Crypto assets meaning
The advent of distributed ledger technology (more often referred to as “blockchain”), has given rise to a new class of assets – cryptographically secured representations of value or contractual rights, or, in layman’s terms, a crypto (electronic) currency.
These differ from traditional assets as they are stored peer-to-peer on a blockchain (think of it as a modern-day, legal, secure Napster), rather than through a central bank or depository.
The most commonly known example of a cryptocurrency is Bitcoin, whose value has risen and fallen dramatically in recent years. Because cryptocurrencies have a value they can be exchanged for goods and services.
However, the technology is still in its infancy and use is at this time-limited, in addition to being slower and more expensive to use than traditional currencies. Institutions such as the Bank of England tend to refer to them as “crypto assets” rather than cryptocurrencies.
Crypto Assets HMRC
In HMRC’s latest policy paper, they note that they “do not consider crypto assets to be currency or money”. This follows the guidance from the Cryptoasset Taskforce Report, which identified the following three types of crypto assets:
Exchange tokens are intended to be used as a method of payment and encompass “cryptocurrencies” like bitcoin. Unlike utility or security tokens, they do not provide any rights or access to goods or services.
Utility tokens provide the holder with access to particular goods or services on a platform. A business would issue the tokens and commit to accepting the tokens as payment for the goods or services in question.
Security tokens may provide the holder with particular interests in a business, for example, in the nature of debt due by the business or a share of profits in the business.
The HMRC policy paper considers the taxation of exchange tokens, which may also provide the starting principles for utility and security tokens.
We have therefore examined the taxation implications which arise from this policy paper for those who hold, or are looking to invest in exchange tokens – this will be dependent on the nature and use of a particular exchange token.
Capital Gains Tax – personal investment [and certain other disposals]
Most individuals who buy and sell exchange tokens will do so for personal investment. They will be liable to pay Capital Gains Tax on any gains realised on a disposal of the exchange tokens.
The same rules will apply where an individual disposes of exchange tokens received through employment, or those awarded for so-called “mining”, as a fee for “transaction confirmation” or received through an “airdrop” in connection with non-trade activities.
A disposal includes, but is not limited to, the sale of exchange tokens, their exchange for a different type of crypto-asset, the use of exchange tokens to pay for goods or services, or gifting them to someone who is not a spouse or civil partner (there is generally no Capital Gains Tax when a donation is made to charity).
Certain allowable deductions and amounts of the exchange token already charged to income tax are taken into account in calculating the chargeable gain.
The gain or loss on each operation is not considered individually – each type of exchange token (eg. Bitcoin, Ethereum) is instead “pooled” with a record kept of the pooled allowable costs. There is a deemed “part-disposal” when exchange tokens belonging to a particular pool are sold.
In calculating the gain or loss on the part-disposal a deduction is allowed for the corresponding share of the pooled allowable costs. Special rules apply if the same type of exchange token is disposed of and acquired on the same day or within 30 days of the disposal.
The application of the pooling provisions is further complicated by the creation of new pools where eg. a “fork” creates new tokens or an individual is allocated tokens by way of an airdrop.
If tokens become worthless or of negligible value, individuals can crystallise losses by making a negligible value claim (in respect of the whole pool) with the effect that the tokens are disposed of and immediately re-acquired at claim value.
Income Tax – trading activities
In very limited instances, where individuals buy and sell tokens in a regular, organised and sophisticated manner, the activity may amount to a financial trade – whether this is the case can determined based on existing guidance and case law on trading in shares and securities.
Tokens awarded for mining or transaction confirmation fees may also constitute trade receipts depending on commerciality, frequency, organisation and risk of the operations, as may airdrops received in connection with a crypto-assets or mining business.
Where operations constitute a business, Income Tax will apply to trading profits – trading losses may be carried forward or offset against other profits. Any increase in the value of the token between its acquisition and disposal is taken into account in calculating trading profits.
Income Tax – non-trading activities
Awards for mining, transaction confirmation fees, and airdrops provided in return for or in expectation of a service, that are not related to trading activities are taxable (and should be reported in a self-assessment tax return) as miscellaneous income after deduction of certain expenses. Losses may be carried forward to later years.
Crypto asset management – a how-to guide
Earnings from employment
Individuals are liable to Income Tax and National Insurance contributions (NICs) on exchange tokens received as part of employment income.
The liability to account for the correct amount of tax on the value of the token will depend on whether or not it constitutes a Readily Convertible Asset (RCA) (to be treated as if it were cash for employment tax purposes) or a benefit in kind.
If it constitutes an RCA, the employer must account for the amount of tax due and NICs. If it is a benefit in kind, the individual will have to report it as employment income in a self-assessment tax return (if the employer does not operate PAYE on payments earnings that are not RCAs) – the employer will be liable to pay any Class 1A NICs.
