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The IBA’s response to the war in Ukraine
Mark H Leeds, Mayer Brown, New York
Maria Seung Yon Chang, Bae Kim & Lee, Seoul
Sahel Assar, Buchanan Ingersoll & Rooney, Washington, DC
Albert Collado, J&A Garrigues, Madrid
Marcel R Jung, MLL Meyerlustenberger Lachenal Froriep, Zürich
Romain Desmonts, McDermott Will & Emery, Paris
Thursday 3 November 2022
The chair introduced the session with a quick reminder of how crypto-assets (or ‘cryptos’) work and how the market has fared in 2022.
A key aspect of cryptos is that they come in a finite number, which helps create value. Once the cryptos have been created, they can be transferred through a decentralised mechanism known as a blockchain. In most cases, cryptos are not simply placed onto a blockchain, they are created through the solving of complex mathematical problems to record prior transactions on the blockchain, which requires high computing power. This process of creation of cryptos is referred to as mining (in a proof-of-work system). The recording of transactions on the blockchain can also be made through a process called staking (in a proof-of-stake system), which rewards participants for holding cryptos. Mining and staking are not to be confused with an airdrop, which is the free distribution of cryptos, or with forking, which is the creation of a new blockchain from an existing blockchain, thereby creating a new type of cryptos. As an example, the Bitcoin Cash currency is the result of a split from the original Bitcoin blockchain into a new blockchain (the fork) and the distribution to each Bitcoin owner of an equal number of Bitcoin Cash units (the airdrop).
In 2022, investors made significant losses on cryptos, which performed worse than equity. When markets collapsed, lending platforms, which allowed users to place cryptos in a wallet in exchange for a rate of return, gated. This means that they forbade users from withdrawing the assets that they lent out. These lending platforms work in two different ways: either you remain the owner of the borrowed cryptos or the platform becomes the owner, in which case you only have a contractual right to recover ownership rights on the borrowed cryptos when the time comes (or an ‘IOU’). This can have significant ramifications when a lending platform goes into economic distress.
Another question that arises when a non-resident of a jurisdiction participates in crypto transactions through an investment fund that is established in that jurisdiction, is whether such an investment can create a nexus for taxation in that jurisdiction.
Cryptos also provide a significant amount of anonymity to traders, which raises issues around tax evasion and compliance.
This session, therefore, provided guidance on the tax treatment of gains and losses on cryptos, the issues arising in connection with the use of crypto funds, tax compliance matters in relation to crypto ownership and trading, and the tax treatment of staking (but not mining) in South Korea, Spain, Switzerland and the US.
South Korea is one of the jurisdictions where crypto taxation is least developed and is a work in progress. The tax regulations are far behind other jurisdictions because of political, regulatory and tax reasons. Draft tax regulations were proposed in 2020 and were supposed to be introduced in 2023, but the new government postponed the introduction until 2025. Thus, gains on cryptos have not been taxed in South Korea to date due to the lack of a legal basis. South Korean tax authorities, however, have taken the position that foreign individuals making gains on cryptos in South Korea should be taxed by way of withholding, which is being disputed in court.
The South Korean authorities recognise cryptos as virtual assets, which means that they are regarded as personal property rather than currency. This should give an indication of the future tax treatment of gains from cryptos. Current proposals would place such gains into the ‘other income’ category subject to income tax at 22 per cent, would allow the recognition of losses only upon disposal of the cryptos and an offset against gains realised in the same year, and would not provide for any carry forward rules.
For individuals, gains and losses from the sale of cryptos are treated as capital gains and losses subject to income tax at 26 per cent (postscript: the rate is 28 per cent as of 2023). Losses (including from the loss of the crypto itself) are generally deductible against gains in the same year and can be carried forward for four years. There is no deduction of unrealised losses.
For entities, cryptos are not regarded as a financial asset because they are neither cash nor a security nor a debt instrument. This means that cryptos are regarded either as an intangible asset (highly contentious due to an amortisation over ten years and thanks to difficulties in determining the basis for amortisation) or as inventories (if there is regular trading in cryptos). Cryptos are not a means of payment, but a means of exchange, which raises further questions on how to record them on the balance sheet (first in, first out (FIFO), average cost price) and also places crypto transactions in the complex realm of swap transactions.
Switzerland has not yet enacted legislation to regulate crypto taxation. Standard taxation rules apply, which make a distinction between private assets and business assets.
Private assets are generally not subject to the taxation of gains (nor deduction of losses) in Switzerland.
