The recent news cycle has extensively followed the astronomical growth — and the odd sharp dip — in the value of Bitcoin, the cryptocurrency phenomenon.
With an unprecedented level of public interest in Bitcoin and other forms of cryptocurrency, it is timely for tax advisers to consider how the Australian tax laws apply to taxpayers who have been early adopters of what may be — depending on which expert opinion piece you read — the game-changing future global medium of exchange, or the next ‘bubble’ to crash.
What is cryptocurrency … and why the hype?
Cryptocurrency is digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds.
Cryptocurrency is decentralised. Currently, no form of cryptocurrency is regulated by any government or financial institution. The transfer of funds does not involve a financial institution intermediary — and is generally anonymous.
Bitcoin … and its bridesmaids
The original and most famous cryptocurrency is Bitcoin. It was created in 2009 by an anonymous person or group using the pseudonym ‘Satoshi Nakamoto’. Now, nine years later, there are (according to Wikipedia) over 1,300 different cryptocurrencies available on the internet. While Bitcoin is still the predominant household name and dominates in terms of market capitalisation, other cryptocurrencies leaving a significant virtual mark include Ethereum, Ripple and Litecoin. These non-Bitcoin cryptocurrencies are commonly referred to as ‘altcoins’.
Is Bitcoin a doomed ‘bubble’ or a sure bet?
The notoriously volatile price of Bitcoin recently made the news headlines in the lead-up to Christmas when its price hit its historical peak at around USD 19,000 per Bitcoin on 17 December 2017. The remarkable aspect was not the price per se, but the fact that it had started the year with a low of below USD 1,000 in early January 2017. This is a 20-fold increase in value within a calendar year — albeit with less extreme highs and lows in between.
Just one month after the record high, on 16 January 2018, the price sharply dropped below USD 11,000. The vigorous yoyo-ing of the price — not just in recent months but also a familiar sight in earlier years — has captured the attention of the general public as well as tech and investment pundits.
Cryptocurrency also makes the news from time to time due to hackers stealing data from various online exchanges throughout the world — the most recent and largest example of which is the theft of 58 billion yen worth of an altcoin from a Japanese exchange.
Some Bitcoin loyalists are adamant that if Bitcoin holders can ride out its current fickleness, they will be abundantly rewarded by financial gains. Others are dubious of its viability and predict that the ‘bubble’ will inevitably burst. In online commentary, there have been parallels drawn with the dotcom bubble of the early 2000s, the Wall Street crash of 1929 and even the Tulipmania of the 1630s.
A bit about Bitcoin …
What is ‘blockchain’?
Bitcoin — and other cryptocurrency — is created using blockchain technology.
Blockchain is a decentralised, real-time ledger which simultaneously records transactions on a large number of computers in a network. Blockchain creates permanent and secure records and promises to reduce the scope for fraud — mainly due to fact that, as a decentralised system, there is no single IT system to hack. Instead, information is securely stored in separate, decentralised records (i.e. ‘blocks’), which cannot be removed or changed.
The use of blockchain technology is not limited to cryptocurrencies. Commentators have suggested that, in the future, blockchain might be used for these varied purposes:
- to automatically create contracts or execute financial transactions;
- for land registry and deed management;
- to process insurance claims;
- storage of personal identification;
- security of electronic voting systems.
How is Bitcoin acquired?
This summary relates only to Bitcoin. It may reflect the processes relating to other cryptocurrencies to varying degrees.
Bitcoins are created by the process of ‘mining’. Mining Bitcoin involves using a computer program to solve mathematical problems to verify various transactions. Bitcoin miners are paid a certain number of Bitcoins for solving those problems.
A user of Bitcoin has a personal Bitcoin electronic ‘wallet’ which can be downloaded from a number of websites and mobile apps. The wallet is not used for storing Bitcoins per se — as they are not actually stored anywhere. Instead, records of Bitcoin transactions are stored in the blockchain which acts as a public ledger.
The wallet stores the user’s private ‘keys’, which are strings of letters and numbers formed from an encryption algorithm and are used to authorise transactions. The user also receives a Bitcoin address for sending and receiving Bitcoin.
With a wallet, the user can buy and sell Bitcoin through numerous online Bitcoin exchanges — including over a dozen which service users in Australia. These exchanges are not regulated by government. They operate differently, but generally, exchanges enable Bitcoin to be purchased with regular currency using traditional payment methods such as bank transfers, credit cards and debit cards, and allow it to be sold to other users. A Bitcoin exchange generally charges transaction fees. Broadly, transacting on a Bitcoin exchange is somewhat akin to buying and selling shares using an online account.
