Cryptocurrency tax reviews are here… are you prepared?
The ATO's recently announced cryptocurrency data matching program continues its steady push into working out how to apply the tax laws to cryptocurrency. It also has the potential to cause some panic among those involved in cryptocurrency dealings.
The ATO has advised that it may contact people and give them the opportunity to verify the information collected, before any compliance action is undertaken – with at least 28 days being allowed for people to clarify any information that has been obtained from the data provider. The Commissioner estimates that records relating to between 500,000 and 1 million individuals will be obtained, so this is no small exercise.
As interest in cryptocurrency has increased, the ATO says it has been working to understand the tax implications and to "plan an appropriate regulatory response". Currently, the ATO acknowledges that it has limited data on the level of investment, gains, losses, transactions made by Australian taxpayers and other information relating to cryptocurrency as there are limited obligations for taxpayers and third parties to provide this information. So, the data obtained from the data matching exercise will be used by the ATO to identify the buyers and sellers of crypto-assets and quantify the related transactions. With the ATO's cryptocurrency data matching program potentially reaching so many people, time is of the essence now more than ever.
Forming a response to clarify information the ATO collects means those affected need to be sure of their position. Adequate records are essential, but not always kept…. and reconstructing records in a short time can be a fraught exercise. Will the ATO be able to reconstruct better and more accurate records of a taxpayer's cryptocurrency dealings than the taxpayer can? While this is unclear, we would not recommend relying solely on the ATO's information and calculation of a cryptocurrency tax bill, or waiting for the ATO to contact the taxpayer.
Given the ATO's cryptocurrency data- matching program will span from 2014-15 to 2018-19, it would be prudent for an affected taxpayer to contact a tax advisor to discuss the extent of their cryptocurrency dealings and if their strategic approach should be considered or revised.
Strategies to help navigate and manage cryptocurrency tax risk could include either, or a combination of:
- Seeking tax advice that is subject to legal professional privilege (LPP);
- Applying for a Private Binding Ruling (PBR) from the ATO to confirm the tax treatment of cryptocurrency dealings. Generally, the Commissioner must give a decision to a PBR request within 60 days. However, in our experience, given the complexity surrounding the tax treatment of cryptocurrency dealings, as well as the difficulty in obtaining accurate and complete records, it is not uncommon for rulings to issue 6 months or more after the application is made;
- Preparing a Reasonably Arguable Position Paper (RAPP); or
- Making a Voluntary Disclosure to the ATO which sets out the grounds for the position that the taxpayer proposes to take with regard to their actual or proposed filings and why penalties and interest should not be applied to the cryptocurrency tax liability.
It is important to note that there are some uncertainties surrounding the tax treatment of cryptocurrency dealings for Australian resident individuals. As well, the information-gathering powers and forensic techniques available to the ATO to find out about cryptocurrency dealings must be kept in mind.
Some uncertainties surrounding tax treatment of cryptocurrency dealings
With regard to the tax treatment of cryptocurrency dealings, there has been no case law to date, there are still uncertainties that prevail and there are circumstances that warrant case-by-case, and differing, applications of traditional tax principles. Whilst the Commissioner has published detailed guidance on the taxation of cryptocurrencies on the ATO website and in Taxation Rulings published in 2014, the guidance can be impractical for token holders to apply. Despite the impracticalities, the guidance is generally appropriate for the limited scenarios that have been covered in the guidance. However, a number of scenarios are not covered.
Some of the impracticalities and tensions for Australian resident individuals dealing in cryptocurrency include:
- High compliance cost and effort, particularly for crypto-to-crypto transactions - Generally, individuals involved in cryptocurrency dealings consider the record-keeping requirements onerous and impractical. This is especially so because of the lack of information generally produced (by the ICO team, exchange, or other counterparty if one exists) at the time of the cryptocurrency transaction, although this is improving. Individuals are also not assisted by the lack of accounting and reporting/tracking tools available to record the details of cryptocurrency transactions that are relevant for tax purposes, although this is also improving.
- Difficulty applying personal use exemption - Individuals may acquire payment tokens and/or stablecoins to hold and use in a similar way to holding and using cash in a bank account. Similarly, individuals may acquire utility tokens because they wish to support the project and anticipate using the token once the functionality is developed.
- The Commissioner has stated that the longer the period of time that cryptocurrency is held, the more likely it looks like an investment (held on capital account), rather than it being held for personal use. To an extent, the Commissioner's view is appropriate however should not narrow and unduly limit the personal use exemption for longer term holding of cryptocurrencies where an individual genuinely wishes to store and use cryptocurrencies as if they were cash in a bank account.
