Comparative cryptocurrency taxation
“Another name goes up in lights, like diamonds in the sky”- Taylor Swift (The lucky one)
Introduction
The ‘Fourth Industrial Revolution’ as described by Professor Klaus Schwab[1] as a description of our present age, is fundamentally different from the preceding three. It is characterized by a range of new technologies that are focused on the integration of the physical, digital and biological worlds which impacts almost all disciplines industries, and even challenges ideas about what it means to be human. The resulting shifts and disruptions mean that we live in a time of both, great promise and peril. The world has the potential to connect billions more people to digital networks, dramatically improve the efficiency of organizations and even manage assets in ways that can help regenerate the natural environment, potentially undoing the damage of previous industrial revolutions.
Altering the nature of the medium of transaction is perhaps the greatest challenge of any ‘revolution’ for a multitude of reasons including a systemic inertia arising out of a sense of familiarity. Gold, with its combination of lustre, natural scarcity and malleability dominated[2] in this domain for about 5000 years- used first solely for religious purposes and then beginning 700 BC and its usage as tokens or ‘coins’ then as monetary unit and at its peak, as the hallowed ‘gold standard’. With time and other historical externalities, the value of a dependency of ‘money’ on an international gold standard seemed redundant which led to the birth of the Fiat currency. The guarantee of the value of the money is determined by the government retaining its value through government stability and that of the nation’s economy. Cryptocurrency has the potential to cause a great disruption in the financial system akin to the one ushered in by Fiat. It is thus important to reconcile new technological developments that are principally similar in character as existing entities with the regulatory architecture and incorporate the same within the legal system so as to not create a situation where the legislative provisions related to taxation are not inadvertently deemed de facto irrelevant. In this regard, it is pertinent to assess how other jurisdictions deal with this subject to draw important principles from developments in other jurisdictions that are relevant to reach a position where cryptocurrency may be taxed viably within the Indian legal system
Cryptocurrency classification
The categorisation of income is the primary basis for the calculation of total income for the purposes of levy of income tax. This is thus the first challenge with the umbrella term of ‘cryptocurrency’ as they can be classified in functionally various types. Cryptocurrency is a blockchain token, it is essentially information stored on a blockchain that grants a member of the blockchain network specific rights- thus, it can be thought of as a form of intangible property or goods as the common factor of ‘conferment of specific rights’ is a common thread. Thus, tokens may be of various forms such as equity tokens which grant their holder ownership rights in an underlying entity, asset, or process. A holder of an equity token has the right to dividends or to a share in the profits or assets of a specific business or legal entity. That type of equity token is similar to a share of stock or a partnership interest. Equity tokens may also grant its holder an ownership interest in a specific asset or grant a share in a pool of assets. Utility tokens are tokens that may be used to access specific services in a closed ecosystem. For example, utility tokens may be used as a medium of exchange between consumers and service providers and thus has the characteristics of currency as a medium of exchange. Intrinsic tokens are tokens generally similar to utility tokens, except they may be used anywhere as they function in an open ecosystem. An intrinsic token can be used as a medium of exchange between any two willing parties for the transfer of goods or services and these include currencies like Bitcoin (BTC), Litecoin (LTC) etc. Asset-backed tokens track the monetary value of particular assets, such as gold or demarcated land. There are hybrid currencies like Ethereum (ETH) which are used as medium of exchange for fiat currencies and even for other property or services.
Taxation in the United States
In the United States, the formal guidance issued Internal Revenue Services is Notice 2014–21 which provides a useful but somewhat outdated and vague guideline with regards to taxation. The basic rule thus lays down that cryptocurrency is ‘property’ for federal income tax purposes.[3] This is relevant as treatment of tokens as currency for tax purposes would mean that taxpayers would be able to use blockchain tokens as described, as a functional, private and alternate currency for all accounting and other administrative purposes[4] of section 985 of the Federal Tax code, and the acquisition or disposition of cryptocurrency by a taxpayer whose functional currency was not a cryptocurrency would be a ‘foreign’[5] currency for all taxation purposes. If, on the other hand, cryptocurrency is deemed to be ‘property’ for federal tax purposes, the additional rules governing and regulating the holding and disposal of foreign currencies would not apply to transactions in cryptocurrencies. If, however cryptocurrencies are deemed property, every disposition of cryptocurrency is a disposition of property which means that basis must be recorded and tracked each time a cryptocurrency is purchased
for fiat currency, and that gain or loss is recognised each time chunks of cryptocurrency is acquired or disposed off similar to capital gains taxation. It is thus limited by its terms by limiting what we consider “cryptocurrency,” to property alone thus choosing to ignore utility tokens or equity tokens as aforementioned, used primarily for transactional purposes. The notice applies to any cryptocurrency that can be used to pay for goods or services and equally to currency that is held for short- or long-term investment purposes. The notice focuses on cryptocurrency that has an equivalent value in fiat currency or that acts as a substitute for fiat currency (‘convertible’ cryptocurrency). The notice mentions Bitcoin (BTC) as one example of a convertible cryptocurrency because it can be digitally traded between users and can be purchased for, or exchanged into other fiat currencies.
