Bitcoin – Why All The Fuss?
First, what is bitcoin? Wikipedia describes it as follows:
‘Bitcoin is a digital asset and a payment system invented by Satoshi Nakamoto, who published the invention in 2008 and released it as open source software in 2009. The system is peer- to-peer; users can transact directly without an intermediary. Transactions are verified by network nodes and recorded in a public distributed ledger called the block chain. The ledger uses bitcoin as its unit of account. The system works without a central repository or single administrator, which has led the US Treasury to categorise bitcoin as a decentralised virtual currency. Bitcoin is often called the first crypto currency, although prior systems existed. Bitcoin is more correctly described as the first decentralised digital currency. It is the largest of its kind in terms of total market value.
Bitcoins are created as a reward for payment processing work in which users o er their computing power to verify and record payments into a public ledger. This activity is called mining and miners are rewarded with transaction fees and newly created bitcoins. Besides being obtained by mining, bitcoins can be exchanged for other currencies, products and services. Users can send and receive bitcoins for an optional transaction fee.’
Bitcoins are stored in an electronic wallet or file which gives the address for receiving them. There are several routes to do this, from trading online or face to face to the UK’s first bitcoin ATM in Shoreditch in the UK. There are also smartphone apps. Bitcoin can be faster than bank transactions, and there are no transaction fees.
In effect, bitcoin is digital cash, created and used outside the conventional banking system, leading to volatility in its value and sending regulators into a spin. The use of bitcoin on the dark web gave it a shady reputation. For example, when the most notorious darknet marketplace, Silk Road, started, in 2011, bitcoin was the only valid payment method. When Silk Road was shut down, around 175,000 bitcoins confiscated by the US Government were auctioned off.
Response To Bitcoin From Economies Around The World
Bitcoin has had a mixed reception from governments. In June 2013, the Financial Times reported that US officials were targeting virtual currencies due to fears that Americans are using them to evade taxes. An IRS official was quoted as saying:
“Clearly the increasing use and misuse of cyber-based currency and payment systems to anonymously transfer illicit funds, as well as hide unreported income from the IRS, is a threat that we are vigorously responding to…
The globalisation and digitalisation of our currencies is a significant emerging threat … It doesn’t take much of a leap [to think] that these currencies would be used for tax evasion.”
In July 2013, Thailand’s central bank declared it illegal to trade bitcoins, to move them in or out of the country, or to use them to buy or sell goods or services.
In August 2013, the German Ministry of Finance formally recognised bitcoin as a unit of account (which can be used for private transactions), but not as a currency. is means that those who have invested in bitcoin could now be liable for German capital gains tax if they sell at a profit less than a year after acquisition.
Also in 2013, a US judge ruled, in Securities and Exchange Commission v. Trendon T. Shavers and Bitcoin Savings and Trust, (Civil Action No. 4:13-CV- 416), that, in the context of US federal securities law, bitcoin is money (and can therefore be regulated to combat fraud):
‘It is clear that Bitcoin can be used as money. It can be used to purchase goods or services and … used to pay for individual living expenses. The only limitation of Bitcoin is that it is limited to those places that accept it as currency. However, it can also be exchanged for conventional currencies, such as the US dollar, Euro, Yen and Yuan. Therefore, Bitcoin is a currency or form of money, and investors wishing to invest in BTCST [Bitcoin Savings and Trust] provided an investment of money.’
In March 2014, the IRS issued a notice providing answers to FAQs on virtual currencies such as bitcoin. The notice provides that virtual currency is treated as property (rather than a currency) for US federal tax purposes. General tax principles that apply to property transactions apply to transactions using virtual currency. Among other things, this means that:
- Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes;
- Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply. Normally, payers must issue Form 1099;
- The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer;
- A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.
Further details are in Notice 2014-21.
The UK Government Sets Out Its Position
The UK tax authority’s views on the tax treatment of bitcoin and other crypto currencies were set out in a Revenue and Customs Brief issued on March 3, 2014. The VAT treatment was said to be provisional pending further developments in the regulatory position and at EU level. Taxpayers can rely on the VAT treatment outlined below until HMRC announces any changes. Any changes will not apply retrospectively.
