Decrypting the past, regulating the future

INTEREST in cryptocurrencies is running at an all-time high at the moment. Investors with a healthy risk appetite are attracted to the large returns which can be made, while many governments and businesses are starting to seriously consider the far-reaching implications of the underlying technology.

At the heart of most cryptocurrencies is a publicly accessible, distributed ledger called a blockchain. This comprises a series of blocks which record transactions between different cryptographic addresses. Transactions are processed by "miners" who deploy computing processing power in exchange for a reward. While all transactions on the blockchain can be inspected by anyone, there is no way to know who holds private keys to which addresses.

The combination of anonymity and decentralisation has historically given cryptocurrencies an anti-establishment mystique. Bitcoin, the frst decentralised cryptocurrency, has been heavily criticised as the transactional medium of choice for organised crime. The now defunct New Silk Road is a prime example of this.

It is clear that cryptocurrencies have now evolved beyond the fringes and their mainstream potential is immense. Within the fnancial services sector, cryptocurrencies offer the promise of increased speed and accuracy in payment processing; greater access for the unbanked; and a detachment from centralised monetary policy. The immutable nature of the blockchain offers almost limitless uses in other parts of the global economy. This includes the development of self-executing smart contracts and zero trust transactions which rely upon information contained in the blockchain.

The rising popularity of cryptocurrencies is evidenced by the rapid increase in initial coin offerings (ICOs). This is a funding structure whereby a new blockchain venture issues its own token to investors as opposed to traditional shares or debt. The economic motivation for investors participating in an ICO is different from the purchase of debt or equity in a new venture. Investors will only realise an economic return if there is demand for the token itself, which can come in the form of fevered speculation or a real-world business case. The most common business use for a token is that it is "fuel" for executing transactions on a blockchain.

Up until recently, the general position has been that a cryptocurrency is not a "security" for securities law purposes. This is particularly true for utility tokens which provide a network usage right, as compared to those which enable a share in the profts of the coin issuer. ICOs have to date been conducted with comparatively light informational disclosures and none of the investor protection mechanisms which are common for a standard IPO or debt issue. The US Securities and Exchange Commission and the Monetary Authority of Singapore have both, however, recently stated that the issue of a token may come within existing securities laws. Chinese regulators have also indicated an intention to regulate ICOs.

Regulatory and tax issues

The trend towards government intervention is an investor protection response. There are many risks and information asymmetries for an investor participating in an ICO. It is common for sponsors to pre-mine a signifcant amount of the tokens which are issued and retain these as part of their incentive. There is no law stopping the sponsor of an ICO embarking on a pump-and-dump once the token is listed on a public cryptocurrency exchange. There is also potential for price manipulation and trading on asymmetric information in a manner which would be considered insider trading if the tokens were securities.

In the immediate wake of the statements made by the US, Singapore and China authorities, issuers are now starting to exclude investors from these jurisdictions participating in an ICO. There are a number of methods which are used. These include the creation of investor white-lists (some of which require proof of identifcation documentation) and geoblocking participants from these countries during the ICO itself. Issuers are also changing the features of their tokens so that they are less likely to be considered securities. Many of the large cryptocurrency exchanges are based in the US and they will not list a token for trading if in their view it is a security. An inability to list on major cryptocurrency exchanges hampers liquidity and consequently the price of the token itself.

There are a signifcant number of tax issues for cryptocurrency investors. The most obvious question is whether trading gains are income or capital. This is an important distinction as the rules of many tax regimes apply a more concessional treatment to capital gains. A related question is the place where any trading gains are to be taxed. Is it the place where an individual issues trading instructions or is it the country in which a cryptocurrency exchange is based? There can be an overlapping of the taxation systems of two jurisdictions where a different nexus test is applied. In these circumstances, it may be necessary to apply the provisions of a double taxation agreement to avoid double taxation.

In addition to the taxation of trading gains, there are a multitude of other less obvious tax issues. These include the taxation of tokens which are given away by the issuer or "air-dropped" and any rewards obtained for token staking or lending. The estate tax position of a cryptocurrency held through an exchange is unclear - the decentralised nature of cryptocurrencies means that it is diffcult to identify a jurisdictional nexus for estate tax purposes. Businesses accepting cryptocurrencies as a form of payment can face a unique issue of double taxation in a value-added tax context.

For investors, the exchange of information is perhaps the most signifcant tax related issue which is yet to be adequately addressed. Countries the world over have signed up to a programme of international information exchange developed by the Organisation for Economic Co-operation and Development (OECD) called the common reporting standard. This results in the automatic exchange of detailed and specifc information about the holders of fnancial accounts to the jurisdiction of their tax residency. It is not yet clear whether a trading account held with a cryptocurrency exchange which does not accept transfers of fat currency, would be taken to be a fnancial account for these purposes.

Cryptocurrencies have seen a meteoric rise this year. Investor interest and sophistication are growing in this space notwithstanding the considerable investment risks. For both issuers and investors alike, it is important to remain up to date on the regulatory and tax developments as they unfold. W

Stephen Banfeld is Special Counsel, Withers KhattarWong