Tax, blockchain and cryptocurrency – what’s all the fuss about?
Blockchain, cryptocurrency, etc – all this new language – what's it all about and why the fuss?
Good questions and questions beginning to focus the minds of more and more people, including tax practitioners. Blockchain and cryptocurrencies are on the rise, so it's important to have some idea of what's going on and some appreciation of likely tax consequences of the cryptocurrencies and structures around them.
The Australian tax consequences for Australian resident investors upon the purchase of cryptocurrency and upon each release of functionality can vary from taxable to non-taxable based on the differing characteristics of cryptocurrencies. As such, it is important to understand the initial and proposed future characteristics of a cryptocurrency before purchasing. In addition, each time there is a change to the characteristics of the cryptocurrency, there is potentially a taxing event for the investors and the issuing entity/foundation and/or a change in the tax treatment of the cryptocurrency.
Blockchain is developing technology and these comments are general and subject to change. In simple terms, blockchain technology represents a type of next-generation business process improvement software. Blockchain-based systems could operate at a number of levels including at whole or parts of government, industry, consortium, exchange and market platforms and public and private businesses. Cryptocurrencies are based on blockchain technology.
Unlike the internet that had almost 20 years to improve before significant investment and mass uptake, the market capitalisation of blockchain projects (largely cryptocurrencies) was already $158.5 billion at August 2017 at less than 10 years since the Bitcoin blockchain was launched in 2009.
This level of capitalisation suggests the need for regulatory bodies, especially the ATO, to invest in understanding the technology and to put appropriate measures in place that protect business and consumers while encouraging innovation.
What is blockchain?
In basic terms, blockchain technology is a means to record the truth without a trusted intermediary like a bank. A public blockchain is an online, open-source database of transactions that is managed by a network rather than just one entity. Blockchain technology is also referred to as distributed ledger technology because of its reliance on a network of "miners" (or nodes) to verify transactions in a block. What happens on a blockchain cannot be subsequently corrupted or changed unless the network agrees to the change, which the network is not incentivised to do.
Miners share the responsibility for verifying transactions through a consensus (or proof of work) process, which is based on cryptography. Alternatives to proof of work such as proof of stake are the subject of great discussion for their ability to address some inefficiencies and costs of obtaining consensus by proof of work.
Cryptography is another defining feature of blockchain technology. Cryptography is most simply explained as a process that requires a mathematical equation to be solved before transactions are recorded on a blockchain. Using cryptography, miners compete against each other to find the mathematical equation that successfully verifies the block of transaction data. The first miner to solve the mathematical equation is generally rewarded for its effort and the transactions are recorded as another block on the blockchain.
Private and permissioned blockchains are very attractive for business and industry application. A private blockchain is managed by a central authority, which can be one person or organisation or a private consortium. Private blockchain technology might contradict the founding and defining feature of public blockchain technology (which requires transactions to be verified by a decentralised network) however represents a private testing ground for businesses and private consortiums to experiment with the technology.
Tax disclosures when raising funds through an initial coin offering (ICO) or token generation event (TGE)
In Australia, raising funds via the issue of securities in a company or units in a trust generally requires a disclosure document (eg prospectus, information statement, product disclosure statement) to assist non-sophisticated investors make an informed decision about the risks and returns of the investment.
Where a prospectus is required, the content of that prospectus must include any significant tax implications of the investment. In addition, any claims about material tax advantages must be supported by statements from experts or a tax ruling from the Commissioner of Taxation (Commissioner).
Raising funds via an ICO may not require a disclosure document where the cryptocurrency being offered has the same characteristics as Bitcoin because Bitcoin is not considered a security or a financial product. However, to comply with the Corporations Act 2001, a disclosure document may be required at the time that further functionality is developed if that functionality changes the characteristics of the cryptocurrency to resemble a security or other financial product. Most digital currency businesses provide a Whitepaper, which is a document that sets out the basic technical specifications of the blockchain-based cryptocurrency. Concerns of a cryptocurrency bubble are largely driven by the fact that the technology does not have to be built (or the concepts tested) at the time of ICO/TGE and of writing the Whitepaper.
