Cryptocurrencies such as Bitcoin and Ethereum have been a hot topic of late. With Bitcoin ATMs appearing in convenience stores, and an increasing number of business accepting cryptocurrency as acceptable tender, their legitimacy in the eyes of the general public has grown. In this article we’ll take a look at what cryptocurrencies are, how they work, and why you should understand the tax situation before diving in.
For the purposes of this article we’ll often refer to Bitcoin as a representative cryptocurrency, as this particular cryptocurrency accounts for around 50% of the total market capitalisation. It should, though, be noted that Bitcoin is just one of over 900 cryptocurrencies, and that its market share has dropped – in large part due to growth in the Ethereum and Ripple cryptocurrencies – from over 80% in January 2017.
What is a cryptocurrency?
In the simplest possible terms, a cryptocurrency is a digital currency. In this respect it is not unique – in a way, much of the traditional currency we use every day is in a digital form. However, cryptocurrency differs from traditional currencies in a number of ways.
First and foremost, cryptocurrencies are not governed by any central bank, nor do transactions involving them have to pass through any such institution. Bitcoins are created through a process called ‘mining’, which effectively perpetuates both the independence of the currency, and its use. Mining is a competitive process in which users utilise specialised hardware to process transactions and are rewarded for their activity. Bitcoins are credited to a user’s wallet, and all transactions occur directly between two wallets.
The use of cryptography is also a defining factor. Each user has a unique, anonymous and ‘uncrackable’ signature, and all transactions to and from that wallet are stamped and logged with it. These transaction stamps contribute to a central and public database referred to as the blockchain. This reliability and transparency is designed to make transactions less susceptible to fraud, and to enable greater confidence for merchants and users of all kinds.
What is a blockchain?
As described above, a cryptocurrency runs on a blockchain. A blockchain is a shared ledger or document, duplicated across a network of computers, that contains a record of every single crypto-transaction and the ownership of every single unit of the cryptocurrency. Transactions and ownership information are logged with identifying cryptographic sequences that are, to all intents and purposes, entirely anonymous.
The updated document – the blockchain – is distributed and made available to all holders of the cryptocurrency. It is run by miners, whose powerful computers are utilised by the network to process and log transactions and ensure the authenticity of information, guaranteeing safe and proper processing.
Why are people investing and what are the risks?
The value of Bitcoins has skyrocketed this year, inviting a lot of media attention and a lot of speculation on whether or not it represents a good investment. At the start of January of this year one Bitcoin surpassed $1,000, and by mid-August had reached and exceeded $4,000. Coupled with low susceptibility to fraud, investing in a product that has essentially quadrupled in value in less than 8 months could well seem like a clear choice.
However, there are factors that one must take into account when looking at these figures:
1. Volatility. The total number of Bitcoins in circulation, and the total number of businesses using them, is relatively small. This makes the value at any given time particularly susceptible to relatively low level market forces. What would be a trivial event to an established currency can have dramatic consequences for a ‘start-up currency’.
2. Infancy. Cryptocurrency is still in its infancy. As such, the software and networks that facilitate are evolving rapidly, and these could realise great changes in the operation of the currency.
3. Speculation. Coupling the previous 2 points, cryptocurrency is highly susceptible to speculation. The lack of history and the not-yet-upscaled nature of the commodity means that nobody has a clear idea of how high it might peak, and whether or not it will trough.
Taxation and cryptocurrency
Whether and how Bitcoin transactions and activities are subjected to taxation are, in some ways, subject to the legal definition of cryptocurrency – namely whether or not it is defined as money. In other respects, for different types of taxation, whether a transaction is completed using Bitcoins or traditional forms of money is immaterial, and tax should be collected as usual.
At this stage cryptocurrencies fall outside of the European Central Bank’s definition of money, meaning that VAT is not applied. Income relating to Bitcoin mining, exchanges of Bitcoin for physical/national currencies, and income from activities related to Bitcoin are all currently exempt from VAT. However, VAT will still be due on products and services that are exchanged for Bitcoin in the same way that it would be if exchanged for any other currency. The VAT due is calculated as the Sterling value of the Bitcoin exchanged at the point of sale.
Regarding Corporation Tax (CT), Income Tax (IT) and Capital Gains Tax (CGT), the treatment of income received from, and charges made in connection with, activities involving cryptocurrencies should be viewed in the context of specific cases and the related circumstances. Generally, though, the following summaries apply:
CT – the profits or losses on exchange movements between currencies are taxable, with the general rules on foreign exchange and loan relationships applying. As it is currently interpreted, no special tax rules for Bitcoin transactions are required. The profits and losses of a company entering into transactions involving Bitcoin would be reflected in accounts and taxable under normal CT rules.
IT – the profits and losses of a non-incorporated business on Bitcoin transactions must be reflected in their accounts and will be taxable on normal IT rules.
Chargeable gains: CT and CGT – if 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 CT or CGT purposes. Gains and losses incurred on cryptocurrencies are chargeable or allowable for CGT for an individual, or for CT on chargeable gains if they accrue to a company.
Due to the evolving nature of tax regulations for cryptocurrencies, as well as the individuality of circumstances considered, it’s important to keep your clients accountant up to date with all gains and losses.
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