Tax officials are tightening their control over crypto

Over the past four years, the tiny island of Puerto Rico has quietly become a hub for cryptocurrency billionaires and other digital asset holders for one reason: taxes.

As a US territory, the island has had a piece of the tax haven pie since 2012 with two laws that led to drastic reductions in tax rates.

The transformation caught the attention of cryptocurrency holders in 2018 after Bitcoin's first dramatic rally made many early buyers very rich. Brock Pierce, a former child actor and co-inventor of the cryptocurrency Tether, was one of the first big names to choose the low-tax island as his new home. Since then, many others have made the same move, for the same reasons.

In the US, capital gains tax on cryptocurrencies can be as high as 37 percent, but long-term holders can completely avoid taxation on digital assets on the Caribbean island.

Far from Puerto Rico, British advisers say they are also encountering a small but growing cohort of people interested in switching countries for crypto tax reasons. Chris Etherington, tax partner at RSM, an accounting firm, says he has noticed more inquiries from younger clients who are "very keen to move overseas to crystallize their experiences". coin” in low-tax countries such as the United Arab Emirates.

While the exodus may seem extreme, these measures illustrate the strong interest of many investors in minimizing taxes in this rapidly evolving new asset class.

HM Revenue & Customs says bluntly that it views crypto assets as a type of property like stocks and shares, gold or impressionist paintings. Taxes – in particular capital gains tax – can therefore be levied on the profits achieved. The US Internal Revenue Service takes the same stance, as do tax offices in many other industrialized countries.

These authorities fight hard to ensure that the correct amounts of taxes are paid – including by requesting data from crypto exchanges about their users.

But several points of contention remain. Tax experts say rules designed for the pre-Internet era are difficult to apply in the digital age. They argue that regulations for assets that are clearly located in one jurisdiction or another cannot be easily adapted to a decentralized asset class whose backers often claim that it has no home jurisdiction at all, indeed no home country.

Experts add that there is a lack of certainty in the UK regarding the tax treatment of crypto assets as there is no specific crypto tax law. HMRC has issued guidance on the taxation of cryptocurrencies. However, this is not legislation and is definitely being challenged by some tax professionals – including the Society of Trust and Estate Practitioners (Step).

“It's just an unpleasant situation for the taxpayer because the tax office is incorporating new technologies into the tax code that have been around for a long time,” said Tom Wallace, director of tax investigations at the consulting firm WTT and a former tax inspector. “The CGT law has been around since the 1960s, when crypto would have been something you would have seenStar Trek.”

FT Money takes a look at this complex and sometimes opaque landscape and attempts to find a way through its rapidly changing features.

A new front in an old tax dispute

The US tax authorities are widely considered to be the most aggressive in their efforts to ensure that investors pay the taxes due on crypto. The IRS has successfully issued subpoenas known as John Doe Summons, used when a person's name is unknown, to obtain investor information from crypto exchanges Coinbase, Kraken and Poloniex.

This data was used to review information submitted to the IRS by hundreds of thousands of crypto investors and identify discrepancies. "It's been very successful in getting people to come forward and file an amended tax return," says Shaun Hunley, a tax consultant at Thomson Reuters Tax & Accounting based in Atlanta.

In May, the IRS announced that it had created a specialist team to analyze blockchain – the technology that powers cryptocurrencies – to combat tax evasion. The mission is called Operation Hidden Treasure.

Meanwhile, as part of President Biden's $1 trillion infrastructure bill, plans are underway to make it the law for crypto brokers to report their clients' profits directly to the IRS. The bill, which has drawn howls of protest from the crypto industry, will make it easier for the IRS to collect information than through the courts.

“What we will see in this space is forced compliance, which is very different from the current system of voluntarily reporting crypto profits,” says Hunley.

Critics argue that the bill's definition of what constitutes a broker is too broad and could harm the emerging sector. But despite furious lobbying, it looks like it will pass.

In the UK, HMRC has in recent years used its intelligence gathering powers to request lists of crypto investors from exchanges.

In 2019, exchanges Coinbase, eToro and CEX.IO went public with news that HMRC had requested user data to hunt down investors who owed UK taxes. And the tax agency has continued with such requests for information, says Adam Craggs, partner at RPC, a law firm that acts for a crypto exchange platform.

Tax authorities also include data on crypto investors in the information they collect across borders. A freedom of information request from Gherson Solicitors, a law firm, confirmed this year that HMRC had used its powers to collect information on crypto investors in and outside the UK for tax years 2017/18 up to and including 2019/20. The details included the names and addresses of investors and the value of crypto assets held.

HMRC says it "regularly collects data from a range of information sources, using Parliament's powers. The data is used to improve the integrity of the tax system and identify those who have not declared their profits".

Financial authorities are struggling to keep up

Despite repeated data collections, the industry is moving so quickly that officials are generally forced to play catch-up in a game that still has a long way to go.

The UK takes a different approach to treating crypto assets as property for tax purposes than foreign exchange holdings, where gains do not attract CGT when used for personal expenses outside the UK. But important legal definitions such as “virtual currency” have yet to become law.