From a tax perspective, further functionality may change the nature of the cryptocurrency from something that has the same characteristics of a Bitcoin to something that falls within the definition of a security or other financial product. The ATO has already provided guidance on the general income tax treatment of cryptocurrency in Australia, specifically Bitcoin, although it cannot be relied upon as advice. Where other cryptocurrencies have the same characteristics as Bitcoin, the ATO guidance should apply equally to the tax treatment of those other cryptocurrencies.
In broad terms, an individual simply paying for personal use goods or services in Bitcoin should not be subject to income tax or GST - any capital gain or loss from disposal of the Bitcoin will be disregarded if the Bitcoin was purchased at $10,000 or less. However, where Bitcoin is used in business transactions or for investment purposes, gains and losses should be assessable and deductible.
Without general tax comments being included in a disclosure document, the ATO guidance may be sufficient for investors to have reference to in determining the tax implications of their initial investment in a cryptocurrency at the time of the ICO. However, to the extent possible, we would strongly recommend that a disclosure document address the general tax implications for investors upon each functionality release. Alternatively, investors should be informed as early as possible before new functionality is released, about the general tax consequences resulting from the changing nature of the cryptocurrency.
Despite the general tax comments, investors must be told to seek their own tax advice based on their personal circumstances.
As a basic standard, those considering an ICO or TGE should review the initial and proposed characteristics of the cryptocurrency (as per the Whitepaper) against the ATO guidance on tax treatment of cryptocurrencies in Australia, to determine whether the ATO guidance is generally applicable for the investors. If the ATO guidance is not applicable, the Australian tax implications for investors in the cryptocurrency will vary based on the investor's purpose for purchasing or acquiring the cryptocurrency (eg for investment, trading, carrying on a business, mining or conducting an exchange).
The above process should be repeated for each release of new functionality. It is important to understand how each functionality release will change the nature of the cryptocurrency. For example, does the new functionality create rights that commonly attach to a share (ownership, voting, participation in profits)?
Due to the emerging nature of blockchain and cryptocurrency, we strongly recommend that a ruling be obtained from the ATO to confirm the appropriate tax treatment of the cryptocurrency initially and upon each release of functionality, at least for investors and at best also including tax considerations for parties involved in the underlying structure.
Due to China's recent ban on ICO's and digital currency exchanges, Australia has become an attractive destination for overseas entities to undertake an ICO.
If the current or proposed legal and contractual arrangements between the relevant parties is lacking in documentation that would ordinarily exist between independent, arm's length parties, there is an increased risk that the ATO could assert the arrangement is not consistent with one that independent parties would enter into. As a result, the Commissioner could issue amended assessments based upon Australia's transfer pricing rules. The burden then falls upon the taxpayers to prove the arrangement is arm's length.
In addition, the newly introduced Multinational Anti-Avoidance Law (MAAL) could potentially apply when a non-resident that is a Significant Global Entity (ie global sales of more than AUD1 billion) establishes an Australian associate to sell cryptocurrency to Australian end-users when it otherwise would have done so through a taxable permanent establishment (PE). Despite that a cryptocurrency will be available for sale globally, the MAAL rules could be triggered and result in significant penalties.
