As Britain’s Financial Services and Markets Bill brings crypto assets into the mainstream financial industry, attention is invariably turning to crypto taxation.
The wide-reaching bill — currently being examined by committee after its second reading in parliament — extends the scope of regulation to stablecoins, paving their way for use in the U.K. as a recognized form of payment. As crypto is brought into the official fold, questions around taxation are now firmly on the legislative agenda. For instance, the government recently called for evidence from stakeholders on how crypto asset loans and staking related to decentralized finance (DeFi) should be taxed. The consultation sought opinions on questions such as whether alignment between the underlying economics of the transactions involved and their tax treatment could be improved.
This is just one of a broader range of issues that will define the impending debate over crypto taxation in the U.K. — from inheritance to pensions to dealing with losses from theft.
One key question is how crypto assets will be treated for the purposes of inheritance tax. Last year, the U.K.’s tax authority, HMRC (Her Majesty’s Revenue and Customs) published guidance stipulating that crypto will be classed as property in this regard — a position it reaffirmed this August.
Legislators now face the prospect of having to rule on these relatively new assets without recourse to legal precedent. There are difficulties in tying crypto assets, which exist only as a digital database entry, to a specific location — in contrast, say, to a physical property such as a house.
HMRC has expressed the view that crypto assets are located wherever the beneficial owner is resident. However, the Society of Trust and Estate Practioners (STEP) — a professional body in the inheritance sector — notes that this position appears to be a pragmatic conclusion, rather than one based on any legal principle. Complications arise when, for example, the private key required to access crypto assets is held by a third party — such as a cryptocurrency exchange or a custodian — or where the assets are owned jointly by more than one person. STEP argues that relevant common-law principles must underpin how residence is determined.
Moreover, there are open questions around whether distinct types of crypto assets should be grouped together when designated as property. For example, should payment tokens, which are primarily mediums of exchange, be treated in the same way as utility tokens, which give holders access to blockchain-based services?
Pension tax treatment
If crypto is indeed property, there are implications for income tax relief when these assets are put into pension schemes. HMRC currently takes the position that since it does not consider crypto assets to be currency or money, the assets cannot be used to pay a tax-relievable contribution to a registered pension scheme.
A question relevant to this discussion relates to how a future central bank digital currency (CBDC) issued by the Bank of England would be treated. If such CBDCs are — as expected — recognized as money and therefore eligible for pension scheme tax relief, will authorities persist with the view that privately-issued cryptocurrencies should be subject to different rules?
Tax loss, capital gains
In August of this year, security issues were in the crypto industry’s spotlight after an attack on the Solana network drained millions of dollars of funds from 8,000 wallets. In the bigger picture, digital thieves stole US$3.2 billion worth of cryptocurrency over 2021 — the majority of that amount pilfered from DeFi protocols. While security breaches in which hackers gain access to victims’ private keys account for much of this criminality, there are also growing incidences of theft due to faulty code, particularly in DeFi. This raises the question of whether stolen crypto assets can be claimed as tax losses, and thereby used to offset other capital gains. Under current rules, the answer is often: “it depends” and varies by jurisdiction.
In the U.K., HMRC’s position is that theft does not constitute a disposal of a stolen asset — since the individual who was victimized by the theft continues to own that asset and has a right to recover it. This would imply that victims of theft cannot claim a loss for the purposes of capital gains tax. However, if a victim can show there is no prospect of recovering the assets, they may be able to make a “negligible value” claim. If that claim is accepted, the individual would then indeed be able to crystalize a capital loss.
On the other hand, the U.S. appears to have taken a less flexible position. IRS tax reforms in 2017 stipulated that only casualty losses stemming from federally declared disasters are tax-deductible — implying that stolen crypto assets cannot be claimed as a capital loss.
The U.K. government recently announced that it intends to extend the scope of the Investment Manager Exemption” (IME) — which spans much of the fund management industry — to encompass crypto.
Since most of the world’s funds are not located in the U.K., the IME provides clarity to non-resident funds with a U.K.-based investment manager that they do not have a taxable presence in the U.K. (provided that certain qualifying tests are met). Crypto assets are not currently on the Investment Transactions List (ITL) that determines eligibility for the exemption. This is set to change.
A key question — which is currently under public consultation — is determining how eligible crypto assets should be defined. The government is looking for a definition that includes only assets that utilize cryptography and distributed ledger technology, but which are also “future proof” in a rapidly evolving industry.
The wider strategy by HM Treasury is to turn the U.K. into a global crypto hub — to lead the pack in attracting investment and jobs.
It set the plan in motion earlier this year by laying out a series of proposed measures — from regulating stablecoins in the Financial Services and Markets Bill, to establishing a “Cryptoasset Engagement Group” that works closely with the industry, to introducing a crypto sandbox that offers a secure environment for business participants to experiment with blockchain technology.
What is clear is that market participants will need clarity on the tax rules that govern crypto assets — which will be essential for the next stage of the industry’s development in the U.K., if the nation is to realize its crypto hub ambitions.