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At ETC Tax, we have been dealing with clients’ crypto assets and activities for at least four years, so we have found ourselves quite ahead of the curve in terms of tax treatment. We also admit to a little bit of in-house geekery, with many of our number dabbling enthusiastically in this space; from simple HODLing, to staking in liquidity pools and playing blockchain games. While some companies may have a lottery syndicate, we have a crypto syndicate!
Tax is one thing. Talking about the subject matter is another. We don’t claim to be technical adepts of the underlying technology behind crypto assets and we certainly could not write a smart contract. In this article, we will share some of our working knowledge of some of the activities going on and with which your clients may be involved.
Once there was only one cryptocurrency; BitCoin. And there was only one blockchain; the BitCoin network. Now there are very many.
A chain, blockchain or network is otherwise known as a ‘distributed ledger’. In basic terms, all of the transactions on the network are recorded and verified on connected computers (or ‘nodes’). If you downloaded a BitCoin core client (surprisingly easy to do) you would turn your computer into a node and also end up downloading a copy of the ledger recording every transaction of the BitCoin network. All of them. From the very beginning.
The nodes speak to one another, peer-to-peer and come to a consensus to confirm transactions. That is what makes crypto so transparent and yet also secure; to fool the blockchain, you would have to control more than half of the nodes.
The advent of Ethereum introduced a new thing to blockchains. The innovation of Ethereum was that the blockchain doesn’t only record transactions ; it also allows code to be run over the network (the ‘smart contract’). In simple terms, someone writes some code and records it on the blockchain. It gets shared among all the nodes and becomes part of the blockchain history. Later, when the triggering event occurs, the code is executed, again across the whole network as all the nodes update to the current status quo.
In a sense, the Ethereum blockchain is a virtual machine or computer. The possibilities of these networks are huge. For example, ‘oracle nodes’ are now in existence. These nodes operate as providers of confirmed information for the network. This could be anything from the winning horse of a race to the temperature in Los Angeles today. This means that smart contracts can be written to incorporate events external to the blockchain. Some argue that such networks will become an ‘alternative internet’.
There are now many blockchains or networks in addition to BitCoin and Ethereum, such as the Binance Smart Chain, Polygon, Fantom and many others. In some cases, blockchains have even been developed by governments for the storage of public records.
Networks like Ethereum allow anyone to create their own tokens and those tokens can behave like a currency themselves. So, on each network, there is now a wealth of various tokens. Some rise in value and popularity while others recede into ignominious obscurity.
A recent explosion that may have caught your attention is that of the NFT or ‘non-fungible token’. Fungible means that one unit is interchangeable and indistinguishable from another (such as GBP). NFT’s are not interchangeable.
One of the uses to which NFT’s has been put is in the art market (though some would question the artistic value of many artworks in the space). Essentially, a token is made on the blockchain and a piece of art is matched to it, creating something like a digital signature for that artwork.
That signature is forever matched to the artwork on the blockchain and its ownership and all the hands through which it passed to get there is a matter of public record, thus solving one of the problems in the art world; that of authentication. Whereas a token made on the chain to be used as a currency may have millions or billions as a maximum supply, an NFT will have only one, or a small number of uniquely identifiable versions (1 of 4, 2 of 4 and so on) so that each NFT is unique or one of a limited edition run.
NFT’s like this are now being used to sell music albums and unique perks to go with them. They are also being used in computer games, so that assets developed and earned by playing games can now be monetised by the payers.
Mining is the process by which information on the blockchain. Essentially, nodes add transactions to the latest block on the blockchain. Those transactions are then confirmed between the nodes and then the block becomes a fixed part of the historical record. This process is called ‘minting’.
Minting includes adding new coins to the network (a massive oversimplification – as is much of this article), recording transfers of coin from wallet to wallet and smart contracts and the results of their execution.
BitCoin and Ethereum require nodes to solve complex mathematical problems to confirm transactions on the blockchain. This deliberately makes it hard to do and accordingly very hard to fake or cheat. In return, the miners get a fee from the network for doing that work, which encourages people to run nodes in the first place; it pays to do it. When you pay a ‘network fee’ for a transaction, that’s where it goes; to the miiners.
