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Tax officials tighten their grip on crypto

In the past four years, the island of Puerto Rico has quietly become a centre for cryptocurrency billionaires and other digital asset holders for one reason: tax.

A US territory, the island has made a play for a piece of the tax haven pie since 2012, when it passed two laws that resulted in a drastic reduction in rates.

The transformation caught the eyes of cryptocurrency holders in 2018, after bitcoin’s first dramatic rally made many early buyers very rich. Former child actor and the co-inventor of cryptocurrency Tether, Brock Pierce was one of the first big names who chose the low-tax island as his new home. Since then many others have made the same move, for the same reasons.

In the US, capital gains tax on cryptocurrencies can be as high as 37 per cent, but long-term holders can avoid tax altogether on digital assets on the Caribbean island.

Far away from Puerto Rico, British advisers say they are also encountering a small but growing cohort of people interested in moving country for crypto tax reasons. Chris Etherington, tax partner at RSM, an accountancy firm, says he has noticed more inquiries from younger clients “quite happy to move overseas to crystallise their coin” in low-tax jurisdictions such as the United Arab Emirates.

While emigration might seem extreme, these actions illustrate the keen interest many investors have in minimising tax in this fast-evolving new asset class.

HM Revenue & Customs says bluntly that it considers crypto assets a type of property like stocks and shares, gold or Impressionist paintings. So tax — specifically capital gains tax — can be levied on gains made. The US Internal Revenue Service takes the same stance, as do tax offices in many other developed countries.

These authorities are fighting hard to ensure the right amounts of tax are paid — including by demanding data from crypto exchanges about their users.

But several bones of contention remain. Tax practitioners say rules designed for the pre-internet era are hard to apply in the digital age. They argue that regulations designed for assets that are clearly located in one jurisdiction or another are not easily adapted to a decentralised asset class whose backers often claim it has no home jurisdiction at all, indeed no home.

In the UK, experts add, there is a lack of certainty around the tax treatment of crypto assets as there is no specific crypto tax law. HMRC has set out guidance on taxing cryptocurrencies. But this is not legislation and is in any case being contested by some tax professionals — including the Society of Trust and Estate Practitioners (Step).

“It’s just an awkward situation for the taxpayer because the Revenue are shoehorning new technology into tax legislation that’s been around for a very long time,” says Tom Wallace, director of tax investigations at consultancy WTT and a former tax inspector. “CGT law has been around since the 1960s when crypto would have been something you would have seen on Star Trek.”

FT Money takes a look at this complex and sometimes obscure landscape and tries to find a way through its rapidly-changing features.

A new front in an old battle over tax

The US tax authorities are widely considered to be the most aggressive in their efforts to make sure investors pay tax due on crypto. The IRS successfully issued legal summonses, known as a John Doe Summons — used when a person’s name is unknown — to obtain investor information from crypto exchanges Coinbase, Kraken, and Poloniex.

This data has been used to check information submitted to the IRS by hundreds of thousands of crypto investors and to identify discrepancies. “It has been very successful at getting people to come forward and do an amended tax return,” says Shaun Hunley, tax consultant at Thomson Reuters Tax & Accounting, based in Atlanta.

In May the IRS announced it had set up a specialist team to analyse blockchain — the technology used to power cryptocurrencies — with the aim of tackling tax evasion. The mission is called Operation Hidden Treasure.

Meanwhile, under President Biden’s $1tn infrastructure bill, plans are afoot to make it the law for crypto brokers to report their customers’ gains directly to the IRS. The bill, which has drawn howls of protest from the crypto industry, will make it easier for the IRS to gather information than through the courts.

“What we’re going to see in this area is forced compliance, which is quite different than the current system of voluntarily reporting crypto gains,” says Hunley.

Critics argue the bill’s definition of what constitutes a broker is too wide and could harm the emerging sector. But despite furious lobbying, it looks set to go through.

In the UK, HMRC has used its information-gathering powers to demand lists of crypto investors from exchanges over the past couple of years.

In 2019, exchanges Coinbase, eToro and CEX.IO went public with news that HMRC had requested user data to hunt down investors who owe UK tax. And the tax authority has continued with such information demands, says Adam Craggs, partner at RPC, a law firm, who acts for a crypto exchange platform.

Tax authorities are also including data on crypto investors in the information they collect across borders. A freedom of information request by Gherson Solicitors, a law firm, this year confirmed HMRC had used its powers to gather information about crypto investors in and outside the UK for the tax years 2017/18 to 2019/20 inclusive. Details included the names and addresses of investors and the value of crypto assets held.

HMRC says it “regularly gathers data from a range of information sources using powers provided by Parliament. The data is used to improve the integrity of the tax system and to identify those that have failed to declare their gains”.

Tax authorities struggle to keep up

Despite repeated data grabs, the industry is moving so fast that officials are generally forced to play catch-up in a game that has a long way to go.

In treating crypto assets as property for tax purposes, the UK takes a different approach from the way it views foreign exchange holdings, where gains do not attract CGT if used for personal expenditure outside the UK. But key legal definitions such as for “virtual currency” have yet to become law.

Meanwhile, the sector’s rapid development means that, for example, a whole new sector has sprung up, where assets can be bought, sold, lent and borrowed without human intermediaries, using only pre-programmed algorithms. This decentralised finance industry has grown to $65bn industry in just a year.

In May, a group of cryptocurrency advocates filed a legal claim against US tax authorities, claiming that by trying to levy taxes on profits from newly-created digital coins the “United States here seeks to use the federal income tax law to do something unprecedented, which is tax creative activity rather than income”.

