concluded the same treatment would apply to other precious metals purchased in bullion form. Cryptocurrencies share some similar traits to bullion so on the Inland Revenue’s analysis any disposal would be taxable. However, the still evolving nature of cryptocurrencies means there are significant differences with bullion. For example, Ethereum is not only a cryptocurrency but a platform integral to blockchain technology.

Other cryptocurrencies have created subsidiary cryptocurrencies, in effect creating a separate revenue stream. Bitcoin, the biggest cryptocurrency of all, did so on 1 August when a split or “fork”, created Bitcoin Cash. What’s more these “forks” can only happen with the approval of existing investors. On Inland Revenue’s reasoning, this would make such cryptocurrencies more akin to shares, invalidating the argument of the draft QWBA.

In the absence of definitive Inland Revenue guidance, the income tax treatment of cryptocurrencies is currently little more than an elaborate “It depends.” Not exactly an answer anyone sweating on a potentially significant tax liability wants to hear.

Other jurisdictions such as Australia, the United Kingdom, and the United States are able to treat cryptocurrencies as falling within their respective capital gains tax regimes if the activity is not already taxable as income.

However, here in New Zealand the income tax treatment is unclear. It will remain so at least until Inland Revenue releases its guidance on the topic. This could be within the next 18 months as an item on the taxation of cryptocurrencies has been included in the Public Rulings work programme for 2017-18. (The ruling will also cover the GST issues which are a whole other matter outside the scope of this article).

As an aside, preparing a policy for the taxation of cryptocurrencies highlights the continuing need for Inland Revenue to recruit and retain the highly skilled staff required to address this and other operational issues. I am not confident Inland Revenue’s proposed staff restructure properly recognises this issue.

Given the substantial gains already made and with the cryptocurrency boom not showing many signs of slowing down, a cynic might conclude that Inland Revenue is unlikely to pass up the possibility of taxing cryptocurrencies. Cynicism aside, it is an indictment of current tax policy that such uncertainty exists. It underlines the need for comprehensive tax reform particularly in relation to capital. Whether this means the introduction of either a comprehensive capital gains tax or an equivalent of the “fair dividend rate” expanded to apply to all assets, we’ll have to wait and see.

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