Cryptic crypto: is Bitcoin escaping tax liabilities?

Many have called into question the extent to which cryptocurrencies like Bitcoin are escaping tax liabilities, but until a regulatory framework is decided upon, the issue will remain unchecked

A tax haven? The secretive world of cryptocurrencies has left many wondering if Bitcoin users are avoiding tax liabilities
A tax haven? The secretive world of cryptocurrencies has left many wondering if Bitcoin users are avoiding tax liabilities 

“If you mow your neighbour’s lawn, it doesn’t matter if he pays you $20 in cash or $20 worth of Bitcoins (or $20 worth of tomatoes for that matter), you are still legally required to report that as income. When using Bitcoin for payment, the taxing authorities may be less likely to be aware of the payments, but try to mow 10,000 neighbour’s lawns and not report the income,” read a somewhat suspect note of caution on the Bitcoin wiki earlier in the year. This, it would seem, is representative of a penchant for tax avoidance among the cryptocurrency community, who believe their illegitimate dealings in this space are masked by anonymity.

Some might say the age of the island retreat has passed and in its stead has come the safe haven that is the cryptocurrency, which has attracted a wave of new users whose intentions lie not only in subverting fiat currency, but in evading the tax authorities.

An unknown quantity
A sense of obscurity, which first arose with the birth of the Bitcoin five years ago, is something that has served to complicate the ways in which cryptocurrencies are understood, and it is this that has riled debate concerning how it should be taxed.

“This is not a new compliance problem by any stretch; it’s really the same one you have with cash, and virtual currency is very similar to cash inasmuch as it’s incredibly difficult for the IRS to track,” says the Director of Tax Issues at the US Government Accountability Office (GAO), James White. “We just don’t know the true extent of the compliance problem. We’ve found that the data out there isn’t very good, especially on the nature of virtual currency transactions. Sure, you can get some information about the total volume of transactions, but whether those transactions are taxable and what jurisdiction they’re coming from, that’s a lot harder to identify.”

According to peer-to-peer-network-generated statistics on Blockchain, over 98 million Bitcoin transactions were recorded as of January 17, although the log offers little to no indication of how many taxable events may well have occurred in this time. It is this ambiguity that has seen many label cryptocurrency as a means to a criminal end.

However, contrary to popular opinion, cryptocurrency transactions are far from anonymous, and do in fact leave a trail of data in their wake, especially on various centralised services such as exchanges and wallets. Although not all codes can be traced to their source, a lot of information can be dissected with the appropriate technical tools and knowhow. Granted, Bitcoin transaction records, or ‘block chains’, do present a few complications, namely for those tracking the actual individual involved as opposed to an IP address, but what is quite clear is that they are far more transparent than cash.

What is a cryptocurrency?
For this reason, the actual scale of non-compliance among cryptocurrency users should be considered secondary to the essential task of understanding exactly how it is they should be taxed once they are traced. The problem need not be any larger than cash, provided an agreement can be reached on the specific tax liabilities that apply to the phenomenon.

“The tax authorities have been playing a wait-and-see game on this question for quite some time. Only now, following 12 months of rapid growth in the market (approximately $10bn today) are they trying to determine if they can slot digital currencies into pre-existing categories with ready-made tax regimes,” says Richard Asquith, Head of Tax at TMF Group. “Initially, tax authorities labelled virtual currencies as vouchers, however, this is now changing as it is clear they are a store of wealth in their own right and their values can fluctuate. Consequently there is growing pressure for them to be re-categorised as private currency. The closest ‘real world’ example is gold, in particular gold sovereigns, which is used for both short-term trading and longer term investment and as a hedge against sovereign currencies/equities trading.”

For all intents and purposes, cryptocurrencies are subject to much the same tax liabilities as any other asset, or currency for that matter. However, the issue here is not one of tax itself, but rather one of uncertainty; and an uncertainty that will continue to confound users and authorities alike for as long as the IRS and authorities like them neglect to pin down and properly address what a cryptocurrency is.