Private Capital Implications
As cryptocurrencies become increasingly widely held it is critical for investors to consider the issues these crypto-assets raise when it comes to estate planning. Proper planning has always been important, but never more so than in the digital arena, where security measures such as encryption, passwords, and private keys can provide effectively unbreakable levels of security.
This provides the investor with privacy and protection during their lifetime, but what about after death?
Cryptocurrencies are a new financial innovation and as yet there are no specific laws dealing with their inheritance in Scotland. That said, the law as it stands indicates that holdings of cryptocurrency would form part of the investor’s estate as what is known as moveable property.
Effectively this means that cryptocurrencies will be treated in a similar way to traditional investment assets and may be passed on to beneficiaries on death.
Over the past few years, as the value of certain cryptocurrencies have surged, we’ve seen a number of stories where staggering values of crypto assets have been lost. Most recently, within the past few days, we’ve seen the turmoil surrounding the QuadrigaCX exchange, where some $140 million in crypto assets are allegedly inaccessible or missing as a result of its founder’s death and his apparent failure to leave any record of the exchange’s passwords and private keys.
For bitcoin alone, it is estimated that around 25% of all bitcoin mined up to this point is now inaccessible due to private key loss. Based on current valuations this represents an irretrievable loss in excess of £10.5 billion.
If you do hold cryptocurrencies then there are a number of concrete steps which you should take to avoid your holdings becoming part of this statistic. As a cryptocurrency investor, it is vital to be proactive to avoid the risk of loss.
Firstly it is important to make your ownership of cryptocurrency known. As part of good estate planning it is important that executors are made aware of all estate property, but unlike physical assets or traditional investments, which if overlooked can often be turned up by asset searches, cryptocurrencies are decentralised with no public register of ownership.
A useful step to take could be to compile a list of your crypto assets and keep it regularly updated; keep this list in a safe place, somewhere that will be accessible to your executors in the future.
Cryptocurrencies are a technically sophisticated product so you should be sure that your executor understands what they are and how to deal with them. It is important that you leave your executor with all the information they will need to access your holdings, including all required keys and security codes.
Certain cryptocurrency exchanges will allow the transfer of assets to executors upon production of a death certificate, however, this is not widespread practice and, as with all policies, can be subject to change. You should take care to keep your list of access codes up to date, stored securely and separately from your list of assets.
Finally, you should make sure that you make your wishes for these assets known. Consider where you would like them to go after death, whether they should be passed on directly to a beneficiary, or whether your executor should realise their value and transfer a cash legacy to your heir.
Cryptocurrencies can be subject to extreme price volatility so it is important to be clear about your wishes in your Will, bearing in mind the issues around valuation.
Crypto assets regulation
For any estate administered in Scotland, there is one more important issue to bear in mind, relating to what are known as Legal Rights. Under Scots law, a surviving spouse, civil partner, and any children are entitled to a certain proportion of the deceased’s estate. Legal Rights are intended to make sure that the deceased makes some provision for those with whom he/she had the closest family ties.
A surviving spouse or civil partner is entitled to one-third of the deceased’s worldwide moveable estate if the deceased left children, with a further one-third to go to the children collectively. If the deceased left no children then the surviving spouse or civil partner will be entitled to one-half of the moveable estate.
The spouse, civil partner, or children are not required to take their Legal Rights award and may decline it if they wish. If they are to receive a benefit under the deceased’s Will they must choose between taking their Legal Rights claim or the benefit under the Will – they may not take both.
Cryptocurrencies, as part of the deceased’s moveable estate, will form part of the pot from which any Legal Rights payment is made and, if cryptocurrency forms a large part of your assets, it may be that your executor will need to realise the value of some of your holdings in order to make any Legal Rights payments.
Mark Carney, the Governor of the Bank of England, explained why exchange tokens are not considered to be “currency or money”, noting that crypto assets “are too volatile to be a good store of value, they are not widely accepted as means of exchange, and they are not used as a unit of account”.
Nevertheless, it seems a perverse and short-term outlook to suggest that a crypto asset, even one in its infancy, whose primary purpose is to pay for goods and services (and can be done so with an increasing number of vendors) is not “currency or money”.
However, nothing can be said to be certain, except death and taxes, and, for now, the policy paper gives welcome guidance to understand the taxation rules under which we must abide by when dealing with cryptocurrency.
Whether this will remain the case as exchange tokens become more widely accepted as a means to pay for goods and services remains to be seen. It is, therefore, of vital importance to actively plan under the current regime, as well as keep abreast of developments as this new technology enters the mainstream.
- This article was co-authored by Callum O’Brien, Karolina Rosochowska and Donald Morrison, of Scottish commercial law firm, Burness Paull.