- The Commissioner's views regarding the tax treatment of tokens other than bitcoin have not been publicly stated. The tax treatment of cryptocurrencies that do not have similar characteristics to bitcoin, such as stablecoins, utility tokens, multi-characteristic tokens and multi-tiered tokens, is unclear.
- Private rulings - The Commissioner has stated that the ATO will not consider private ruling requests with questions around the application of the personal use asset exemption unless the cryptocurrency has been disposed. This does not promote confidence in the market to support utility token projects.
- Implicit from the ATO web guidance, it would appear the Commissioner's view in relation to utility tokens is that if the functionality does not exist at the time of acquisition, the token has been purchased as a speculative, investment asset (on capital account). There is little or no certainty that the utility will eventuate so the token will be treated as speculative until it is certain or reasonably certain that the utility will eventuate. There is a lack of precedent at this early time for utility eventuating and the token being used for its utility in Australia.
- Whether foreign currency taxation rules apply to sovereign tokens - It would seem appropriate that a sovereign token - a cryptocurrency issued by a government, such as the Petro token by Venezuela - should be treated as a currency and foreign currency for Australian income tax purposes. However, with the Government of the city of Dubai launching its own cryptocurrency, Emcash, rather than a cryptocurrency being issued at UAE level, further thought should be given to the appropriateness of our foreign currency taxation rules for individuals making large but personal transfers using sovereign tokens.
- Losses arising from profit-making schemes - Insufficient guidance has been provided by the Commissioner in relation to: an individual's ability to claim losses incurred on certain isolated transactions entered into with the purpose of making a profit; and how to distinguish an isolated profit-making scheme from a single investment on capital account.
- If a single cryptocurrency transaction is considered as undertaken as a profit-making scheme, the loss would be on revenue account; if an investment, the loss would be on capital account. From a policy perspective, the distinction needs to be clarified because there will likely be a significant number of taxpayers that invested at the market peak in late 2017/early 2018 and are sitting on realised or unrealised losses, who are likely to reasonably claim a revenue tax loss rather than a capital loss.
- Hard forks / chain splits - The Commissioner's guidance is favourable to taxpayers in that new cryptocurrency received as a result of a chain split is not considered, in the Commissioner's view, to give rise to the derivation of ordinary income or a capital gain. Instead, the capital gain must be calculated at the time the new cryptocurrency is disposed of, where the Commissioner considers the cost base of the new cryptocurrency is zero.
- The technical basis for the Commissioner's view is not explained and is published as guidance on the ATO website, which is not administratively binding upon the Commissioner.
- Tax advisers consider that the tax law does fall short in the case of a hard fork / chain split and that the tax law could be interpreted to result in double taxation. In the event the Commissioner "u-turns" from existing web guidance, taxpayers are left exposed. For example, attempting to determine the tax treatment of a hard fork / chain split by analogising with the tax treatment of share splits, demergers, bonus shares may appear to be logical analogies. However, these tax rules, that were written without anticipation of the nature and nuances of distributed ledger technology, cryptocurrencies and ICOs, do fall short and in some cases anomalies arise where the tax technical outcome is not consistent with what is generally the intention of the tax law (eg no double taxation).
- Although not binding on the ATO, guidance published in the UK by HMRC states that a cost base apportionment occurs so that part of the initial investment in the original cryptocurrency is apportioned to the new cryptocurrency. In addition, as long as taxpayers follow a reasonably fair approach for apportioning the cost base, it is likely HMRC will accept the taxpayer's valuation of the apportionment.
- Airdrops - Individuals may not be aware that they have received airdropped cryptocurrency and the tax treatment of the receipt of airdropped cryptocurrency is unclear. For example, if an individual discovered their ownership of an airdropped cryptocurrency after lodging the relevant year tax return, would the individual: be required to amend the prior year tax return to disclose an amount of income; or not be required to amend on the basis that the tax treatment of airdropped cryptocurrencies should accord with the Commissioner's views regarding new cryptocurrency received from a chain split?
ATO's information-gathering powers and forensic techniques
In addition to the ATO's cryptocurrency data matching program, it has its traditional information-gathering powers available as well as forensic techniques to help fill gaps in information about taxpayers.
Each is discussed below.
Cryptocurrency transactions on an open-source blockchain are pseudonymous, not anonymous. For example, you can download the entire transaction history of Bitcoin (ie the public ledger) from websites such as Blockchain.info or Block Explorer.