“It’s very difficult right now in the US to develop a good estimate of whether there is much in the way of tax revenue being lost, and this is partly why we recommend the IRS puts up informal guidance on the matter,” says White. “Because there is so much speculation out there, we feel it is important for the IRS to be out in public saying something on the matter.”

Taxable gains lost through cryptocurrency transactions are often a product of misunderstanding as opposed to any deliberate attempt to evade authorities, which serves to underline the importance of putting an official framework in place. “If taxpayers using virtual currencies turn to the internet for tax help, they may find misinformation in the absence of clear guidance from the IRS. For example, when we performed a simple internet search for information on taxation of Bitcoin transactions, we found a number of websites, wikis, and blogs that provided differing opinions on the tax treatment of Bitcoins, including some that could lead taxpayers to believe that transacting in virtual currencies relieves them of their responsibilities to report and pay taxes,” reads the GAO’s Virtual Economies and Currencies report.

For this reason, authorities must seek to instil a system that makes clear cryptocurrencies’ taxable liabilities. “A global definition and understanding of what constitutes a virtual currency is almost certainly required,” says Asquith. “The problem is who would put this together. The European Commission or OECD would be a good start. However, as with other related questions (e.g. how do we tax companies with global operations?), countries still have sovereign authority, so would not necessarily by bound by any international standard.”

Tax indecision
In December, Norway’s government deemed Bitcoin unworthy of the conventional currency tag and opted instead to treat it as an asset, given that it’s not tied to any centralised government agency. Elsewhere, Singapore’s Inland Revenue Authority recently decided to tax Bitcoin under the goods and services bracket, whereas both Slovenian and German governments have pledged to crack down on related tax issues, though the system by which this is enforced is yet to be decided upon.

This same sense of ambiguity has worked in the favour of Bitcoin these past 12 months

This same sense of ambiguity has worked in the favour of Bitcoin these past 12 months, as individuals across the globe have clamoured to get on board with what remains the world’s most unregulated and valuable currency. For those unfamiliar with the events of this past year (see Fig. 1), a single Bitcoin was worth as little as $13.50 at the onset of 2013, and by November had reached a peak of $1,200. Put mildly, Bitcoin is gaining momentum, and some suspect it could easily be worth as much as $100,000 as it moves into the mainstream in the coming months and years.

The key question going forward should be whether cryptocurrencies are labelled as a currency, or an alternative financial instrument of some sort. This question, though seemingly trivial, will come to determine how entities such as Bitcoin are taxed and, more importantly, at what rate. The decision ultimately boils down to whether cryptocurrencies should be subject to income tax or capital gains tax, and with the former being much higher than the latter, it’s quite clear which option proponents of the currency will be rooting for.

Mounting concerns
It is only after clear guidelines have been set out by authorities that questions can then be asked of the extent to which users are manipulating the system. “I think it is fast becoming a concern with the 2013 appreciation in the value of Bitcoin,” says Asquith. “This has put it on the radars of tax authorities around the world. They see it as a potential source of new revenues and are anxious to exploit this in the wake of the financial crisis and ballooning government deficits. The tax authorities also want to help the new currencies flourish, especially if they do emerge as an acceptable alternative payment platform. This means giving clear tax guidance to the market players so that they can plan their businesses and grow.”

By design, cryptocurrencies such as Bitcoin were not intended to be anonymous but rather decentralised, and the perpetuation of anything else is merely a misunderstanding on the part of ill-informed sources. While the currency’s paper-thin regulatory bounds appear to have worked in its favour in recent months, for the phenomenon to be more readily accepted by authorities across the globe and for its to continue to grow, users must be prepared to embrace the appropriate tax implications.

There is no doubt that cryptocurrencies such as Bitcoin could come to be seen as a currency in their own right by authorities, but before that happens, they must put to paper exactly how they are liable to tax, so as to avoid it being seen merely as the tax havens of the digital era.