There are several reasons for this lacuna in policy primarily that in relatively prehistoric 2014, almost all tokens in circulation were intrinsic tokens such as Bitcoin (BTC) or Ethereum (ETH) and thus policy was created with only those tokens in consideration. The number of utility tokens and equity tokens and other forms of cryptocurrency in circulation has increased significantly since then. This has resulted in anachronisms such as during purchase of tokens, regardless of the intended purpose, a purchase using fiat currencies is not a taxable event for federal income tax. However, if tokens are purchased using another cryptocurrency, a U.S. taxpayer would recognize gain or loss for federal income tax purposes in an amount equal to the difference between the value of the tokens purchased and the tax basis in the cryptocurrency exchanged thus being forced to treat a mere purchase of property -essentially a non-taxable event as a primary sale of holding token which is taxable as capital gains and secondarily a purchase of new token. A mere medium of exchange is thus unfairly penalised and actively discouraged by implication. This risks impediment of the growth of the decentralised currency ecosystem.
Similarly, for a sale of the tokens or their usage in exchange for goods or services, the transaction usually will be considered a taxable exchange of the tokens for consideration and will give rise to capital gain or ordinary income, depending on the purpose for which they’re held by purchaser. The amount of the gain or loss will be the difference between the token holder’s basis in the tokens and the amount of fiat currency or the fiat value of property or services received for them. If the tokens were held for investment purposes or for trading, the gain or loss typically should be capital gain or loss, and it would be short-term or long-term gain or loss depending on the period of holding. If the tokens were held by an individual as ‘personal use’ property and not for any broader investment purposes (to access media, personal commerce etc), that property would be a capital ‘asset’, and any gain recognized on the disposition of the cryptocurrency would be treated similarly following provisions for those assets which creates a problem as individuals usually may not deduct[6] losses concerning personal use property, except for casualties caused to the property and thus capital losses would not apply.
Additionally, there is no de minimis exception for ‘smaller’ transactions, and a significant question for holders is the determination of the basis of the tokens used and the value of the property or services received in return. In cases where the token is used as a purely transactional item for regular activities like for example paying money at a restaurant, even though the cost of the service is known, the value of token is not self-evident or more commonly, not traceable where for example it is held at a cryptocurrency exchange. This will thus create significant issues in terms of the holder’s reporting obligation as the holder, by essentially paying for a mere service is liquidating his asset and is thus liable to be taxed if he has an income from the liquidation.
The transaction exemption
Whereas cryptocurrency may be reasonably taxed as ‘property’ as intangible, non-fungible goods, the same ignores the primary objective of a virtual currency. The idea stems from the conception of cryptocurrency in a manner similar to other non-tangible ‘goods’ like shares of a company where transactions may be feasibly taxed as income tax under several heads of income primarily as income arising from capital gains. However, this approach forces digital tokens to conform to singular definitions of intangible investment tools like ‘digital gold’ alone. It defeats the basic purpose of a currency as a medium of exchange and seeks to curb the scope of growth for medium of exchange other than sovereign fiat currency. Whereas there is now a trend on part of governments to create Central Bank Issued Digital Currencies (CBDCs) using blockchain, they are regulated, just as ordinary money by the Central Bank of the sovereign government which again defeats the purpose of greater financial freedom by usage of independent and decentralised instruments of exchange. Cryptocurrency can easily be classified as a currency because it acts as a medium of exchange, it is a unit of account, and it is capable of storing value. This has led to the recognition of cryptocurrencies like Bitcoin (BTC) to be classified as legal tender in El Salvador. However, it does not behave like currency in some regards generally dur to its intrinsic nature. Due to the high fluctuations in its value, traders choose the time of sale of goods and services based on when the specific cryptocurrency peaks. Such vast fluctuations do not happen for normal currencies and thus, the price instability makes it unsafe as a medium of exchange. There may however be no need for a zero-sum solution to this unique situation.