Business assets are generally subject to taxation upon realisation of a gain. Today, exchanges of cryptos are viewed as a taxable event. This places a heavy burden on crypto traders to assess the gain on the exchange and comply with the tax rules. There is a proposal to treat exchanges of cryptos as like-kind exchanges with no recognition of gains or losses until the crypto is traded against a fiat currency. If the taxpayer has to prepare financial statements, unrealised capital losses must be recognised immediately for tax purposes. However, if the taxpayer has a smaller business, gains and losses on cryptos may be recognised on a cash basis, when they are realised. Losses on cryptos can be offset against other income and can be carried forward for seven years.
Cryptos should be treated as commodities. Gains and losses should, therefore, be treated as capital gains and losses, which are segregated from ordinary income. Capital gains are taxable at the ordinary income tax rate, unless the asset has been held for more than a year, in which case the applicable tax rate is approximately 50 per cent of the ordinary rate. Capital losses are only deductible against capital gains. A question generally arises when a taxpayer wants to make a sale to realise a loss and reestablish a position within a short period of time (wash sale). Wash sale rules apply to securities and prevent the deduction of losses on such transactions. Because cryptos are regarded as commodities, wash sale rules should not apply to them. However, to strengthen this position, it is preferrable to reestablish a position in a similar crypto and not the same crypto.
Questions also arise with respect to stolen cryptos, especially when an exchange has been hacked. In theory, it is always possible to find in the blockchain where a stolen crypto is located. This could make claiming a loss on the stolen crypto difficult under US theft loss deduction rules, as they require the asset to be unrecoverable.
Another question is what happens when a lending platform becomes the owner of a borrowed crypto in exchange for an IOU, which could trigger gain recognition. In the same vein, there are uncertainties when a platform freezes or becomes gated about whether the lender can claim a non-business bad debt (short-term capital loss); the mere gating might not be sufficient to recognise such a loss, as such bankruptcy filings might be necessary.
Depending on what they represent, non-fungible tokens (NFTs) could be regarded as a commodity or a collectible, although recent guidance suggests that NFTs should be regarded as commodities. NFTs present unique opportunities in that they can be used to embed the ownership of a bond, which can considerably increase the liquidity of the debt market (transactions times go from T+ten days to T+ten minutes).
The question of Swiss permanent establishments arises particularly in the context of mining and staking.
A permanent establishment requires a fixed place of business; it does not require people to be physically present, but it should be permanently accessible. This is where a distinction comes into play between centralised servers, such as with e-commerce websites, and decentralised servers, such as with blockchains.
In mining, a reward goes to a person who can solve a complex task. In staking, a reward goes to a person who holds a large number of cryptos. In both cases, however, the reward is not given for solving a task or for holding a stake per se, it is given for recording a series of transactions (or ‘block’) on the blockchain. Mining requires computer power and, therefore, hardware. Mining farms in Switzerland can be viewed as a permanent establishment if there is physical access to the premises where the servers are located, although contractual arrangements could mitigate that risk. In staking, there is no such need for computer power; only a computer and an internet connection is required. Therefore, the characterisation of a permanent establishment is unlikely in staking systems because the process is decentralised and does not involve physical access to the premises where servers are located.
The South Korean approach to permanent establishments is similar to Switzerland and close to the Organisation for Economic Cooperation and Development's (OECD’s) principles. A distinction again must be made between mining and staking. A mining farm requires computing power and therefore servers which, if located in South Korea, could qualify as a permanent establishment. This risk is much less material for staking.
Crypto funds have yet to appear in South Korea due to a regulatory framework that is not conducive to such funds. Under the traditional approach to permanent establishments in the investment fund industry that should apply to crypto funds, a permanent establishment can be characterised if there are people on the ground, especially fund managers that are making commercial decisions. In this respect, the South Korean tax authorities are quite aggressive in their view on permanent establishments and investment funds should, therefore, carefully structure their operations when they open up shop in South Korea.
Under US law, a commodity trading safe harbour rule allows non-US investors engaging in security and commodity trading to not tbe subject to US tax. This rule requires that there be an established market, although the transaction does not need to be made on that market (eg, OTC). Most tax practitioners consider that exchange platforms for crypto should be regarded as an established market and allow the application of the safe harbour rule to crypto trading. However, certain accounting companies are sometimes reluctant to treat crypto trading as commodity trading eligible for the safe harbour and may require a legal opinion.