HMRC’s views were as follows:
1. Income received from bitcoin mining will generally be outside the scope of UK VAT. This is on the basis that the bitcoin mining is not an economic activity for VAT purposes because there is an insufficient link between any services provided and the consideration received;
2. Income received by bitcoin miners for other activities, such as the verification of specific transactions for which charges are made, will be exempt from VAT under the banking exemption in Article 135(1)(d) of Directive 2006/12 as “transactions, including negotiation, concerning deposit and current accounts, payments, transfers, debts, checks and other negotiable instruments”;
3. When bitcoins are exchanged for a “traditional” currency, no VAT will be due on the value of the bitcoins;
4. Charges made for arranging or carrying out any transactions in bitcoin will be exempt from VAT under the banking exemption in Article 135(1)(d) (referred to in 2. above);
5. VAT will be due in the normal way from suppliers of any goods or services sold in exchange for bitcoin or other similar crypto currencies. The value of the supply will be the sterling value of the crypto currency at the point the transaction takes place;
6. Payment with bitcoin will not affect the timing of any liability to direct tax;
7. For corporation tax, the normal rules on foreign exchange gains and losses and on loan relationships will apply to tax profits and losses on bitcoin exchange movements, by reference to the exchange rate between bitcoin and the company’s functional currency;
8. For income tax, profit and losses arising from bitcoin transactions should be reflected in the accounts and will be taxable in the normal way;
9. Where a profit or loss on a currency contract is not within trading profits or otherwise within the loan relationship rules, it would normally be taxable as a chargeable gain or allowable as a loss for corporation tax or capital gains tax purposes. Gains and losses incurred on bitcoin or other crypto currencies are chargeable or allowable for CGT if they accrue to an individual, or for corporation tax on chargeable gains if they accrue to a company;
10. In some cases a transaction “may be so highly speculative that it is not taxable or any losses relievable,” as is the case with gambling winnings and losses.
This treatment, in practical terms, makes crypto currencies equivalent to traditional foreign currencies for UK tax purposes. The VAT analysis of bitcoin transactions may have to be revisited (see below), although the result will be the same.
In August 2014, the UK Treasury announced a major program of work looking into the benefits and risks associated with digital currencies and underlying technology, with a particular focus on the question of regulation. In November 2014, the Government published a call for information to gather views and evidence on these questions. In March 2015, the Treasury published a document summarising the responses it had received and the next steps it intended to take in this area, which were:
- Applying anti-money laundering regulation to digital currency exchanges in the UK, to support innovation and prevent criminal use;
- Looking at how to ensure that law enforcement bodies have effective skills, tools and legislation to identify and prosecute criminal activity relating to digital currencies, including the ability to seize and confiscate digital currency funds where transactions are for criminal purposes;
- Working with the British Standards Institution and the digital currency industry to develop voluntary standards for consumer protection;
- Launching a new research initiative to address the research opportunities and challenges for digital currency technology.
Treating Bitcoin As A Currency
In October 2015, the European Court of Justice ruled that bitcoin and other virtual currencies are to be treated as currencies for VAT purposes, meaning that crypto currencies can be exchanged without VAT in the EU and thus putting them on a level playing eld with traditional currencies. This was in spite of the fact that the Court recognised that bitcoin was not legal tender in any country.
The judgment was in the Swedish case of Skatteverket v. David Hedqvist (C-264/14). The facts were that Mr. Hedqvist wished to provide services consisting of the exchange of traditional currency for bitcoin, and vice versa through a company owned by him. The transactions were to be carried out electronically through the company’s website. The company would purchase bitcoins from private individuals and companies, or from an international exchange site. The company would then resell the bitcoins or store them.
Mr. Hedqvist requested a preliminary decision from the Swedish Revenue Law Commission in order to establish whether VAT had to be accounted for on the purchase and sale of the bitcoins. The Swedish Revenue Law Commission’s view was that bitcoins were a means of payment used in a similar way to legal means of payment and the transactions that Mr. Hedqvist intended to carry out must, consequently, be exempt from VAT.
The Swedish Tax Authority appealed against the Swedish Revenue Law Commission’s decision to the Supreme Administrative Court of Sweden. It submitted that the transactions that Mr. Hedqvist intended to effect are not covered by the exemptions provided for in Directive 2006/12. The Supreme Administrative Court of Sweden referred to the European Court the question of whether such transactions are subject to VAT and, if so, whether they are exempt from VAT under Article 135(1) of Directive 2006/12.
The European Court first confirmed that bitcoins are intangible assets, so that Mr. Hedqvist’s company would be supplying services for VAT purposes. The services would be provided for consideration in the form of the margin included in the calculation of the exchange rate, regardless of the fact that no fee or commission was charged. There was a direct link between the service provided and the consideration received. There was therefore a supply.
The Court then noted that the transactions covered by Article 135(1)(d) were financial transactions which did not have to be carried out by banks or financial institutions. These transactions involved services or instruments which operated as a way of transferring money. Unlike “debts, checks and other negotiable instruments” referred to in Article 135(1)(d), the bitcoin virtual currency is a direct means of payment between those that use and accept it. Therefore, the transactions to be carried out by the company did not fall within the scope of Article 135(1)(d). However, Article 135(1)(e) exempts transactions involving, inter alia, “currency [and] bank notes and coins used as legal tender.” Bitcoin was a means of payment accepted as such by operators and was therefore exempt as falling within the scope of Article 135(1)(e).
The UK Government’s action plan on digital currencies referred to above aims to bring them into the regulatory fold, and this approach is likely to be adopted by others. If this happens, crypto currencies will be less susceptible to use by fraudsters and criminals but will inevitably become more cumbersome as payment tools. It will be interesting to see if they survive the transition.
This article first appeared in Global Tax Weekly, 21 January 2016, Issue 167.