The impact of digital assets and cryptocurrencies decentralised finance on taxation in various jurisdictions

Digital assets and cryptocurrencies continue to evolve by offering new services and products such as Decentralized Finance (DeFi) and non-fungible tokens (“NFTs”), but is tax legislation also keeping up to date with the ever-changing world of digital assets and cryptocurrencies? 

The introduction of digital assets and cryptocurrencies to the traditional financial market has required various taxation laws to be amended, updated, and in certain circumstances new laws to be introduced to specifically deal with this new asset class and its complex transactions. 

From an administrative and practical perspective, some hurdles have been overcome. There are various investors that are involved in high volume trading (or “bot trading”) resulting in thousands of transactions being actioned on multiple cryptocurrency exchanges and Over Counter (“OTC”) platforms. These high-volume transactions require accurate and complete record-keeping to allow for the determination of the investor’s tax obligation. 

What we have found is that it is not feasible to manually account for these high-volume transactions, due to the complexity of the calculation and the various costing models used (i.e. First In, First Out (“FIFO”), Weighted Average, etc.). The issue however is not necessarily the availability of tools to track transactions and calculate the taxable profit with the use of Application Programming Interface (“API”) integration, but the coverage of these tools over the various exchange platforms. 

In most circumstances, the tools or applications used to calculate the taxable income only has API or comma-separated values (“CSV”) integration for some exchanges. The trades which become problematic are those where investors trade across platforms when arbitrage opportunities present themselves. 

The process of record-keeping is further complicated where legislation is not being amended or where collection agencies do not provide proper guidance on the specific tax treatment of cryptocurrency investments (e.g. capital versus income). This results in some taxpayers omitting cryptocurrency-related transactions from their tax disclosures, which has a financial impact on the collection agencies but could also have a dire consequence for the taxpayers. 

We have also seen taxpayers not grasping the tax impact of taxable transactions they incur when dealing with cryptocurrencies. As an example, an individual might receive cryptocurrency as remuneration, subsequently use that cryptocurrency to pay for goods and services, exchange it for another cryptocurrency or liquidate it for fiat currencies[1]  all while keeping track of the weighted average of FIFO cost. 

This lack of understanding of the tax impact of each of the taxable events could result in a potential error or omission in respect of the taxpayer’s tax liability. It is due to the complexity of the transactions and the lack of tax-related knowledge on the side of taxpayers that we have found it more efficient, in mitigating risk, to have the client use these available tools and applications to determine its taxable income. Once these clients are able to provide us with their taxable income we can further assist them from a tax compliance perspective. 

Cryptocurrency has evolved beyond being a medium of exchange, store of value, and unit of account to other products such as non-fungible tokens (“NFTs”). From an income tax perspective, this has not raised too many questions, but from a Value-Added Tax (“VAT”) perspective the matter does become more complex. In most circumstances, NFTs may or may not fall within the ambit of digital assets or cryptocurrencies as defined by the relevant tax legislation. The sale of NFTs is also usually not limited to the sale in a specific jurisdiction. Issuers of NFTs, therefore, need to take into consideration the applicable tax legislation for relevant jurisdictions, as the sale to international collectors might be seen as an exported good. 

The introduction of Decentralized Finance (“DeFi”) has also brought new products into the cryptocurrency market like automated market makers, decentralized exchange liquidity providers, wrapped tokens, and collateralized lending. These new concepts involve unique transactions that may differ vastly from each other. This requires investors and tax experts to understand the flow of transactions within the product, alongside the applicable tax legislation and practice in the relevant jurisdictions, to determine the applicable tax implication.

It follows from the above that it has become paramount for tax experts to have a good grasp of cryptocurrencies, digital assets, and the inner workings of the various products to enable them to determine the tax implication of these transactions and appropriately advise clients.

  [1] A fiat currency is one that is not backed by any commodity such as gold or silver but is typically declared by a decree from the government to be legal tender.