Cryptoassets and tax

Answer

Introduction

On 31 October 2008, Satoshi Nakamoto (a pseudonym) laid out a vision of a cryptographically secured peer-to-peer electronic payment system, one that would remove third-party systems and give control to the consumer. It was the birth of the Bitcoin.

The use of terms such as ‘electronic cash’ in Satoshi’s paper is indicative of Bitcoin’s proposed use as a medium of exchange. And so it was that on 11 May 2010, the first ‘official’ Bitcoin purchase reportedly took place – a pizza purchase of 10,000 Bitcoin that would cost more than £200 million if it took place today.

A key tenet of Bitcoin is that there’s a hard limit on the number of Bitcoin that will ever exist. This number is set at 21 million and as of 29 January 2023 there remains only 1,723,675 Bitcoin left to mine. Given Bitcoin’s novel nature, it’s attracted global interest and the wide-spread emergence of cryptocurrency brokers has increased accessibility to Bitcoin and other cryptocurrencies such that it can be traded on a mobile phone. This has not come without risks. In the last 12 years, there have been four cryptocurrency bubbles, each with increasing severity. While volatility may not have been in Satoshi’s vision, it’s now a crude reality of modern-day cryptoassets. So much so that cryptoassets are increasingly being used as a method of investment rather than as the medium of exchange Satoshi envisaged. Given that institutional investors, such as Goldman Sachs, Morgan Stanley and JP Morgan, have all invested heavily in their cryptoasset services recently, it’s unlikely that this trend will slow down.

However, not all parties are unified. Despite transactions involving Bitcoin totalling more than 813 million, HMRC has been an ardent critic of cryptocurrency being used as a means of exchange. In HMRC’s CRYPTO manual, it explicitly states that it doesn’t consider cryptoassets to be currency. Relying on the position set out in the 2018 Cryptoasset Taskforce report, cryptoassets are “too volatile to be a good store of value, not widely accepted as means of exchange, and they are not used as a unit of account”.

This article will examine the relationship between individual ownership of cryptoassets and the interaction of the UK Capital Gains Tax (CGT) and Inheritance Tax (IHT) regimes. Income Tax may also be applicable – for example, liability may arise where individuals receive cryptoassets for employment, through mining or staking, on the receipt of certain airdrops, or where an individual buys and sells cryptocurrency as a financial trade, although this is out of scope of this article and will not be considered further. The article has been limited to CGT and IHT as they’re most relevant to most UK resident owners of cryptoassets.

Defining Cryptoassets

So, if cryptoassets aren’t currency, what are they?

HMRC provides the following definition:

“cryptographically secured digital representations of value or contractual right that can be:

• transferred;
• stored; and
• traded electronically.”

The CRYPTO manual suggests four main types:

Exchange tokens

Exchange tokens are crypto tokens that are issued by cryptocurrency exchanges; the most common example being Bitcoin. HMRC concedes that exchange tokens are intended to be used as a medium of exchange, but stresses that they’re increasingly used as a means of investment.

Utility tokens

Utility tokens represent access to goods or services. Most non-fungible tokens (NFTs) are likely to fall under this category and tend to also include an underlying smart contract to govern what’s being purchased or sold, often real-world assets.

Security tokens

Security tokens offer rights or interests in a business and are somewhat comparable to the purchase of shares. They’re a less common form of cryptoasset, most likely due to them being subject to stricter regulation.

Stablecoins

A stablecoin is a type of exchange token that’s pegged to a reference asset, often fiat currency or precious metals. As they’re designed to be a less volatile alternative than other forms of cryptoassets, they’re arguably the most practical store of value and consequently the best alternative to traditional currencies. The global attraction to stablecoins lies in this lack of volatility and, provided this condition is fulfilled, mainstream adoption of stablecoins may weaken HMRC’s assertion that cryptoassets are too volatile to be considered currency.

While the tax treatment of different types of cryptoasset is generally uniform, it’s possible that in the future, HMRC may take a differing approach to maintain stability and protect the public from unexpected volatility.

IHT treatment of cryptoassets

Cryptoassets are considered property for the purposes of Inheritance Tax, and so when calculating the value of an individual’s estate, any cryptoassets should be identified and valued.

Particularly volatile holdings can give rise to certain issues.

Volatility may lead to disproportionate IHT liability

Assets are generally valued for IHT purposes as at the date of death. If there’s an IHT liability on the estate, and cryptoassets drop significantly in value prior to their sale, the IHT liability could be disproportionate to (or even exceed) the value of the holding. There are potential reliefs available to executors where this occurs with shares or land, but as it stands these reliefs don’t extend to cryptoassets.