Germany in this paradigm offers a viable alternate model[7] that goes beyond the scaffolded treatment of currency as property in the United States while resisting a capitulation to the idea of a libertarian utopia. Cryptocurrency is viewed as a ‘private asset’ in Germany, which means it attracts an individual head of taxation rather than a simple Capital Gains Tax. Germany only taxes cryptocurrency if it is sold within the same year it was acquired. while Germany taxes certain crypto events, like short term trades, mining and staking, its tax rules are relaxed to a greater extent than in other countries. That’s because bitcoin and other crypto is not treated as property under the German Tax Acts. Instead, cryptocurrency is classified as ‘other assets’, and selling it is a ‘private disposal.’ This distinction is important since the private sale of assets holds tax benefits in Germany. As a ‘private sale’ in Germany crypto gains are completely tax-exempt after a holding period of one year. In addition, profits on ‘sales’ up to EUR 600 irrespective of when the currency was bought remains tax free, taxes are levied only when transaction exceeds income of EUR 600 and the token was held for less than a year as any profits made after a year of holding is also exempted which thus allows for transactions of smaller value to be as seamless as traditional currency. Gifts are additionally tax-free up to a value of EUR 20,000 (for friends) and up to EUR 500,000 (for spouses), any higher value is taxable under the “Schenkungssteuer”, which has different tax rates depending on who you gift it to (spouse, your children, your parents, your siblings, or friends). The tax rates for gifts range from 7% up to 50%. The tax exemption limits are renewed after 10 years.
Conclusion
As a study on the issues regarding the taxation of income from cryptocurrency shows, certain problems linger in treatment of cryptocurrency as a subclass of traditional assets and ‘property’. Any legislation, rules or orders regarding the taxation of cryptocurrency in India must be mindful of these hurdles that have been faced and dealt with varyingly in different jurisdictions across the world. Taxation of cryptocurrency is necessary- however, it cannot be done without recognising the nuances in dealing with disruptive technology. The German model provides a fine blueprint for an eventual Indian tax policy as it overcomes the greater challenges that the American model faced without creating a policy blackhole.
[1] World Economic Forum, The Fourth Industrial Revolution, by Klaus Schwab, available at- https://www.weforum.org/about/the-fourth-industrial-revolution-by-klaus-schwab (Last visited on 11th September 2021)
[2]Nick Lioudis, Gold Standard, April 26, 2021, available at- https://www.investopedia.com/ask/answers/09/gold-standard.asp (Last visited on 11th September 2021)
[3] Internal Revenue Services, Notice 2014–21, 2014–16 I.R.B. 938 (Issued April 14, 2014)
[4]Code of Laws of the United States of America, Title 26, Internal Revenue Code, 1954, Subtitle A, Income Taxes Chapter 1. Normal Taxes and Surtaxes Subchapter N, Tax Based on Income from Sources Within or Without the United States Part III. Income from sources without the United States Subpart J. Foreign Currency Transactions, §985 (United States of America)
[5] Code of Laws of the United States of America, Title 26, Internal Revenue Code,1954, Subtitle A, Income Taxes Chapter 1. Normal Taxes and Surtaxes Subchapter N, Tax Based on Income from Sources within or without the United States, Part III. Income from Sources without the United States Subpart J. Foreign Currency Transactions, §988 (United States of America)
[6] Code of Laws of the United States of America, Title 26, Internal Revenue Code, 1954, Subtitle A, Income Taxes Chapter 1. Normal Taxes and Surtaxes Subchapter B, Computation of Taxable Income, Part VI- Itemized deductions for individuals and corporations, §165(c) (United States of America)
[7] Koinly, Germany Crypto Tax Guide 2021, May 18, 2021, available at- https://koinly.io/guides/crypto-tax-germany/ (Last visited on October 18 2021)