It is also possible to trade Bitcoin directly with someone else. There are even Bitcoin (and altcoin) ATMs located worldwide which can be used to buy and sell Bitcoin.
It is possible to transact a part of one Bitcoin. One Bitcoin — denoted as BTC — has eight decimal places. One mBTC is one 1,000th of one Bitcoin. The smallest recognised unit of Bitcoin is Satoshi, of which there are 100 million in one Bitcoin.
Out of government hands … for now
A defining characteristic of cryptocurrency has historically been its independence from government control. However, in the past couple of years, governments all around the world have attempted to become involved to varying degrees:
- Central banks: The central banks of China, Japan, Sweden, Estonia, the United Kingdom, Uruguay, Kazakhstan and the United States are all looking into creating their own cryptocurrency.
- China: In recent years, Chinese Bitcoin exchanges had accounted for more than 90 per cent of all Bitcoin trades; but in September 2017, regulators shut down all exchanges in mainland China and banned cryptocurrency trading.
- Europe: The United Kingdom and other European Union governments plan to bring cryptocurrency within anti-money laundering and counter-terrorist financing regulations.
- South Korea: The government has banned cryptocurrency trading from anonymous accounts and plans to implement a tax.
- Venezuela: The government intends to create and issue 100 million ‘petros’, which will be backed by Venezuela’s oil and mineral reserves.
- Australia: The Australian Government has granted $8.6 million to Power Ledger, the first Australian company to be listed on digital currency exchanges which, in October, made Australia’s first initial coin offering through the Ethereum cryptocurrency network.
Further, the Anti-Money Laundering and Counter-Terrorism Financing Amendment Act 2017 — which received Royal Assent on 13 December 2017 — will extend the scope of the Anti-Money Laundering and Counter-Terrorism Financing Act 2006 to include regulation of digital currency exchange providers. Digital currency exchange providers will be required to:
- register with the Australian Transaction Reports and Analysis Centre (AUSTRAC);
- implement a program to mitigate and manage money laundering and terrorism financing risks;
- identify and verify the identities of their customers;
- report suspicious matters and transactions involving $10,000 or more (or foreign equivalent) to AUSTRAC; and
- keep relevant records for seven years.
It will be a watershed moment if (and when) a government adopts — or creates — and regulates a cryptocurrency as legal tender.
However — at least in Australia — the absence of official recognition or regulation doesn’t prevent Australia’s taxation laws applying to transactions involving cryptocurrency. The challenge for taxpayers and the ATO is that the taxation legislation has not been updated to adequately deal with these real-world developments (save for some recent amendments to the GST legislation — see below).
The cryptocurrency taxation dilemma is not unprecedented. In recent years, the ATO has published its interpretations of how the established principles in the income tax and GST law should apply to the growing population of online sellers, the sharing economy juggernaut and the ubiquitous Uber network of contractor-drivers in the absence of modernised statute to provide certainty.
Taxing cryptocurrency transactions in Australia
As noted above, Bitcoin is the original and predominant cryptocurrency. The Australian Government and the ATO have mainly focused on Bitcoin in their quest to clarify how the taxation law should apply. The general principles in the guidance (discussed below) may also apply to other forms of cryptocurrency but care must be taken to account for any distinguishing features from Bitcoin.
Income tax treatment of Bitcoin — ATO views (no legislation)
In a suite of taxation rulings issued in 2014, the ATO set out its views in relation to the income tax implications of transactions involving Bitcoin.
Central to the ATO views expressed in its binding guidance is its conclusion that Bitcoin is not money — and is not ‘foreign currency’ — but is instead ‘property’ for tax purposes.
This position is in direct contrast to the recent legislative development (discussed below) which — while it stops short of defining cryptocurrency as a form of money — enables digital currency to be treated in the same manner as money for GST purposes. Despite these changes, the ATO has not withdrawn its income tax guidance nor altered its premise that Bitcoin is not money for income tax purposes.
The Government has not announced any further plans to amend the income tax legislation in relation to the treatment of Bitcoin or other forms of cryptocurrency. Similarly, the ATO has not indicated whether it is reconsidering its income tax position in light of the GST amendments. Currently, taxpayers and their advisers can only rely on the binding interpretation of the ATO.
Aside from the suite of rulings, the ATO has more recently — in late 2017 — released non-binding general website guidance titled Tax treatment of crypto-currencies in Australia — specifically bitcoin (QC 42159).
In the meantime, taxpayers seeking certainty can apply to the ATO for a private binding ruling. As at the time of writing, there are over 20 publicly available edited private rulings relating to Bitcoin.
Non-business use: so is it a revenue, investment or personal use asset?
