Cryptocurrency is a digital currency designed to work as a medium of exchange through a network of computers, each called a node.
Cryptocurrency is built off a blockchain technology with a digital ledger which takes a record of all transactions.
Cryptocurrency operates as a decentralized system and a third-party institution like a central bank with a formal regulatory authority does not control it.
It, therefore, relies on nodes in a peer-to-peer network to validate and record transactions. Cryptocurrency is considered a form of payment and can be sent through a crypto wallet. Cryptocurrency relies on encrypted algorithms for security.
There are numerous types of cryptocurrency including Ethereum, Litecoin, Monero, Ripple (XRP) and Stellar (XLM). Ripple (XRP), for instance, focuses on facilitating international money transfers in real-time. Despite a variety of cryptocurrency, one important commonality about them is that they their value fluctuates significantly, even over the course of an hour. These fluctuations make cryptocurrency a highly speculative investment with associated risks.
Trading in and Using a Cryptocurrency
Dealers or investors in cryptocurrencies in fact regard them as a property with valuable consideration. There are mainly three ways in which a cryptocurrency is traded. Trading in it can be done directly through a peer-to-peer without the involvement of any third party. The second is through decentralized exchanges whose purpose is to facilitate such peer-to-peer trades with customers retaining custody of their private keys (identities).
The third mechanism is through centralized exchanges which generally hold their customers’ private keys and make transactions on their behalf to earn a commission. Resulting from the chain of events, transactions in and the creation of cryptocurrency are the issues of income taxation and VAT or sales tax.
Cryptocurrencies and Tax Design
Cryptocurrency taxation varies by country. Thus, a cryptocurrency is not treated the same as other currencies with regard to taxation. In effect, current practices in these areas are diverse, in many cases await clarification, and largely in a state of flux. Nonetheless, in some countries, payment in exchange for goods or services with cryptocurrency is considered taxable income.
Also related is the fact that all earnings from mining, staking, or payments in the form of crypto are taxable. This happens when people make a profit or gains on cryptocurrencies. How much tax is charged on cryptocurrency is determined by each country’s governmental institution of taxation. In some cases, the taxable amount is the cryptocurrency’s fair market value on the day and time a dealer receives payment.
Income Taxation
Cryptocurrencies might be classified for income tax purposes in two main ways – as property (like shares, or bonds) or as (foreign) currency. Classification as property usually gives rise to capital gains tax. The rates vary based on the amount of time a dealer holds the cryptocurrency. Assets, including cryptocurrency, held for less than a year qualify for the short-term capital gains and losses tax rate. Possession of the asset for more than a year qualifies for the long-term capital gains and losses tax rate. In the US, for instance, the characterization of cryptocurrencies as property means that capital gains are in principle reportable on all transactions, with lower than the ordinary income tax rate applying if held for more than one year.
Some schools of thought have drawn similarities between the holding of cryptocurrencies and gambling, with the apparent implication that is should be taxed in the same way. This would have implications not only for income taxation but also for VAT and sales tax which treat gambling in complex and diverse ways. In practice, the most common approach appears to treat cryptocurrencies for income tax purposes as property and subject to the corresponding capital gains tax rules.
The fundamental obstacle to tax enforcement in relation to cryptocurrencies is the element of anonymity. Anonymity means an inability to link a transaction with a specific individual or a legal entity. What impedes its anonymous implementation in the blockchain case is the inability of the tax authorities to insert themselves into the chain.
Similarly, implementing a flat rate income tax does not require the identification of taxpayers. It does though require information which is also not available on the blockchain or on the nature of transactions (to pick out, for example, a payment of interest).
Furthermore, more complex tax structures require some means to identify distinct transactions with the same individual in order to aggregate over them, including transactions conducted by means other than cryptocurrencies.
In the limit, if all transactions were conducted in cryptocurrencies and individuals or firms each had a unique digital identifier, one could conceive of sophisticated tax systems being implemented with the use of smart contracts. A smart contract is based entirely on the blockchain and this in principle would not require the tax authorities to identify the real individuals and firms behind those identifiers. Privacy in this respect could be fully respected.
Value Added and Sales Taxes
Much of the discussion of the tax implications of cryptocurrencies and of crypto assets has more generally focused on the taxation of income and especially of capital gains. Looking forward, however, some of the greatest risks to the broader tax system may be those arising in relation to the VAT and sales taxes. To note, cryptocurrency taxation tools and software are essential elements for tracking tax season and reducing calculations and verification time. These instruments help people to track transactions and calculate tax payments and thereby make the task of tax tracking and verification very efficient.
The use of cryptocurrencies to acquire goods and services directly is apparently modest now, and not a feature of everyday life (even where Bitcoin is legal tender). The future of cryptocurrencies is highly uncertain. For some, they are a bubble that will eventually implode. To others, they will prove the foundation for fundamental innovations in decentralized finance.
In either case, however, tax systems need to accommodate them with a coherence, clarity, and effectiveness that, not having been constructed without crypto assets in mind, they currently lack. They need to do so, moreover, in the context of continuing rapid and complex innovation, based on limited information while balancing the core objectives of securing efficiency, fairness and revenue in taxation against the risk of stifling innovation.
Key Takeaways
Cryptocurrency regulation in the world is a multifaceted issue with no single body overseeing the market. Issues of importance that require regulatory attention border on anti-money laundering measures and know-your-customer (KYC) or due diligence procedures. Crypto assets are not considered money or currency by key financial institutions. However, from a tax perspective, crypto assets are treated like shares and accordingly taxable. Crypto traders and investors need to be aware of the wide array of transactions ranging from basic purchase and sell orders all the way through to hard forks, airdrops, staking and more.
Conclusion
Cryptocurrency is typically treated as property, resulting in potential capital gains taxes on profits from selling, trading, or disposing of it. The crypto industry is developing rapidly and the position on tax has inevitably become more complicated. The emergence of complex cryptocurrency-like gaming and gambling platforms, as well as and hybrid tokens for specific purposes, has changed the asset class.
BERNARD BEMPONG
Bernard is a Chartered Accountant with over 14 years of professional and industry experience in Financial Services Sector and Management Consultancy. He is the Managing Partner of J.S Morlu (Ghana) an international consulting firm providing Accounting, Tax, Auditing, IT Solutions and Business Advisory Services to both private businesses and government.
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