22 Jan 2018

Cryptic currency

11 March 2015

The mysterious world of bitcoin

KEY POINTS

  • Bitcoin is an independently run cryptocurrency.
  • It is stored in an electronic file and traded online.
  • Questions exist about its security and probity.
  • HMRC treat bitcoin like a foreign currency for corporation and income tax.

I had always regarded bitcoin as something used by other people a long way away, possibly in fictional universes.

The financial press often includes articles about bitcoin – perhaps discussing its future, the fall or rise of its markets, its alleged popularity among criminals, rarely, its tax treatment.

How many of us, though, can honestly say they understand what it is, or have encountered it in real life?

What is bitcoin?

Bitcoin is a virtual or cryptocurrency. It has no physical existence; you cannot obtain coins or notes denominated in it. This sounds odd, but how many transactions do you carry out using cash?

Transactions using credit cards, Oyster cards, and internet shopping all take place without using the physical presence of currency. For that matter, paper currency was itself only a substitute to save people from carrying heavy gold, and was once regarded with similar suspicion.

Bitcoin is an independent currency run either by nobody or by all its holders. It is dealt with person to person, via complex computer encryptions that protect the integrity of each transaction. Each user has a copy of the “blockchain”, a secure digital ledger rendering it impossible to create forged bitcoins.

Bitcoin is run on open-source software, so anybody who has sufficient technical knowledge can see how it works and suggest improvements.

Each bitcoin is divisible into 100,000,000 units and there will only ever be a maximum of 24,000,000 bitcoins in total. This is not a currency which will suffer from inflation or be controlled by quantitative easing; economists generally view it as a deflationary currency.

There is another key distinction between it and traditional currencies. Most of the latter are supported by a country or group of countries. They have value because the entities concerned support them, although this does not necessarily make them safe.

The Weimar Republic is a notable example of the result of failure. Where a country is no longer a good credit risk, its currency can go into free fall and become virtually worthless, devastating the economy as wages cannot keep up with price inflation. Similarly, crippling economic effects have occurred at times of deflation, as happened during the Great Depression.

Why was it invented?

The reasons for bitcoin’s existence are vague. It has been suggested that it was founded to free people from government oversight and from the need to pay banks for even the simplest business transaction.

Further, given the rapid increase in the surveillance state, many wish to protect their privacy, so bitcoin may be attractive even for the innocent. It is no longer a currency used by a bunch of eccentric techies around the world. Many businesses accept it, some as a gimmick, but others are primarily attracted by its speed, freedom from bank charges and convenience.

Governments around the world are taking bitcoin seriously. On 3 November 2014, the UK government issued a “Call for information” to help it make decisions regarding the benefits, risks and regulation of bitcoin.

How does it work?

Bitcoin is stored in an electronic wallet or file which gives the address for receiving the currency. There are several routes to do this, from trading online or face to face, to the UK’s first bitcoin cash machine in Shoreditch, London. There are also smartphone apps.

People who allow their computer systems to be used to record and track the blockchain can occasionally discover new unowned bitcoins as part of the code they analyse. These become theirs, and this procedure is known as bitcoin mining.

Bitcoin can be spent, like normal money, in participating venues or used to buy goods or services online, by giving your details electronically to the seller.

Perceived advantages

The most attractive aspect of bitcoin to a legitimate business person is that it avoids transaction fees from banks. An individual can make a payment directly to a business, without the bank or credit card company taking a percentage of the transaction for processing it.

Hence, the trader can either reduce prices or make a larger profit. The benefit is even greater if a foreign currency transaction is otherwise involved, because bitcoin removes exchange commission and the less than generous exchange rates banks use.

Bitcoin can also be faster than bank transactions, potentially moving monies person to person in any location.

The attractions to criminals and terrorists are also clear. It is hard for the authorities to trace or monitor these transactions. The Dark Web exists for people who desire anonymity and want to use an untraceable currency.

Silk Road 2.0 was an anonymised online marketplace for illegitimate trade, from drugs to guns, that accepted bitcoin. According to the FBI, it was making $8m a month before it was closed down.

Anyone may wish to anonymise their spending. State oversight can be very intrusive in this age of electronic cash transactions. Individuals who live in oppressive states, straightforward libertarians and privacy advocates may not wish to have their every move, however legal, recorded by the state.

Other advantages of bitcoin are that, as a decentralised currency, it is believed to be less vulnerable to bank failures and it cannot be forged.

Perceived disadvantages

A software flaw in February 2014 caused several exchanges to suspend trading due to a risk of fraud by hackers and the value, relative to conventional currencies, dived. This volatility could have some odd effects on a client’s business accounts, similar to normal currency fluctuations, but more extreme.

The circumstances in which bitcoin can be spent are limited. Transactions once processed are not reversible, leading to security issues when dealing with strangers, and the need for escrow services which may introduce costs.