Another scenario worth considering is where cryptoassets are gifted during an individual’s lifetime. Lifetime gifting is a common method of estate planning; provided the donor survives for seven years and ceases to retain a benefit in the asset, the value of that asset will not form part of their taxable estate. If the donor dies within seven years of the gift, the value of the asset will form part of their taxable estate but will be frozen at the value as at the date of the gift. Gifting assets that are expected to increase significantly in value can therefore prove useful for estate planning, even if the donor fails to survive seven years, although this may result in unintended consequences where volatile assets are gifted.

Effect of gift with reservation of benefit rules on stablecoins

If the donor retains a benefit in the asset, the gift may fall under the gift with reservation of benefit (GROB) rules, and the value of the asset as at date of death would remain in the donor’s estate. This has particular relevance to cryptoassets that are linked to an underlying asset. If the donor retains a benefit in that underlying asset, a GROB may arise, irrespective of the donor relinquishing their ownership of the cryptoasset itself.

Situs

The location of an asset for tax purposes (its ‘situs’) will impact its UK tax treatment for certain individuals. Those who are non-UK domiciled are generally only subject to IHT on their UK situs assets. Those who are UK resident, but non-UK domiciled are eligible to be taxed on the remittance basis; an alternative tax treatment where non-UK income and gains are only subject to UK tax if and when they’re brought into and used in the UK.

The rules relating to the situs of property differ depending on the type of property in question. While land has a physical location and its situs is more easily identified, cryptoassets are digital representations of value and so can prove more challenging.

Where cryptoassets represent a physical underlying asset, HMRC guidance states that the situs will be determined by that underlying asset and not the crypto itself. Where there’s no underlying asset, the guidance is more controversial. Let’s take exchange tokens as an example, where HMRC takes the position that the residence of the beneficial owner is the determining factor. While this is only guidance and hasn’t been legislated, the approach has been somewhat reflected in the courts.

In Ion Science Ltd v Persons Unknown (unreported, 21 December 2020) and Fetch.ai vs Persons Unknown [2021] EWHC, it was determined that the lex situs of a cryptoasset is the place where the person or company who owns it is domiciled. In Ion Science, Butcher J conceded that there was no authority for the decision but referenced Professor Andrew Dickinson's book Cryptocurrencies in Public and Private Law in his judgment.

It’s more likely that the test applied in the courts will be one of residence over domicile. The recent decision in Tulip Trading Limited v Bitcoin Association for BSV and others [2022] EWHC 667 (Ch) provides some clarity. In obiter, Justice Falk refers to Butcher J’s comments and suggests that the discussion in Dickinson’s book was actually one of residence, not domicile. She goes on to state that “Butcher J himself referred to residence in the same judgment, strongly indicating that he was not intending to say that domicile was the sole relevant test”.  

This is an unfavourable position for UK resident and non-UK domiciled individuals, who may therefore be liable to UK tax on cryptoassets without availability of the remittance basis. In addition, if such a person was to purchase cryptoassets using untaxed foreign income or gains, they may have inadvertently remitted those funds into the UK. From an IHT perspective, cryptoassets wouldn’t be considered excluded property by virtue of Section 6 of the Inheritance Tax Act 1984, increasing IHT exposure for non-UK domiciled individuals and limiting their available estate planning opportunities.

The approach is somewhat of a departure to common law treatment of other intangible property, a point which the Society of Trust and Estate Practitioners (STEP) raise in its guidance published 3 September 2021. It argues that instead “a case could be made for allocating the location of cryptocurrency to the place where it can effectively be dealt with. This is, for example, the principle that has been applied to shares (and is normally where the share register is located)”.

In the case of cryptoassets, a private key is required for its use; a long line of cryptographically secured code that is stored in a crypto wallet. Crypto wallets can be custodial, meaning a third party is responsible for safeguarding the key, or non-custodial, where the onus for safeguarding is on the owner. To further muddy the waters, a distinction can be made between ‘hot’ wallets, stored on the internet, and ‘cold’ wallets stored offline (commonly on external hard drives).