Overseas entities considering an ICO or TGE in Australia should have regard to:
- whether the Australian entity is acting as principal or agent of an overseas entity
- the source of ICO proceeds and any subsequent gains and losses
- whether the digital currency business being conducted outside of Australia could be treated as a PE in Australia
- whether any amount of the ICO proceeds and gains/losses could be apportioned between Australia and overseas locations
- whether investment in the cryptocurrency by international related parties could result in Australia's transfer pricing regime applying or disclosures being required in the Australian entity's International Dealings Schedule (attached to the annual income tax return if certain international transactions exceed $2 million)
- whether, for transfer pricing purposes, the Australian entity managing the ICO/TGO could be treated as liable to pay an arm's length licence/royalty fee to an overseas entity for use of the blockchain technology in Australia notwithstanding the absence of a formal licence agreement, in addition to royalty withholding tax
- whether, for transfer pricing purposes, the Australian entity could be treated as assessable on an arm's length management fee payable from the overseas entity, notwithstanding the absence of a formal agreement
- whether, as further functionality is released, earlier tax treatments could be impacted and
- whether nodes could be treated as controlled foreign entities of the Australian entity.
In order to provide Australian tax advice in respect of the activities being conducted by the Australian and overseas entities, a tax advisor would need to understand a number of things, including the functions, assets and risks of the Australian and overseas entities, including in relation to the ICO and subsequent functionality releases, whether the blockchain code will be open-sourced and where the contract for the purchase and sale of the cryptocurrency is entered into and by which entity.
Australia is leading the development of international standards on blockchain technology. In April 2016, Standards Australia submitted a New Field of Technical Activity proposal on behalf of Australia for the International Organisation for Standardisation (ISO) to consider making standards to support blockchain technology. Since then, the ISO approved the proposal for new international blockchain standards and Standards Australia:
- was appointed manager of the Secretariat of ISO/TC 307 Blockchain and electronic distributed ledger technologies
- hosted the first international blockchain standards meeting
- prepared a Roadmap report to inform the development of ISO/TC 307.
Standards Australia is advocating for clear guidelines for developing blockchain applications, as well as relevant privacy and security measures. Interoperability standards, so that blockchains can interact with each other, is a key focus. Otherwise, Standards Australia suggests that broad adoption and use of blockchain technology will not be possible.
We strongly recommend that a Whitepaper include reference to its interoperability capability.
The Australian Digital Commerce Association's (ADCA) Code of Conduct establishes best practice standards for digital currency businesses in Australia, including digital currency businesses based outside of Australia but which provide services within Australia and is the only current Australian standard for digital currency businesses.
Obtaining ADCA certification is voluntary and costs involved are borne completely by the business.
An ADCA Certified Digital Currency Business must implement business processes, systems and policies that enable it to comply with the Code. For example, the business must:
- convene an ADCA Code Compliance Committee
- maintain accurate and complete records of all transactions
- maintain a risk-based level of professional indemnity insurance cover of not less than $1 million as well as other appropriate insurances
- comply with the Sanctions Law and applicable Anti-Money Laundering (AML) / Counter-Terrorism Financing (CTF) Law, or to the extent that AML/CTF does not apply must comply with so much of AML/CTF as would be applicable if AML/CTF Law applied to Digital Currency Business
- clearly describe their complaints handling process and contact details.
The business seeking ADCA Certification must initially provide the following to its Code Compliance Committee in addition to payment of the application fee:
- completed self-assessment using the Code Compliance Checklist
- a written undertaking to instruct an external auditor approved by ADCA to conduct a review of the business processes, systems and policies and provide a report within 5 months of the Committee providing Provisional Certification; and
- a written undertaking to observe all the provisions of the Code.
Once the Committee provides Provisional ADCA Certification, the business may apply to the ADCA Board for ADCA Certification. The ADCA Board will determine the application fees to be paid and the fee/s are not refundable in the event of an adverse determination.
Provisional Certification will lapse if the applicant does not provide an external auditor's report within 5 months or if a material act of non-compliance with the Code is committed. Once Certification is granted, the business must, at its own expense, commission a two-yearly external review of its business processes, systems and policies to confirm they remain adequate and compliant with the Code.
There is a lot of detail to become familiar with and consequences to understand, in the emerging world of blockchain and cryptocurrencies. Developments and changes continue and it is hoped this article may have set out a useful starting point.
This article was first published in the Thomson Reuters, Weekly Tax Bulletin.
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