Taxation of Trading in Cryptocurrencies

Understanding cryptocurrencies

A cryptocurrency is a virtual currency that is uses Block-chain (a distributed ledger enforced by a disparate network of computers) as the underlying technology. This makes it impossible to counterfeit. Cryptocurrencies are not fiat money in any country except Ecuador. Therefore, these currencies cannot be used to buy your daily needs, pay utility bills, or buy a few gallons of fuel. As the cryptocurrencies are not issued by the Central banks, there is no government interference or control. This allows portability of cryptocurrencies globally, immunity from inflation and transparency in transactions.

“Crypto” refers to the encryption algorithms and cryptographic techniques that safeguard secure payments online denominated in terms of virtual “tokens”. The tokens are represented by ledger entries internal to the system. Encryption algorithms and cryptographic techniques commonly used are elliptical curve encryption, public-private key pairs, and hashing functions.

Bitcoin was the first Block-chain based cryptocurrency. It was created and launched by a person or group of people under the pseudonym “Satoshi Nakamoto” in 2009. The number of Bitcoins in circulation is limited so as to prevent manipulation and retain value in the asset. There are, however, numerous alternate tokens or cryptocurrencies that are popular globally and traded frequently on the Crypto Exchanges. Most of these are spawns of the Bitcoin but a few are new currencies built from scratch and use different algorithms.  

A list of frequently traded Cryptocurrencies is given below:

Using Cryptocurrencies it easier to transfer funds between two parties, without the services of a trusted intermediary like a bank. The use of Public and Private Keys and incentive systems ensure the security and privacy of the transaction. Funds are transferred with minimal processing fees and avoid the steep fees charged by financial intermediaries.

The privacy and anonymity associated with cryptocurrency transactions are the reasons that the system is well-suited for illegal financial activities, including tax evasion, terrorist financing and money laundering. Some cryptocurrencies are very private and often difficult to trace. It is often said that the origin of cryptocurrencies lies in the dealings of the underworld.

Asset class or currency

The misuse of the cryptocurrency systems has caused the Governments across the world to react differently to the legal issues arising from crypto currencies.

1. The appalling economic situation in Ecuador has resulted in the Government there to allow cryptocurrencies to be used as fiat money. This is probably the only country in the world that has allowed cryptocurrencies to be used as fiat money
2. Countries that are the target of terrorist and other illegal activities, such as India, have sought to ban trading in cryptocurrencies and have tried to prevent the operation of crypto exchanges in the country.Until recently, the Reserve Bank of India had prevented the set-up of crypto exchanges in India and the conversion of cryptocurrencies into Indian rupees. The Supreme Court of India overturned this ban on the grounds that it was unconstitutional. As a result, trading in cryptocurrencies is now permitted. Cryptocurrencies are treated as a valid class of assets.
3.  A majority of the countries, do not treat allow cryptocurrencies to be used as fiat money. However,  cryptocurrencies are treated as a valid asset class.

Crypto Exchange

Crypto Exchanges can be of three kinds:

1. Centralized Exchange

These crypto exchanges are fully regulated and controlled by a designated authority in a country. It therefore functions as a stock exchange. The transactions are either Fiat currency to Crypto currency to crypto currency. Transactions are faster on such an exchange and given a high liquidity, the settlement takes place faster. The exchange is the custodian of the cryptocurrencies for the investor’s. While highly acceptable, this type of exchange is devoid of an important characteristic of the cryptocurrency system I.e. no regulatory control.

2. Decentralized Exchange

These are peer-to-peer marketplaces where trading takes place between parties on the Blockchain platform. Government has no role to play in these transactions. Due to the limited functionality and lack of Government supervision, these exchanges are less liquid, transact in lower values and have less liquidity. 

3. Hybrid Exchange

A hybrid exchange is a high point in the Crypto-currency system, which allows transactions in any currency or in fiat money or crypto-to-crypto transactions between peers. The government controls are minimal in such cases also.

All crypto exchanges earn their money through a fee charged per transaction. The fee depends on the number of transactions rather than the value of the transaction.

Taxation

1. Taxation of Crypto Exchange

A crypto exchange is treated as any other business entity and would be taxed on its profits from the business. At present there are no special rules for taxation of a crypto exchange. In countries where operation of a crypto exchange may be illegal, the illegally earned profits may still be subject to tax.

2. Taxation of Traders

Traders in cryptocurrencies would be taxed on their profits or gains from the trading activity either as Business Income or as Capital gains. Specific rules in each country would determine whether the income is to be taxed as business income or capital gains. This may simply depend on the period of holding the crypto assets in some countries while in other countries the intent behind the transactions would determine whether these are for business or for investment.

In some countries, the business income may be considered to be speculative income particularly in relation to intra-day trading activities. There may be specific provisions dealing with speculative income.

In the United States of America, the IRS has issued a set of Frequently Asked Questions of Virtual Currency which clearly sets out their position. The FAQs can be accessed here.

Conclusion

For the purpose of accounting and taxation, it is important to take into consideration, the legal status of virtual currencies. In the case of traders in cryptocurrencies, the accounting and taxation would depend on whether the transactions are to be considered to be ordinary business transactions or investments. 

Disclaimer: This Article is for information only and readers are advised to seek professional advice before acting upon the information provided herein