There are questions about security and probity. The lack of conventional tracing or money laundering rules leads to suspicions that it will be the currency of choice for criminals, which may make respectable businesses reluctant to take it up.

Its untraceability and lack of controlling records also makes it susceptible to loss or hacking, even in professional hands.

Mount Gox, the Japanese exchange that at one time dominated the bitcoin trade, declared bankruptcy in March 2014, having apparently lost 850,000 bitcoins ($490m at March values). Bizarrely, 200,000 bitcoins were subsequently found in an old wallet. The fate of the other 650,000 bitcoins remains unclear – were they hacked, embezzled or lost?

How is it taxed in the UK?

After some understandable delays, HMRC announced the UK tax treatment of bitcoin in Revenue and Customs Brief 9/2014: Bitcoin and Other Cryptocurrencies.

VAT

The VAT treatment of bitcoin is provisional because it will depend on what the EU decides. HMRC state that acquisitions by mining are outside the scope of VAT because mining does not constitute an economic activity. Income received by miners for other activities, such as verifying specific transactions, is exempt from VAT in a similar way to bank charges. No VAT is due when bitcoin is exchanged for other currencies.

When bitcoin is received in return for the provision of goods or services, the value of bitcoin in sterling at the point the transaction takes place is liable to VAT in the normal way.

Corporation and income tax

In the same way as a transaction in sterling is treated, the character of a transaction in bitcoin is considered to determine its taxability. Bitcoin is treated like a foreign currency.

For corporation tax, companies’ exchange gains will be taxable and losses deductible, following the general rules on currencies and loan relationships.

For income tax, profits and losses of unincorporated businesses on bitcoin transactions must be reflected in the business accounts and taxed under the normal rules.


Capital gains tax

Gains or losses on bitcoin or other cryptocurrencies are chargeable or allowable for capital gains tax, if they accrue to an individual and are not covered by trading profit rules. For companies, such gains are chargeable to corporation tax if they accrue to the company and are not covered by loan relationship or trading rules. If a transaction is considered speculative, it may not be liable to tax at all.

This is all rather pleasantly straightforward, although obtaining suitable valuations of bitcoins in relation to transactions may be a chore. There are no complicated new rules to learn and HMRC has basically accepted it at face value as a currency.

Different way

Faced by a totally new type of asset, tax collection agencies across the world have considered how to treat it, and they have not all come up with the same answers as HMRC.

The US Internal Revenue Service issued Notice 2014-21 setting out its view for federal tax purposes. It regards bitcoin as an item of property rather than a currency, and thus as subject to its normal property tax rules.

For tax purposes, bitcoins do not generate foreign currency gains or losses as they would in the UK. The US does, however, follow the same treatment as the UK where the currency is received in return for goods or services, converting the bitcoin at the market rate at the time of the transaction.

In addition, if the virtual currency is a capital asset in the hands of the taxpayer, he can realise a capital gain or loss on sale. Bitcoin acquired by mining by American taxpayers is to be taxed as income in their hands, and mining can be a self-employment.

There are no final rules at state level yet, which makes me glad I am not practising in the US.

Practical points

Given the above, there are a number of issues it would be prudent to cover with a client who has taken, or is contemplating, the step into bitcoin:

  • Security – Bitcoin is susceptible to hacking. A client with a substantial holding would be wise to keep it in a computer system not connected to the internet.
  • Passwords – If you lose your password, you lose access to your wallet and your bitcoin. Clients should keep secure records of passwords and wallet locations. They need disaster recovery plans backing up their records in case of computer failure. They also need a way for their heirs to access and track down assets.
  • Using an agency – There are markets which will help you trade bitcoins, keep your assets in their systems and provide you with the exchange detail needed for your accounts. These agencies charge a fee which erodes part of the benefit of using bitcoin.
  • Record keeping – Bitcoin traders must keep good records. An agency will help, but what if it fails? It will still be necessary to calculate exchange rates for each trade to pull each transaction into your accounts.
  • Payment protection – The use of an escrow service would probably be wise for large transactions but it is likely that charges would be incurred.
  • Holding bitcoin – Given the fluctuations in bitcoin exchange rates, it may not be wise to hold a substantial number. Many traders choose to keep only a float of bitcoin after trading to reduce this risk.
  • Refunds – Is the client holding enough bitcoin in reserve to cover refunds and the potential cost of the related exchange rate variations?
  • International matters – If the client trades internationally, things could become complex as there is no consensus as to the treatment of bitcoin in different jurisdictions.

Other cryptocurrencies

In November 2014, the UK government estimated that 20,000 people in the UK held bitcoin and the total holding was worth approximately £60m.

Even if bitcoin were to fail, there are other cryptocurrencies in the wings, such as peercoin, dogecoin and litecoin, ready to take its place. We need to be ready for them.

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