Taxing Cryptocurrency

Trading in cryptocurrencies and digital assets is becoming an increasingly mainstream activity for many tech-savvy investors and traders. It’s easier than ever to trade in cryptocurrencies, such as Bitcoin, and to build up a digital wallet of your investments, and investing has become more mainstream with the introduction of Bitcoin ETFs in the USA. But if you’re trading in these digital assets, how does this affect your personal tax position and your self-assessment bill?

Digital assets and the differences with traditional cash assets

The emergence of cryptocurrencies and digital assets (or ‘cryptoassets’) is having an impact on the world of finance and investment. But what are cryptocurrencies? And how are they different from traditional cash assets?

HMRC’s Cryptoassets Manual defines cryptoassets as follows:

“Cryptoassets (also referred to as ‘tokens’ or ‘cryptocurrency’) are cryptographically secured digital representations of value or contractual rights that can be:

• transferred
• stored
• traded electronically

While all cryptoassets use some form of Distributed Ledger Technology (DLT) not all applications of DLT involve cryptoassets.”

Cryptocurrencies and digital assets are seen as property, not as cash. Money, in the traditional sense, is the cold hard cash in your hand, whereas crypto is an intangible asset, and is represented on a blockchain distributed ledger.

Ownership and accessing your cryptoassets

You can own a digital asset but it’s only available via your digital wallet – the wallet being the secure software system where you store your cryptoassets and cryptocurrencies

This wallet has both a public key and a private key and both can be ‘hot’ and/or ‘cold’. Hot can be accessed via the internet and cold usually means it is stored offline, such as on a hard drive.

In essence, by buying an intangible asset like Bitcoin, you’re paying to own these coins and to have digital access to them. If you were to destroy the wallet, for whatever reason, you’re only destroying your access to it. You’re not destroying the coins themselves.

When you have the private key, that’s part of the blockchain ledger. You can replicate the public key but not the private key. If you lose this private key, this can result in you losing access to everything in your digital wallet – as happened recently when an early adopter of Bitcoin threw away the hard drive that contained the private key to his digital wallet.

The tax treatment of cryptoassets

HM Revenue & Customs (HMRC) doesn’t see cryptoassets as a currency. As we have mentioned, your digital assets are seen as property, not cash, and will be taxed accordingly.

If you change your sterling into Bitcoin, and then into euros, and then back into sterling, there will be different transactions to account for and different exchange rates to factor in. Each transaction is a taxable event – it is not just when it is converted back into Sterling that an event arises.

If you are mining Bitcoin, or any other minable cryptoasset for that matter, on an organised basis, that may be seen as income if it’s a process that generates income for you.

Crypto mirrors currency in some ways and follows the patterns of more traditional financial transactions. If you trade in cryptocurrencies, and this mirrors traditional financial transactions, you’ll end up being taxed in exactly the same way – even though this is an intangible asset.  That said, given how speculative cryptoassets are, it is very unusual for HMRC to consider that someone is trading, even if they are making over 10,000 transactions per year.

If you are not trading, but holding cryptocurrencies as investments, any gains are generally seen as investment gains and are taxed as capital gains.  Losses can be offset against gains arising in the same year or carried forward.

Ultimately, the way these digital transactions are accounted for is all down to self-assessment. You’re required to tell HMRC what you’ve been trading in, in the same way you would when talking about sterling transactions, or buying stocks and shares, or other investments, such as futures etc.

HMRC’s crackdown on undeclared financial interests

Being open and transparent about your crypto transactions is part of your self-assessment compliance process – and it’s important to make sure everything is declared.

There are no names on the blockchain – it is anonymous. So it’s your responsibility to tell HMRC what you’re doing when it comes to dealing in crypto. The No Safe Havens initiative made it clear back in 2019 that HMRC is clamping down on individuals that have chosen to not give a full declaration of their interests.

HMRC also has a system called Connect which is very sophisticated and can pick up on transactions from a wide range of sources. It’s one of the largest and most diverse collections of data and intelligence in the world and can track all manner of different transactions. It can even pick up information from the immigration authorities and the land registry.

HMRC have also used their powers to request information from the Coinbase exchange regarding individuals resident in the UK who hold, buy and sell crypto using this exchange. It is unlikely to be the only exchange targeted, and we expect to see HMRC ramp up their use of information powers going forward.

HMRC will know when you are in the UK, when you are carrying out transactions and what those transactions may be, especially if you are taking profits and converting these back into fiat currency. So, it’s highly advisable to be totally transparent about your digital assets and any trading in cryptocurrencies.