These days, the volumes of traffic are so high that massive amounts of processing power and time are needed to mint transactions and so different networks are finding new ways to secure their blockchains. The Binance Smart Chain is cheaper to transact on than the Ethereum network and the Polygon network, cheaper still.
One of the most exciting things about the crypto world is that it is decentralised, by its nature.
Your bank balance is recorded on the bank’s computers and they control those records and their security. Your crypto balance is recorded on the blockchain, distributed far and wide around the world. The collective network is responsible for maintaining the records and the security of them.
There are clear advantages to this, including accessibility and transparency. Crypto is often seen as secretive or anonymous but that isn’t really true. Sure, we may not know who is behind BTC (public) address 1FfmbHfnpaZjKFvyi1okTjJJusN55paPH but we can see every single transaction it has ever handled. It is in the public domain.
There are also substantial disadvantages as well. If you lose the private key to your wallet or send ETH to a BitCoin address, there is no centralised bank or anyone else who can help you to unlock the transaction or that account. If you lose something on the blockchain, you can never access it again… even if you can still see it! On this, I speak from direct experience!
Anyone can interact with the blockchains and with smart contracts, that means that the possible functions are incredibly broad. This has given rise to DeFi, or decentralised finance.
If you want to exchange USD for GBP, you need to have an account with a broker to do it.
A broker is also needed to exchange BTC for ETH, or BNB for DOGE. Some brokers are more traditional or centralised; you have an account with a balance of currency or cryptocurrency and through the platform you can place buy or sell orders which are matched with sellers or buyers, just as is done on a foreign exchange platform.
But smart contracts allow for this to be done through DeFi platforms. Here, underlying smart contracts are deployed on the blockchain and allow the user to interact with them. Using a platform like Pancake Swap allows you to exchange one crypto currency for another simply by interacting with the blockchain.
DeFi platforms like Pancake Swap allow users to ‘deposit’ cryptocurrency to provide the resources needed (‘liquidity’) for other users to trade between currency pairs and the smart contract reward them with interest – known as ‘liquidity pool (or LP) staking’.
Another level of this form of investment is the automatic yield farming platform, such as beefy.finance. Here, you can stake cryptocurrency on a platform like Pancake Swap but it is managed through beefy.finance. In return for a small cut, beefy.finance automatically reinvests your rewards so that your yield is compounded at the most optimal rate. The effective compound annual interest rates can be staggering.
More complex trading options are available, such as binary options on the future movement of a currency pair, again with the blockchain regulating the outcomes and paying out rewards automatically.
Lotteries are run. The numbers on your ticket are recorded on the blockchain, as is the way the winning numbers are chosen, for all to see and audit, should they so wish. Your winnings (if you are lucky) are automatically received. Gambling of all kinds is an obvious development.
Other Defi platforms allow anyone who can connect to them with a wallet borrow or lend cryptocurrency. You don’t need to persuade a bank manager that you can afford the loan; the smart contract will automatically liquidate your collateral if your borrowing exceeds a certain threshold.
You can’t spend BTC on the Ethereum network. But because the blockchains are open and developed by the community, many ways of indirectly transacting between networks are available.
A simple way of doing this is with exchanges like binance.com, where you can choose to send cryptocurrency from your balance to a range of different networks.
There are decentralised solutions as well and these allow you to ‘wrap’ a crypto token which is native to one network in code from another so that it can be bought and sold on the newer network (platforms like binance.com simply do this for you).
For a practical example, if you wanted to hold and keep ETH because you think it has the best potential for growth but balk at the very high network fees, you can bridge it to the BSC network where fees are much cheaper, so it will cost less to send it or buy things with it. When you need some ETH back on the ETH network, you can bridge back across, effectively removing the BSC network ‘wrapper’.
ETC Tax makes the complex simple. We strive to make that a reality and not just a slogan.
When talking to clients with crypto transactions, getting to the tax position depends on understanding the underlying transactions. Once those are understood, often the tax position is not all that difficult.
We have barely scratched the surface of what’s going on in the crypto world at the moment and things are developing fast. Even so, an understanding of some of the fundamentals goes a long way when talking to your clients.
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