The income tax treatment of Bitcoin depends — based on the same principles which apply to most other intangible and tangible items — on the purposes for which it is held and the manner in which is it used.
When is Bitcoin subject to the CGT rules?
TD 2014/26 sets out the Commissioner’s view that Bitcoin is a CGT asset, and that:
- CGT event A1 happens if a taxpayer disposes of a Bitcoin;
- a capital gain will arise if the capital proceeds on the disposal of the Bitcoin exceed its cost base; and
- Bitcoin that is kept or used mainly to make purchases for personal use will ordinarily be a personal use asset (see below). In this case, any capital gain arising from a transaction involving Bitcoin will be disregarded (if the first element of the cost base is $10,000 or less), and a capital loss will be disregarded.
In the ATO’s view, Bitcoin will generally be a personal use asset if it is kept or used mainly to make purchases of items for personal use or consumption. For example, if an individual purchased Bitcoin from an exchange and used it to make online purchases for personal use — such as clothing or music — the Bitcoin would be a personal use asset.
Bitcoin would not be a personal use asset where:
- it is used for purchasing income producing investments; or
- the taxpayer keeps the Bitcoin for a number of years with the intention of selling it at an opportune time based on favourable values.
When is profit from sale of Bitcoin taxed as ordinary income from an isolated transaction?
TD 2014/26 states that a gain arising on the disposal of Bitcoin will generally be ordinary income where the taxpayer’s intention or purpose of entering into a commercial transaction was to make a profit or gain. Accordingly, a taxpayer who acquires Bitcoin under a commercial transaction for the purpose of profit or gain will be assessed under s. 6-5 of the ITAA 1997 on the gain arising on disposal, but any capital gain arising under CGT event A1 will be correspondingly reduced under the anti-overlap provision.
In an example given in the determination, where a taxpayer mines a small amount of Bitcoin as a hobby and after two years sells it for a small profit in order to purchase another investment asset, the gain will be assessed under the CGT rules and not as ordinary income. The Bitcoin is not a personal use asset as it was used to purchase an investment. Therefore, the capital gain is not disregarded.
Using Bitcoin for business
Akin to barter transactions
The business’s ordinary income will include the value of the Bitcoin received, expressed in Australian dollars. Under the ATO’s barter transactions rules, the value of the Bitcoin needs to be either its money value or its arm’s length value. The ATO will accept the fair market value — which for example could be obtained from a Bitcoin exchange — as a proxy for the money value or arm’s length value.
Deductions for expenditure paid in Bitcoin will be calculated based on the arm’s length value of what was acquired.
Bitcoin can be trading stock
TD 2014/27 sets out the Commissioner’s view that Bitcoin held for the purpose of sale or exchange in the ordinary course of business is trading stock for income tax purposes.
Bitcoin will be considered trading stock where:
- the Bitcoin is held by a taxpayer in carrying on a business of mining and selling Bitcoin;
- the taxpayer is carrying on a Bitcoin exchange business; or
- it is received as a method of payment by a business that sells goods where it is held for the purposes of sale or exchange in the ordinary course of the business.
Paying salaries and wages in Bitcoin
The ATO has contemplated the possibility of Australian employers offering cryptocurrency as employee remuneration. At the end of 2017, a large Japanese internet company announced its plans to do just that.
In TD 2014/28, the ATO confirms that the provision of Bitcoin by an employer to an employee in respect of their employment is a property fringe benefit — comprising intangible property — for FBT purposes. The determination specifically notes that Bitcoin is excluded from PAYG withholding — and therefore cannot be salary or wages — because it satisfies the definition of a ‘non-cash benefit’.
In practical terms, this means that:
- the employer is liable to pay FBT on the taxable value of the property fringe benefit — unless the value is less than $300 and it is provided a minor benefit (i.e. provided on an infrequent and irregular basis); and
- the Bitcoin is not assessable to the employee.
Interestingly, the position taken in the determination appears to conflict with the more recently released Tax treatment of crypto-currencies in Australia — specifically bitcoin webpage guidance which states that the payment of Bitcoin is a fringe benefit only where the employee has a valid salary sacrifice arrangement with their employer to receive Bitcoin as remuneration. In the absence of a valid salary sacrifice agreement, the guidance states that the remuneration should be treated as normal salary or wages and the employer is subject to PAYG withholding obligations.
It can be inferred that — at least in the context of employee remuneration — the ATO now takes the view that Bitcoin is equivalent to money rather than property. However, TD 2014/28 clearly intends for all Bitcoin provided in relation to employment to be treated as a fringe benefit, as it contains no carve-out for Bitcoin which is not salary sacrificed.