The growing popularity of cryptoassets and NFTs

Using crypto as a means of payment is still relatively rare. It’s unlikely that you would buy your house with Bitcoin, yet (although this has been done). But cryptocurrencies are becoming more mainstream and that means that financial services and the accounting industry (and governments) need to catch up fast.

Crypto is an intangible asset, so nothing tangible actually exists for you to own. It sits in the same category as things like patents, intellectual property or a copyright. Non Fungible Tokens (NFTs) are another kind of digital asset. An NFT is just digital data. There is no physical thing that you own, whether it’s a digital artwork, a photo or a music album. But you do have access to that NFT – and, as such, it’s an interesting way for individuals to invest in cryptoassets and build up a digital portfolio. The copyright holder of the ‘Charlie bit my finger’ viral video sold the rights to that video for a significant amount as a ‘non-fungible token’.  However, the heyday of most of these appears to have been in 2021, with many prices dropping significantly since then.

An NFT of Jack Dorsey’s (the creater of Twitter) first tweet sold for USD2.9 million in March 2021, but when he tried to sell it around a year later, he was offered a tiny fraction of the price he paid for it.

The emergence of DeFi and Yield Farming

DeFi, or Decentralised Finance, is the crypto world’s ‘solution’ to the centralised financial systems we have today, which advocates of DeFi argue is laden with unnecessary intermediaries, high costs and inefficiencies associated with processing transactions. For example, when processing a loan, a lender may typically charge a variety of fees and take a while for the transaction to be processed.

Furthermore, a relatively new phenomenon known as yield farming has become increasingly popular. Yield farming is a process to maximise returns by putting your cryptocurrency assets to work. For example, you could deposit your cryptoassets in a DeFi protocol and earn reward tokens, which in turn are lent out to other DeFi platforms to earn more rewards. The goal of yield farming is to deposit some initial capital and use leverage and arbitrage strategies to maximise the rewards earned.

HMRC’s Cryptoassets manual does cover making DeFi loans, but the tax treatment of any rewards will depend on the operating model.

Accounting for your crypto transactions

Cryptoassets may be intangible, but you still need to account for these transactions in the usual way. As such, it’s vital to work closely with your advisers and to record every transaction.

Any profit that you make from your cryptoassets is likely to be seen as a capital gain, although this is not guaranteed, and can depend on whether you are seen as trading or not. HMRC generally (but not always) sees these gains as an investment, so the outcome will mostly be seen as a capital gain and taxed via the Capital Gains Tax (CGT) system, but as noted above, this is not always the case.

There is also the matter of losses with something as volatile as cryptocurrencies, and losing wallets etc. Of particular note, the founder of a Canadian crypto exchange died and took all knowledge of the private wallets with him – over £105 million (at the time, in 2019) may never be accessed again.  Given the recent upswing in value, this is likely to be worth considerably more now.

Morbid though it may be, there’s also the question of what happens when you die. Who has access to your crypto keys and the passwords? Cryptoassets can be part of someone’s estate and could be bequeathed to other people in a will, but how do you then access them if you don’t have the private key? Where are the cryptoassets located for tax purposes? Will UK inheritance tax be due on these?

Working with an experienced tax adviser

Cryptoassets are a very innovative and interesting way for people to begin investing in their own digital portfolios. But with digital assets you really do need to be careful. Not only are these investments very volatile, and easily influenceable by a few individuals, there are some very sophisticated treatments that not everyone understands, and getting the tax treatment right is vital in this day and age.

It’s possible for financial interests to be missed when submitting your tax return, for incomplete records to be kept and for unintentional tax implications to occur if you don’t take the right advice. Working closely with your tax adviser and keeping them in the loop regarding your investments is highly recommended.

If you’re starting to explore the world of crypto, bear these key considerations in mind:

• The actual mechanics of how blockchain, cryptocurrencies and digital assets works is complex at the technology level.
• However, the ownership and trading of assets like Bitcoin can actually be straightforward.
• You can buy, trade and sell these cryptocurrencies, NFTs and digital assets and build up a portfolio in your digital wallet.
• But you must record and account for these transactions in exactly the same way as you would with more traditional financial transactions.
• Tell your accountant and your tax adviser what digital assets you have, what transactions have taken place and what you have in your digital wallet.

With the appropriate documentation at hand, we can assist you in accurately completing your self-assessment, ensuring that your capital gains tax payments are correct, and properly accounting for any financial gains and losses.

If you’re getting involved in cryptoassets, to seek expert advice get in touch for a chat with our advisers