Meanwhile, the rapid development of the sector, for example, has led to the emergence of a whole new sector in which assets can be bought, sold, lent and borrowed without human intermediaries, only using pre-programmed algorithms. This decentralized finance industry has grown to $65 billion in just a year.

In May, a group of cryptocurrency advocates filed a lawsuit against the US tax authorities, claiming that by attempting to impose taxes on profits from newly created digital coins, the United States is attempting to use federal income tax law to do something unprecedented. which taxes creative activity rather than income.”

Similar disputes are likely to arise elsewhere as industry tests the limits of existing legislation and the tolerance of national lawmakers and technology produces new products. A crypto expert told FT Money that newer crypto assets were constantly coming online, making it harder for tax authorities to decipher money flows, let alone collect taxes.

"There are many privacy-related blockchains. One scenario is that more funds flow into private coins," said the person, who did not want to be identified. "The general idea is that crypto is bad for the state. Once the state no longer controls its own money, all of that tax revenue disappears."

Another fundamental and unresolved issue concerns jurisdiction, a tricky decision in a market that has no official base anywhere.

British authorities believe the owner's location is key. But professional organizations such as Step have argued that HMRC's view is based on practical "convenience" rather than law - and particularly where cryptocurrencies are held by an exchange or custodian, this could be wrong.

HMRC argues that its conclusion that crypto assets held by a UK resident are located in the UK fits most transactions. The tax office told FT Money it wanted to “help people get their tax affairs right and believes taxpayers want to get it right too”. It says its “detailed guide [is designed] to help our clients correctly apply tax law to crypto assets.”

Jonathan Peall, tax director at KPMG UK, says such declarations are not enough. He says: "The law must evolve to codify the situation. However, the crypto world is moving so quickly that it remains to be seen whether the legislative process can keep up."

The challenge for crypto investors

The fact that cryptocurrencies are still new also presents challenges for the often inexperienced investors who are drawn into the market.

To avoid running afoul of tax authorities, citizens must first understand and comply with their tax obligations (see box). However, advisors warn that many crypto investors drawn to the excitement surrounding Bitcoin may be completely unaware that they will have to pay taxes on crypto profits or file a tax report. Others know it, but simply bury their heads in the sand.

As a cryptocurrency investor, you could be looking over your shoulder for an extended period of time

“Some individual taxpayers will turn a blind eye for now until they catch up and get a nasty shock,” predicts Charlotte Sallabank, tax partner at Katten Muchin Rosenman.

Wallace encourages anyone who has not declared profits to seek professional advice. It is always better to report errors to HMRC than to wait, he adds, as penalties increase if a person is discovered rather than coming forward voluntarily.

The UK tax office can examine your tax affairs for four years from the end of the tax year to which the assessment relates. This increases to six years if a person is found to be negligent or negligent, and even to 20 years if the taxpayer deliberately avoided disclosure.

“As a cryptocurrency investor, you could be looking over your shoulder for an extended period of time,” warns Etherington. “If you made a mistake – you can get a f****** [further down the line].”

Etherington has noticed that many more crypto investors are worried about reporting to HMRC and calculating their taxes.

HMRC guidance states that investors must calculate profits and keep detailed records of each trade. This can be difficult, especially when individuals use trading bots that can execute thousands of trades daily. Complex rules cover gains depending on whether assets were bought and sold on the same day and/or within a 30-day period.

Investors often rely on their exchanges for records. However, this could be risky as exchanges may go under or not retain data long enough, Sallabank adds.

The pace of innovation also presents potential pitfalls for investors. NFTs or non-fungible tokens are now an example of a billion-dollar market that did not exist just a few years ago. This year, the art world has embraced these digital platforms and created new works that are sold for digital coins. The record is almost $70 million, a digital collage by contemporary artist Beeple.

"There are a variety of actions that can trigger a divestiture, including gifting crypto assets, using crypto to purchase other assets, and exchanging between different crypto assets. The latter can catch a lot of people out," says KPMG's Peall.

According to HMRC guidance, the disposal of a digital asset triggers a CGT claim. According to Peall, this applies even when holders switch from one coin to another, even if they are stablecoins, special stabilized digital coins that combine fiat currencies and volatile crypto units like Bitcoin.

More recently, owners have been able to lend or “stake” their digital coins and earn a return, an activity that could potentially create new liabilities, Peall adds.

Another potential problem for investors is that they may recognize a gain and a CGT liability, but find that their portfolio has lost value by the time they pay taxes and is therefore not worth enough to cover the liability.

“You can’t pay your tax bill in cryptocurrency, so you would have to sell [other assets including crypto], which itself could trigger a tax charge as if you were exchanging it for cash, which would be considered a disposal,” says Sallabank.

But despite the difficulties, there is every incentive for investors, crypto operators and tax officials to all stay informed. With the crypto market now valued at nearly $2 trillion, the potential gains – and associated tax liabilities – are simply too great to ignore.