Many crypto funds engage in staking, which could be viewed as a service that is not eligible for safe harbour. Income from such services could be regarded as effectively connected income (ECI) and, therefore, be taxable in the US.
Trading through an agent in the US could be treated as ECI or a permanent establishment if the agent is dependent upon the principal. There used to be some degree of certainty that trading through an independent agent should not give rise to a permanent establishment, but this has been eroded over time and being located in a treaty jurisdiction with a dependent agent clause should result in a stronger position that there is no permanent establishment.
Spain applies the OECD rules for permanent establishments (fixed place of business and dependent agent).
Based on a previous ruling, there is a distinction to be made between the management company, which has its own fund management activity, and the fund itself, whose activity is limited to holding assets. A management company should not be regarded as having a Spanish permanent establishment only because it manages an investment fund established in Spain; likewise, the investment fund should not be regarded as having a Spanish permanent establishment only because it is managed by a Spanish management company.
Still, based on the ruling, mining activities are regarded as an economic activity that could result in the characterisation of a Spanish permanent establishment if there are servers or a dependent agent in Spain. Conversely, staking should not be viewed as an economic activity and is, therefore, unlikely to result in the characterisation of a Spanish permanent establishment.
Having a crypto custodian in Spain could be problematic because it could make the crypto a Spanish situs asset, thereby causing the fund to be subject to Spanish tax if it is not located in a treaty jurisdiction. This is likely to impair the growth of crypto custody services in Spain.
Tax compliance concerning cryptos in general is in the works at the international level, especially within the OECD. Record-keeping will be crucial considering the various stages of a crypto transaction and working with a certified public accountant (CPA) will be important.
Brokers will have to provide to the Internal Revenue Service (IRS) with certain information with respect to their customers starting from 1 January 2024, although there is no guidance as to what information is expected from them. Guidance from the IRS should be released in 2023 and there are still debates as to who will be regarded as a broker. Current definitions are expansive and could include miners and stakers, which could create an enormous burden for the industry. Postscript: the IRS has postponed US crypto tax reporting until after the publication of the final regulations.
Spain passed a law on the matter in 2021 and regulations are expected in 2023. Certain service providers, especially custodians and exchanges, and Spanish entities conducting initial coin offerings (ICOs), will be subject to reporting obligations. Reporting will include crypto and fiat currency balances at the beginning and end of the year, withdrawals and details on the crypto transactions (the nature of the transaction, the parties involved, amounts involved, the transaction price and date).
There will be reporting for individuals. There was already mandatory reporting of assets held outside Spain, and this includes, starting in 2023, cryptos held outside Spain.
In Switzerland, general tax compliance rules apply, especially for crypto traders. Crypto traders are generally viewed as self-employed and are subject to the corresponding reporting obligations. A failure to comply may cause taxation on a discretionary basis.
Starting in 2023, South Korea will impose onerous reporting obligations on virtual assets service providers operating in South Korea, with a form that will have to be filled out for each transaction. These reporting obligations should be a preliminary step to implementing the individual taxation of crypto trading.
Staking is unlikely to be regarded as a taxable event for income tax purposes in South Korea. There might be some debate as to whether staking and airdrops could be regarded as a gift subject to gift tax based on a recent ruling.
There are still uncertainties on the tax treatment of income from staking. Some taxpayers have argued that it is economically analogous to earning interest or corporate dividends. In a recent dispute, a taxpayer argued that staking should be considered as similar to selling property and that there should be no difference between the purchase price and the sale price, and therefore no gain. The IRS dropped the case, so there was no court decision, so debates on the tax basis, cost basis and market value of staking and the rewards are still ongoing.
The Swiss tax treatment of staking activities is unclear, and could be considered as a service income, an interest income, or no income at all.
In general, transaction fees (paid by the originators of a transaction to facilitate the recording of the transaction) should be a taxable income. But the treatment of the staking reward (the crypto created for recording a block) is debatable and could depend on whether the staking activity involves self-staking or delegated staking. In self-staking, the reward could be regarded either as the production of an asset, which raises the further question of whether it is a private asset or a business asset, or as taxable income. In delegated staking, staking rewards are not interest income according to a court ruling, and should also be regarded as taxable income.
Staking should not be viewed as an economic activity based on a court ruling. Staking is similar to a deposit and so, income should be viewed as interest. Interest should in theory be subject to a Spanish withholding tax, but there is no practical way to make such a withholding.
From a VAT perspective, the reward is treated as a financial service fee exempt from VAT. However, transaction fees should not be regarded as a financial service and, therefore, be subject to VAT.