It has become necessary for the Government and the ATO to set out their views on how the recent GST amendments (discussed below) will impact on the income tax and FBT treatment of Bitcoin. A flow-on impact is not without precedent; in 2017, the ATO commenced a consultation on how a Federal Court ruling that an Uber driver provided ‘taxi’ services for GST purposes should affect the FBT treatment of Uber rides.
In the meantime, any affected employer or employee may seek a private ruling for tax certainty — preferably prior to entering into an agreement to exchange services for cryptocurrency (whether or not salary sacrificed).
Some taxpayers may be carrying on a business of mining Bitcoin. Any income derived from the transfer of mined Bitcoin to a third party is included in assessable income. Expenses incurred in respect of the mining activity (which, for example, may include depreciation for computer equipment or home office expenses) may be allowable deductions.
The ATO considers that Bitcoin held by a taxpayer carrying on a business of mining and selling Bitcoin is trading stock. The tax treatment of this Bitcoin is in accordance with the normal trading stock rules, including the simplified rules for small business entities.
Record-keeping for tax purposes
The general record-keeping rules apply to cryptocurrency transactions. The ATO has provided some tailored guidance that the following information should be retained:
- the date of the transaction;
- the amount in Australian dollars;
- what the transaction was for; and
- the other party to the transaction (this may be no more than their Bitcoin address).
The onus is always on the taxpayer to maintain adequate information records for the purposes of the substantiation rules. Depending on the data that is readily available from the taxpayer’s cryptocurrency wallet and/or online exchange account, this could necessitate keeping a secondary record (e.g. a spreadsheet) which sets out the transaction information in a readable and understandable format.
If the taxpayer sells some of their cryptocurrency holding, they will need to determine:
- the appropriate cost base and/or deductible expenses referable to the acquisition, and the sale proceeds on disposal, to correctly calculate the gain or loss;
- whether that gain or loss is on revenue or capital account.
They will also need to ensure that these figures can be substantiated.
Correctly determining the cost of a cryptocurrency holding that is subsequently disposed of presents a practical challenge to taxpayers due to the anonymity, encryption, lack of regulation, and the different ways that exchanges and digital wallets operate. Currently, there is no guidance as to whether the disposal of a parcel of cryptocurrency holding should be determined on a FIFO (first-in first-out) basis, or whether the taxpayer can freely determine which parcel they are disposing of.
GST and ‘digital currency’
Recent GST amendments — ‘digital currency’ as a means of payment
On 30 October 2017, the Treasury Laws Amendment (2017 Measures No. 6) Act 2017 received Royal Assent. The Act amends the GST Act with effect from 1 July 2017 to ensure payments of ‘digital currency’ — including Bitcoin — by consumers are equivalent to payments of money by ensuring that:
- a supply does not include a supply of digital currency unless the digital currency is provided as consideration for a supply that is a supply of digital currency or money — new s. 9-10(4) of the GST Act; and
- an acquisition does not include an acquisition of digital currency unless the digital currency is provided as consideration for a supply that is a supply of digital currency or money — new s. 11-10(3) of the GST Act.
The GST Act now contains a definition of ‘digital currency’. This ATO webpage sets out the characteristics of digital currency in the definition, and things that are not digital currency.
Prior to these amendments, consumers who used digital currencies as payment could effectively bear GST twice:
- once on the purchase of the digital currency; and
- again on its use in exchange for other supplies which are subject to GST.
Now, consumers will not have any GST consequences in relation to buying or selling digital currency, or using it to pay for goods or services.
GST consequences for a business
A business may now use digital currency to pay for goods and services without GST consequences in the same way that it would use money.
Sales of digital currency are input taxed sales of financial supplies. That means if a business only makes sales of digital currency, it will not be required to register for GST even if its annual turnover is $75,000 or more. For a registered business, input tax credits generally cannot be claimed on acquisitions relating to the making of digital currency sales, except to the extent that the financial acquisition reduced credit rules apply.
If a registered business receives Bitcoin or another digital currency as payment, the normal GST rules apply. For example, if Bitcoin is received as consideration for a taxable supply, the business is required to remit 1/11th of the amount as GST.
The amount of GST must be reported on the activity statement as an amount of money in Australian currency.
ATO guidance on converting amounts of digital currency into Australian currency
In mid-January 2018, the ATO released draft determination DCC 2018/D1 which sets out the ATO’s proposed method for converting amounts of consideration that are expressed in digital currency into Australian currency for the purposes of working out the value of a taxable supply. The formula is:
Amount of digital currency × your particular exchange rate on the conversion day
- your particular exchange rate is the taxpayer’s choice of a digital currency exchange rate that is:
- obtained from a digital currency exchange;
- obtained from a digital currency website; or
- an agreed rate between the supplier and the recipient.
