In 2008 Satoshi Nakamoto published a white-paper outlining electronic cash peer-to-peer transactions known as Bitcoin, the first virtual currency based on a technology known as blockchain. Virtual currencies present a new digital asset class that is still in a grey area in terms of defining the actual asset. This creates difficulties and uncertainty in the area of taxation of profits arising from the owning, holding, or disposing of the given assets.
Unbundling the Term
Blockchain is a distributed ledger technology for peer-to-peer transactions using decentralized storage of transaction data. This has been proposed as a viable alternative for trusted transaction mechanisms and promises efficiency gains such as faster processes, safe execution, and records immutability, and the advantages of no central point of failure. Market capitalization of virtual currencies has skyrocketed in recent months from below USD 10 billion to above USD 150 billion.
Broadly speaking, there are generally two types of virtual currencies: (1) Cryptocurrencies, including digital assets such as Bitcoin or Litecoin, representing an autonomous monetary regime of digital currencies in which encryption techniques are used to regulate the generation of units of currency and verify the transactions of funds; and (2) Utility tokens, representing a license to use a particular service, which work as an essential element of a self-sustaining system acting as a common good such as Ethereum.
Virtual Currencies and Tax in Practice
From a legal perspective, transactions based on blockchain can be classified as property, barter, currency, or a financial instrument. Although the value of virtual currencies can increase over time, because of their unclear classification and varying characteristics and uses there is no answer on taxation of capital gains arising from their disposal. Any objective increase in the value of assets in realization generally triggers capital gain tax under Slovak law. In case of exit taxes, a tax is even imposed on gains deemed to have arisen on assets that were transferred to another jurisdiction due to change of tax residency, although there is no realization of capital gain. It follows from this that a taxable event should occur.
If a capital gain tax is applicable, how is the tax base calculated when the value cannot be effectively measured in traditional currency? Is virtual currency a security? Would a loss from such a transaction be included into the tax base of a taxpayer? Is the deemed income from the disposal of virtual currency considered ordinary income or capital gain? Is trading with virtual currencies an entrepreneurship? If there is a cross-border aspect, where is the source of income? Which country has taxing rights? Should a tax be imposed only on a factual disposal of the virtual currency or even in cases of latent gain? In the absence of harmonization, how would a regulator avoid the risk of juridical double taxation?
Given these many technical considerations, there are some reasons to believe that scrutinizing gains from blockchain transactions would not be in line with the principle of legal certainty, which is embodied in the very first article of the Slovak constitution and is common in EU jurisprudence. It is a fundamental principle, which requires that legal provisions be clear and precise and that the way in which certain economic relationships are governed be foreseeable.
There are also practical challenges, as disposal of the digital asset is hardly trackable, especially if there is no exit from the digital area. In the absence of a global platform on automatic exchange of information, it appears quite unlikely that Slovak administrators would be active in engaging treaty partners with the aim to receive data about customer account information from platforms such as Coinbase, Kraken, etc. Also, the existence of decentralized exchanges such as EtherDelta with no third-party administrator minimizes the ability to conduct compliance.
Temporary Solution and Learning Curve
In the current environment it could be reasonably argued that potential capital gains arising from disposal of virtual currencies should not trigger any taxation until regulators reach a full understanding of the underlying complexities associated with this emerging asset class. In this respect, we encourage regulators reaching out to experts in the field to accelerate their learning curve, as virtual currencies may become commonly used for tax evasion or money laundering.
By Peter Varga, CEO, Carpathian Advisory Group, and Mattia Gagliardi, Co-Founder, Scytale Ventures
This Article was originally published in Issue 4.11 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.