The public ledger allows you to identify a specific wallet address and trace various transactions going in and out of that wallet address. From there, forensic procedures can be applied to determine who the wallet is linked to. For example, CryptoHound is an open-access tool that allows users to track various crypto transactions by searching a specific wallet address. Moreover, through a method known as clustering, Chainalysis is able to identify accounts that appear to belong to the same crypto wallet and which are assumed to be controlled by the same entity. The forensic tools used by Chainalysis allows wallet addresses to be linked to owners due to Know Your Customer and anti-money laundering regulations which require cryptocurrency trading platforms to verify users' identities before providing access to their platform.
Ciphertrace is another blockchain forensic company which provides a search engine where users can enter a wallet address or transaction ID. Ciphertrace uses big data analytics to cluster data points to provide an overview of wallet activities and to trace the flow of funds in and out of the wallet over time. The tool allows users to perform bulk uploads of large quantities of crypto wallet addresses for investigation.
The rate of development of blockchain forensic tools is exponential, with an increasing number of trading platforms and regulatory bodies utilising them. This means that the anonymity behind many cryptocurrencies is slowly disappearing and is becoming more transparent as the ATO has an increasingly vast array of forensic tools at its disposal.
Information-gathering powers and asset betterment testing
The ATO can require taxpayers to provide it with particular information by sending them a formal notice. That notice can compel the taxpayer, or third parties, to answer questions, attend an interview and provide evidence, and provide various documents to the ATO.
In simple terms, this means that the ATO can ask taxpayers, or their bank or another organisation, to provide information on any crypto transactions they have made in the past as well as disclose the value of any profits they have made from the sale of cryptocurrency.
In addition, through the ATO's various data matching protocols, the Commissioner is able to undertake "asset betterment" testing and issue a default assessment if a taxpayer's reported income is less than their actual income, assets and transactions.
The standard under which the Commissioner can issue a default assessment after an asset betterment analysis has been performed is relatively low. The Commissioner does not need to definitively identify a source of unexplained income. Rather, so long as the assessment is based on some reasonable or rational ground, then the assessment is valid. In effect, the Commissioner is allowed to make an educated guess concerning a taxpayer's actual income and is not required to prove the nature of the taxpayer's income or prove his reasoning. As a result, the courts have been prepared to give the ATO considerable leeway in making default assessments, particularly where the taxpayer has made it difficult for the ATO to assess them accurately.
In relation to cryptocurrency activities, this means that the ATO does not need to positively identify a taxpayer as owning a particular crypto wallet or making a particular transaction. The ATO merely needs some reasonable basis to suggest that a taxpayer made certain crypto transactions, after which, the onus falls on the taxpayer to prove the ATO is incorrect. For example, using the formal information-gathering powers or data matching protocols, the Commissioner may see a certain sum of money coming into a taxpayer's bank account and then through blockchain forensic tools, see that a similar amount left a crypto wallet on the same date. While it is not definitive that the wallet belongs to the taxpayer or that a particular sum of money is cryptocurrency related, the ATO is nevertheless able to issue a default assessment under the suspicion that the unexplained income is a crypto-related gain.
Once the Commissioner has issued a default or amended assessment on the basis of asset betterment, the taxpayer will bear the onus of proving the Commissioner's assessment is wrong, which is a difficult burden of proof. It is well established that in order to satisfy this burden, it is not enough for a taxpayer to merely show that the ATO has made a mistake in the process of its assessment. Rather, the taxpayer must establish definitively that their taxable income is less than the amount assessed by the ATO. In one case, a Court noted that even if a taxpayer is successful in demonstrating that the assessment was incorrectly calculated, this does not discharge the burden of proof placed upon the taxpayer to show that the amended amount did not form part of the taxpayer's assessment. If the ATO alleges certain income as a result of crypto-related gains, the taxpayer would need to prove that the money in question came from another source and provide evidence.
Tax strategy can be complex, not to mention the complexity of the underlying tax treatment of cryptocurrency dealings and keeping appropriate records. In cryptocurrency, where records can be difficult to reconstruct, we may see a number of asset betterment based default or amended assessments being issued to taxpayers. As taxpayers ultimately bear the onus of proving that an assessment is incorrect or excessive, we strongly encourage taxpayers to keep proper records and seek tax advice to properly manage the tax implications of cryptocurrency dealings.
This article was first published in the Thomson Reuters Weekly Tax Bulletin, Issue 20, 10 May 2019
You might be also interested in...
Tax | 28 May 2019
Tim Pallas MP, Treasurer for Victoria, delivered the FY20 state budget (Budget) in Parliament yesterday afternoon and the State Taxation Acts Amendment Bill 2019 (Bill) was introduced to Parliament to implement proposed tax changes.
Tax | 31 May 2019
Talking Tax is our weekly round-up of all things tax…