Similar disputes are likely to arise elsewhere, as the industry tests the boundaries of existing legislation and the tolerance of national lawmakers and technology creates new products. One crypto expert told FT Money that newer crypto assets were coming online all the time that would make it harder for tax authorities to decipher fund flows, let alone impose taxes.

“There are many privacy related blockchains. One scenario is more funds flow into private coins,” says the person, who did not wish to be named. “The general idea is that crypto is bad for the state. Once the state doesn’t control its own money all those tax revenues disappear.”

Another fundamental and unresolved issue is about jurisdiction, a tricky call to make in a market that’s not officially domiciled anywhere.

British authorities take the view that the location of the owner is the key. But professional bodies such as Step have argued HMRC’s view is based on practical “convenience”, rather than law — and, particularly where cryptocurrency is held by an exchange or custodian, it could be wrong.

HMRC argues its conclusion that crypto assets held by a UK resident are located in the UK fits most transactions. The tax office told FT Money it wants to “help people get their tax affairs right and believes that taxpayers want to get it right too”. It says its “detailed guidance [is designed] to help our customers apply tax law to crypto assets correctly”.

Jonathan Peall, tax director at KPMG UK, suggests that such declarations are not enough. He says: “The law will have to develop to codify the situation. That said, the crypto world moves so fast that it remains to be seen whether the legislative process will be able to keep up.”

The challenge for crypto investors

The fact that cryptocurrencies are still novel also poses challenges for the often inexperienced investors drawn into the market.

First, in order to avoid falling foul of tax authorities, people need to know about and comply with their tax obligations (see box). But advisers warn many crypto investors attracted by the buzz around bitcoin may be blissfully ignorant that they need to pay tax on crypto gains or file a tax report. Others know but are simply burying their heads in the sand.

“Some individual taxpayers will turn a blind eye for the time being until such time it will catch up with them and they’ll get a nasty shock,” predicts Charlotte Sallabank, tax partner at Katten Muchin Rosenman.

Wallace encourages anybody who may not have declared gains to seek a professional adviser. It’s always better to tell HMRC of mistakes than wait, he adds, as the penalties rise if an individual is found out, rather than if they come forward voluntarily.

The UK tax office can look into your tax affairs for four years from the end of the tax year to which an assessment relates. This increases to six if an individual is deemed to have been careless or negligent, and even 20 years if the taxpayer has deliberately avoided disclosure.

“As a cryptocurrency investor you could be looking over your shoulder for a significant period of time,” Etherington warns. “If you’ve made a mistake — you can be sucker punched [further down the line].”

Etherington has noticed a lot more crypto investors worried about reporting to HMRC and calculating their tax.

HMRC’s guidance states investors must calculate gains and keep detailed records for each trade. This can be tricky, particularly if individuals are using trading bots — which can perform thousands of trades daily. Complex rules cover gains depending on whether assets were bought and sold on the same day, and/or within a 30-day period.

Investors often rely on their exchange for records. But this could be risky as exchanges might go under or not keep data for long enough, Sallabank adds.

The pace of innovation also hides potential pitfalls for investors. NFTs, or non-fungible tokens, are an example of a billion dollar market today that didn’t exist just a few years ago. This year, the arts world has embraced these digital platforms and new works sold for digital coins have been created. The record stands at nearly $70m, a digital collage by contemporary artist Beeple.

“There are a variety of actions that can trigger a disposal, including gifts of crypto assets, using crypto to buy other assets and exchanging between different crypto assets. It is the latter that may catch a lot of people out,” KPMG’s Peall says.

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Under HMRC guidance, the disposal of a digital asset triggers a CGT claim. Peall says this applies even if holders switch from one coin to another, even if it is into stablecoins, special stabilised digital coins linking fiat currencies and volatile crypto units such as bitcoin.

More recently, owners have been able to lend, or “stake”, their digital coins and earn a yield, an activity that could potentially create new liabilities, Peall adds.

Another potential problem for investors is that they may crystallise a gain and CGT liability but find that by the time they have to pay the tax their portfolio has fallen in value and so not be worth enough to cover the liability.

“You can’t pay your tax bill in cryptocurrency so you’d have to sell [other assets including crypto], which itself could trigger a tax charge as if you exchange it for cash that would count as a disposal,” says Sallabank.

But despite the difficulties, there is every incentive for investors, crypto operators and tax officials to all keep on top of their game. With the crypto market now estimated at nearly $2tn, the potential gains — and the associated tax liabilities — are simply too big to ignore.

Your UK tax responsibilities as a crypto holder

HMRC has published guidance for people holding crypto. Anyone selling crypto assets will be subject to capital gains tax (CGT) on profits — above their annual CGT allowance (currently £12,300). Individuals should report and pay any CGT on their annual self-assessment return. Those not normally filing a tax return, should register with HMRC. The deadline for doing so is within six months of the end of the relevant tax year, for example by October 5 2022 for the 2021/22 year.

HMRC lists actions which can constitute selling a crypto asset, creating a potential capital gains tax bill:

  • Exchanging tokens for a different type of crypto asset

  • Using tokens to pay for goods or services

  • Giving away tokens to another person (unless it’s a gift to your spouse or civil partner)

  • Donating tokens to charity.

There will be circumstances where HMRC considers buying and selling crypto assets to be “trading”. This is based on the frequency and the sophistication of the transactions. In this scenario, you would probably have to pay income tax and national insurance.

Crypto mining and tokens received from employment can count as income and be subject to income tax and national insurance.

Record-keeping

HMRC states individuals “must keep separate records for each transaction”, including:

  • Type of tokens

  • Date you disposed of them

  • Number of tokens you’ve disposed of

  • Number of tokens you have left

  • Value of the tokens in pound sterling

  • Bank statements and wallet addresses

  • A record of the pooled costs before and after you disposed of them.

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