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April 15, 2021

Computer Age: Taxation of Cryptocurrencies

In the 21st century, cryptocurrencies have gained huge traction globally, particularly with the creation of Bitcoin in 2009. Evidence of this significant increase in demand is that there are now more than 4,000 cryptocurrencies to choose from.

However, despite this increasing popularity, a significant proportion of the population is still unsure as to what cryptocurrencies actually are, and whether they are worth investing in from a tax perspective.

Trading in cryptocurrencies certainly has its success stories with there now being an estimated 100,000 people with $1 million or more invested in bitcoin. However, you should take care when considering these investments as there is a large amount of volatility involved when dealing with these transactions. For instance, in January 2021 the total market value of all cryptocurrencies dropped by more than $100 billion over the space of just two days.

What are Cryptocurrencies?

HMRC published their most recent guidance regarding cryptocurrencies on 30 March 2021, where they defined cryptocurrencies as “cryptographically secured digital representations of value or contractual rights that can be transferred, stored and traded electronically”.

For a more comprehensible definition, cryptocurrencies are identified as a method of payment that can be used to purchase online goods and services.

Types of Cryptocurrencies

HMRC’s view on cryptocurrencies is continually developing in line with the increasing commercial awareness, although they have specifically stated that they do not consider cryptocurrencies to be money or a form of currency, but rather an asset an individual owns.

HMRC distinguish between four different types of cryptocurrencies, which are separated into the following categories:

  • Exchange tokens – the vast majority of cryptocurrencies are of this type, where they are used to make payments, and provide no rights to goods or services (e.g. bitcoin).
  • Utility tokens – provides the owner with access to a particular good or service (e.g. game tokens issued by a video game producer).
  • Security tokens – gives the holder a right to certain interests in a business, such as a share of the profits.
  • Stablecoins – coins that are fixed in relation to a specific asset, where this asset has a steady value.

It should be noted that although cryptocurrencies are defined based on the above categories, the tax treatment of each type of cryptocurrency is treated in a similar tax perspective, and the actual tax conduct of a specific cryptocurrency is dependent on how that token is used.

Capital Gains Tax

Where cryptocurrencies are deemed to have been held as a personal investment, the disposal of the asset will be subject to capital gains tax rules in the year of disposal.

HMRC classify an investor as someone who principally engages in cryptocurrencies as a personal investment tool. With this in mind, an investor’s income will be comprised fundamentally from short and long-term capital gains.

The chargeable capital gain will be the difference between the proceeds from the sale of the cryptocurrency and the value of the asset when it was acquired, as well as any other allowable costs (e.g. commission and trading fees) that can be deducted from the sale proceeds.

Moreover, in the case where the disposal of a cryptocurrency creates a capital loss, the normal rules of capital gains tax applies. Namely, the capital loss can be used to offset any other capital gains incurred in the tax year in question, and any unused losses can be carried forward to subsequent tax years to reduce any future gains.

Income Tax

Alternatively, in the case where cryptocurrencies are traded as part of a business activity, any profits earned will be taxed according to the income tax rules.

A trader is someone whose primary source of earnings is the purchasing and disposing of cryptocurrencies. Therefore, rather than each disposal being treated as a single capital gains event, instead the collective profits earned from the cryptocurrencies will be treated as part of an individual’s personal income.

In order to be considered a trader, HMRC will look at the frequency, volume, and sophistication of the trading. In the case of Akhtar Ali v HMRC [2016], it was held that the taxpayer was a trader with the courts, pointing towards the pursuit of a clear business plan in an organised manner as the main contributing factor to this.

In light of the above, the vast majority of individuals are unlikely to meet the required thresholds to be considered a trader. Although, if you believe that you may meet the requirements to be considered a cryptocurrency trader, HMRC encourage you to have a look here for further details.

Types of Cryptocurrency Transactions

There are a number of cryptocurrency transactions that can have a tax impact on individuals, where the following types are the ones that are most commonly used:

  • Forks – obtaining new tokens in addition to your existing tokens, due to a change in the blockchain protocol.
  • Mining – solving “algorithmic puzzles involved in blockchain networks”.
  • Staking – purchasing cryptocoins and then holding them for a set amount of time.
  • Airdrops – acquiring a free token in your wallet.
  • Crypto donations – donating cryptocurrency to charitable organisations.

Please note that these transactions can have varying impacts on your tax position, therefore you should seek advice if you are unsure regarding the tax implications of any of the above.

Record Keeping

Whether your cryptocurrency activities are deemed to be taxed on an income or capital gains basis, it is important that you keep clear records of any of your cryptocurrency transactions.

This is so that you can accurately report any gains/profits on your tax returns to avoid any penalties and interest arising from HMRC.

Please note that the taxation of cryptocurrency is an evolving concept, and this article only covers the fundamental areas. Therefore, if you have any queries around any of the topics discussed in this article, please do not hesitate to get in contact with a member of the team for expert tax advice.

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