Different types of wallet may lead to different conclusions of situs. STEP argues that it’s not necessarily the residence of the beneficial owner that should determine situs, but “the location of the private key or of the person who has control of the private key”. So, where cryptoassets are held on behalf of the beneficial owner by a third party, such as a cryptocurrency exchange, situs should be determined by the residence of that third party. This stance would also suggest that where private keys are held in a cold wallet, situs should instead be determined by the physical location of that wallet. A remittance base user would need to be careful in bringing the wallet into the UK to avoid a taxable remittance.

As it stands, this may lead to a determination of situs that’s inconsistent with HMRC guidance and there’s no guarantee such an argument would be accepted.

CGT treatment of cryptoassets

CGT may arise where an individual disposes of their cryptoassets at a gain. Disposals of cryptoassets include:

• selling them;
• using them to purchase goods and services;
• gifting them (except to spouses and civil partners); and
• exchanging them for other cryptoassets.

The second point is a clear dent in Satoshi’s vision of Bitcoin being used as a means of exchange. If individual holders of Bitcoin are required to calculate gains or losses on crypto they use to purchase goods and services, such users may be dissuaded from regular spending. This may further entrench the perception that cryptoassets aren’t viable means of currency.

There’s an issue for UK-resident owners of crypto that’s somewhat reminiscent of the earlier treatment of foreign currency held in bank accounts. Prior to 5 April 2012, foreign currency bank accounts could give rise to chargeable gains or allowable losses; an account holding foreign currency with a credit balance was treated as an asset, and a withdrawal from that account was treated as a disposal, possibly triggering a chargeable gain.

Section 252 Taxation of Chargeable Gains Act 1992 (TCGA 1992) changed this, mostly to the benefit of the taxpayer. Section 252 states that for individuals, trustees and personal representatives, foreign currency bank accounts are now treated in line with ‘simple’ debts and will not give rise to chargeable gains or allowable losses. In a similar vein, section 269 TCGA 1992 provides another useful exception, such that gains on foreign currency acquired for personal expenditure outside of the UK of the owner and their family or dependents will not be considered chargeable.

As cryptoassets aren’t considered currency, its owners cannot rely on these provisions. If cryptoassets were treated for UK tax purposes in a similar fashion to foreign currency, we might be one step closer to Satoshi’s vision of using Bitcoin as ‘electronic’ cash. However, while volatility remains in the crypto market, most cryptoassets will prove difficult to rely on as a means of exchange and are unlikely to meet HMRC’s threshold for currency. After all, who wants to look back in 14 years’ time and realise that a pizza cost you £200 million?

Looking forward

This article has provided a brief insight into the types of cryptoasset, and commented on the IHT and CGT treatment of cryptoassets. The lack of legislative authority in this regard and inconsistent approaches on situs is evidence that the taxation of cryptoassets is an evolving area of law. However, steps are being taken to regulate cryptoassets and provide certainty. In April 2022, the government committed to introducing a new regulatory regime for cryptoassets, and on 1 February 2023, a consultation and call to evidence was launched. Economic Secretary to the Treasury Andrew Griffith, clarified the government’s willingness to capitalise on the emergence of cryptocurrency, specifically as a medium of exchange, and secure the UK’s position as a world-leader in Fintech. Inviting discussion from market experts, the government is looking to understand how best to bring various cryptoasset activities, including, issuance, payment, exchange, investment and risk management activities, into the regulatory perimeter and the order in which to do so as there’s currently a two-phase process. The regulation is intended to bring certainty to the UK cryptoasset ecosystem and ensure the protection of consumers with the end result of stablecoin cryptoassets being adopted as a viable alternative medium of exchange. The consultation will close on 30 April 2023.

On the global stage, institutions such as the IMF and International Organization of Securities Commissions (IOSCO) have also been actively engaging with the regulation of cryptoassets. In 2022, the IOSCO released its Crypto Asset Roadmap for 2022-2023, which will see the publication of a crypto and digital asset report containing policy recommendations toward the end of 2023. Similarly, at the beginning of the year, the IMF released a policy paper that examined the merits of cryptoassets and provided guidance to IMF members on how to structure an appropriate policy response. Nine key elements were suggested, and interestingly, the recommendation to not grant cryptoassets official currency or legal tender status is listed first, in addition to the adoption of unambiguous tax treatment of cryptoassets, and strengthening of global cooperation, among others. While the UK government is aligned on many of these elements, specifically the adoption of an unambiguous cryptoasset tax regime, it’ll be interesting to see what impact this year’s consultation will have.

Jacob Ashforth is a solicitor in the tax, trusts and family team, and Pritpal Virdee is a trainee solicitor at Burges Salmon LLP.