The cryptocurrency tax challenge
Wren says: “Globally there may be a level of doubt (among investors and service providers) around whether digital assets are actually taxable, but for the most part this doubt is misplaced. The simple answer is that gains are nearly always taxable.”
Subjecting cryptocurrency investments to capital gains tax makes great sense in the UK and the US, but elsewhere this approach may not be such a good fit. The UK, for example, has capital gains tax allowances of around £12,000 – a threshold most private crypto investors will not exceed. In other countries, however, no such capital gains allowances exist, so investors must pay tax from the moment they achieve capital gains, creating an immediate tax obligation.
The tax situation becomes more complex when investors use cryptocurrency to pay for purchases. In this scenario, every transaction counts as a sale of crypto, potentially triggering a capital gains tax liability as well as any applicable sales taxes, such as GST and VAT on the underlying purchase.
Not all countries are following the lead of the US and UK, however. Notable exceptions include Switzerland, Hong Kong, Germany and the Netherlands, where tax rules for selling crypto are different, and countries like Japan and New Zealand which adopt an income tax approach.
Wider adoption of stablecoins, which have a value pegged to a currency or commodity, and central bank digital currencies may also require new tax rules. As these coins are less volatile, they may be less likely to result in capital gains or losses; changes in value will be more akin to foreign exchange differences.
Meanwhile, according to Mercy Joseph, Director, Customer Tax Operations and Reporting Services, EY Corporate Advisors Pte. Ltd in Singapore, the evolution of digital assets taxation in Asia is generally being directed by the attitude of the regulators. “In Singapore, the financial regulators are comfortable and supportive of blockchain technology and innovative use of digital assets, and therefore from a tax perspective there’s an increasing level of clarity around taxation for digital assets in general,” she says. “However, given the cautiousness of the regulator on trading of digital assets, there isn’t the same clarity at the moment in areas such as availability of fund tax incentive upon investment in crypto.”
Taxing income from crypto mining and proof-of-staking
Owning and disposing of cryptocurrencies are not the only taxable events in the digital assets area. The process of creating new cryptocurrency, known as mining, which involves using powerful computers to validate transactions, is one of a growing list of other taxable activities.
Although there is no global tax consensus on crypto mining, Wren says jurisdictions are increasingly applying income tax if an individual earns cryptocurrency by mining it, or if they receive it as a promotion or as payment for goods or services. If an individual retains ownership of cryptocurrency they have mined or earned as a result of mining, and it grows in value before the owner sells or spends it, the owner can then also be liable for capital gains taxes on the profits.
Staking – a process of digitally validating blockchain transactions – is another activity that may be subject to income tax. While the US tax authorities have yet to issue specific guidance in this area, the UK’s HMRC clearly states that any profits from staking are subject to income tax. HMRC’s guidance says: “…The pound sterling value (at the time of receipt) of any crypto-assets awarded for successful staking will generally be taxable as income, with any appropriate expenses reducing the amount chargeable.”
Wren points out that tax positions around mining and staking are not always clear-cut, however. “With crypto mining and staking activities, UK rules treat receiving a coin under those circumstances as an income event,” he says. “But if the owner doesn’t sell the coin, then actually they have a tax liability with no cash to back it up.
“This is a great example of the complexity investors encounter when they move away from simply holding, buying and selling crypto,” Wren continues. “They start to encounter areas where the tax may not be particularly suitable for the asset class.”
Cryptocurrency mining is also a massively energy-intense activity, requiring many data warehouses filled with computer servers to solve complex mathematical calculations. According to Cambridge University’s Bitcoin Consumption Index, the act of creating this specific cryptocurrency alone consumes approximately 128TWh of electricity annually – more than Norway and enough energy to power all the tea kettles in the UK for 29 years. This raises environmental, social and governance (ESG) concerns at a time when whole sectors of the global economy are attempting to reduce energy consumption and decarbonize.
Utility tokens and security tokens, and how they are taxed
While utility tokens are created using the same blockchain technology as cryptocurrency, the similarities end there. Tech start-ups typically sell utility tokens to raise funding for their digital products or services. An investor buys a utility token in order to access the product or service offered by the token issuer. A ride-hailing token, for example, could be used to pay for a taxi journey but not anything else, although it may be exchanged for either government-issued currency or a crypto coin.
Security tokens, however, derive their value from a physical, tradeable asset, such as a stock or real estate. An investor who buys a tokenized version of a stock enjoys the same rights as someone who buys a stock from a traditional stockbroker, including profit share and voting rights. Security tokens also fall under the same regulatory oversight as other investment products. The major difference is that a security token exists in digitized and decentralized form on blockchain.
Most jurisdictions have yet to issue guidance on the tax treatment of utility tokens or security tokens, but that guidance will almost certainly come. “I think most tax practitioners would welcome a tax approach that looks through to the underlying asset and matches it to the underlying asset class,” says Wren. “But the reality is that neither the existing regulatory rules, nor the tax rules, do that at present, and tax authorities may be reluctant to go down that path until they fully understand the implications and risks of doing so.”
What are NFTs and how are they taxed?
Currently, non-fungible tokens (NFTs) seem to be one of the most popular digital assets classes. In simple terms, NFTs, are unique pieces of software, powered by smart contracts, stored on a blockchain. Although NFTs have been used in blockchain solutions for a long period of time, they have become increasingly popular as a way to store and track digital ownership on a blockchain. This could be the ownership of a digital piece of art, a piece of sports memorabilia, a profile picture or the entitlement to an exclusive product of a particular brand, but also a piece of digital land in the metaverse or an object or skin to be used in a game. Typically the underlying asset the NFT represents is not stored on the blockchain itself.
We see a lot of activity in the NFT space with EY clients right now, Post says, predominantly in the technology and consumer products and retail sectors, but the landscape is rapidly expanding. Companies are starting to appreciate that NFTs provide a great opportunity to build and grow their brand community. However, these companies are not always aware that the tax queries around NFTs can be very complex and unclear, he adds.
The tax consequences of NFTS can encompass both direct and indirect taxes. Most of the NFTs being issued at the moment are effectively ownership receipts for the underlying asset. So when it comes to taxation, countries may revert to first principles and tax an NFT on the same basis as the underlying assets, Wren says.
Although jurisdictions have yet to issue NFT specific guidance, most NFTs may be treated as property and taxed in a similar way as cryptocurrency. In some instances they may also be considered as commodities or securities. There is clearly no one-size-fits-all answer to the taxation of NFTs, Post says. There can be various complex direct taxation queries when it comes to the sale and issuance of NFTs such as withholding requirements if the NFTs may involve intellectual property of brands and trademarks. And from an indirect tax perspective, the purchase of an NFT in exchange for cryptocurrency is likely a bartering transaction. Luckily we are able to navigate EY clients through this complex and novel landscape.
Conclusion: The importance of maintaining a dynamic watching brief
The digital assets industry continues to evolve at great speed, generating a high level of tax ambiguity. Best practice followed by individuals and organizations active in this area is to maintain a dynamic watching brief to track the development of legislation and monitor tax guidance, so that they can limit both tax risk and exposure.
It is particularly important that digital assets service providers adopt a watching brief. Until now they have avoided many of the tax reporting obligations fulfilled by conventional intermediaries, but this is already starting to change.
“Whatever your involvement in digital assets, the starting assumption should always be that income and gains are taxable. Don’t assume otherwise until you’ve checked,” warns Wren. “Digital assets service providers’ mandated role may be relatively light at the moment, but that lack of accountability is likely to be short-lived.”