If the exchange rate is quoted in:
- Australian currency — use that rate; or
- foreign currency — convert that foreign currency rate into Australian currency following the GST Foreign Currency Conversion Determination (No. 1) 2017.
- conversion day is the date that the digital currency is converted into Australian currency. The conversion day differs depending on whether the business accounts for GST on a cash basis or an accruals basis.
When the determination is finalised, it will apply retrospectively from 1 July 2017, in line with the amendments to the GST law.
SMSF trustees: Invest in cryptocurrency with caution
An increasing number of SMSF trustees have included, or are contemplating including, cryptocurrency as part of their investment strategies. These trustees must proceed with care, and only invest after doing their due diligence.
There is no law that prohibits SMSF trustees from investing in cryptocurrency. But planning to include these assets in an investment portfolio gives rise to numerous issues stemming from well-established SMSF investment principles.
‘Read the trust deed’ …
The trustee must ensure that the trust deed allows the proposed investment. In this regard, investing in cryptocurrency is no different to investing in any other asset class.
The investment must meet the sole purpose test
An SMSF must be maintained for the sole purpose of providing retirement benefits to its members. The fund will breach the sole purpose test if the trustee or anyone else, directly or indirectly, obtains a financial benefit as a result of investment decisions.
Given the notorious difficulties in tracing and proving ownership of cryptocurrency, the trustee must be diligent in ensuring that the online wallets and exchange accounts — and gains and losses — are clearly attributable to them in their capacity as trustee for the SMSF, for example, with trustee resolutions that make it clear that the asset is held in the name of the trustee (see below).
Cryptocurrency cannot be acquired from related parties
A member of an SMSF may be contemplating making an in specie contribution of some of their personal Bitcoin to the fund. However, an SMSF cannot acquire this type of asset from a related party. Under s. 66 of the Superannuation Industry (Supervision) Act 1993 (SIS Act), an SMSF can only acquire specific types of assets from related parties.
The trustee is able to acquire cryptocurrency only from a third party.
Investment strategy must consider risk and diversity
Section 52B(f) of the SIS Act requires the investment strategy to have regard to ‘the whole of the circumstances of the fund’, relevantly including:
- the risk and likely return from investments; and
- the composition of the fund’s investments including the diversity of the investments,
It is indisputable that all forms of cryptocurrency fall into the ‘risky’ basket of investments. There are regular news items in the media about individuals who have chosen to go ‘all in’ with their savings (i.e. by investing 100 per cent of the fund’s assets in cryptocurrency) and come out on top with windfall gains. This approach may work for individuals with high risk profiles, but it is not compatible with the requirements of s. 52B(f).
Unlike real property and shares, cryptocurrency as an investment class does not have ‘low risk’ or ‘less risk’ options with which to diversify within the same asset class. A trustee wishing to incorporate cryptocurrency into an SMSF investment strategy must consider how much extra risk the investment portfolio should bear.
How can title to the cryptocurrency be proven?
The trustee will need to consider whether the SMSF’s auditor will be able to verify that the trustee — in their capacity as trustee of the SMSF — is indeed the legal ‘owner’ of the cryptocurrency.
The relative anonymity of the cryptocurrency system is touted as one of its great benefits — but an SMSF trustee cannot be anonymous or otherwise not transparent in their dealings on behalf of the fund.
Online digital currency exchanges and wallets are not regulated. Before proceeding with a purchase, the trustee should undertake due diligence on the different providers, understand the new client procedures in place, and confirm the information trail that would be readily available to the trustee, the SMSF auditor, other advisers, and the ATO. The trustee’s own records about cryptocurrency holdings and transactions will not be sufficient for regulatory purposes and must be backed up by records sourced from third parties. The information must also be understandable to the reader and, for example, cannot be lengthy computer code which requires power computer equipment to decipher.
Bitcoin: Another catalyst for tax law modernisation
Is Bitcoin — and any of the altcoins — a bubble doomed to burst, or a sure bet in the sport of wealth generation? History will tell …
Bitcoin — irrespective of its future success — has followed the charge led by online selling (eBay, Gumtree), Uber, and the sharing economy (Airtasker, AirBnb). In some respects, the tax treatment of Bitcoin and other cryptocurrencies is no different to traditional means of payment or exchanging goods and services. But what is clear is that Australia’s tax laws need to be updated and must be robust to accommodate the rapid shift to online, borderless transactions and non-traditional means of exchanging goods and services so that taxpayers have certainty in relation to their technologically-progressive dealings.