A whole new world of money

Bitcoin remains something of a two-headed monster. To some, it is associated with the dark web, capital flight, money laundering and evading government control. This is bitcoin's libertarian tradition.

To others, bitcoin is an expanding cryptocurrency attracting private equity investment. The Winklevoss twins (digital entrepreneurs) have just launched a platform called Gemini, a new bitcoin exchange in New York. It is a fully licensed, fully regulated LLC Trust Company. This represents the mainstream tradition.

The conundrum is that bitcoin is a decentralised currency that is not affiliated to any institution, country, or even one single representative body. In the absence of formal leadership, it is likely that both 'heads' of the monster will continue to flourish for the foreseeable future.

What is bitcoin?

Bitcoin is a digital currency which can be used to make payments or be held as an investment. The acquisition of bitcoin will entitle the purchaser to a unique piece of code which is stored on the 'blockchain'. The blockchain is a publicly viewable (open-source) record of every single bitcoin transaction since its launch in 2009.

Unlike many centralised systems, the blockchain is fixed and cannot be altered. One error in the blockchain will throw out the entire chain and would be instantly identified, and corrected.

Bitcoins are usually held in 'wallets' (comparable to the traditional bank account), downloaded as software or as a mobile application. This will show the number of bitcoins held and their current value as against traditional currency. The bitcoin-sterling exchange is at the time of writing approximately 1 BTC = £250.

There are currently 15 million bitcoin in circulation, although the underlying algorithm was structured so that the total amount of bitcoin in circulation cannot exceed 21 million. The remaining 6 million bitcoin are in the process of being 'mined'.

Mining involves verifying a series of bitcoin transactions and storing them in blocks of trades, which are added to the blockchain. Each verified block is given a unique 'hash' - like a digital signature - which enables another block to be affixed to it. Each successfully verified block will generate a reward of 25 bitcoins. This verification process ensures that every transaction is securely logged to the network, guaranteeing that the same bitcoin cannot be spent again.

Each bitcoin user has a public key and a private key. Users exchange their public key to effect transactions. A private key is kept on a computer or mobile device, or written in a notepad and kept in storage. The private key permits the owner to decrypt and access the bitcoins.

How is bitcoin taxed?

Bitcoin is notoriously volatile, with traders routinely making sizeable gains and losses. Many investors' Bitcoins have increased five-hundred fold. Taxation of gains and losses is therefore particularly pertinent.

Capital Gains

In contrast to bank deposits, bitcoin does not represent debt (Skatteverket v David Hedqvist [2015] (C-264/14) and does not generate interest. In this respect, bitcoin is akin to a commodity.

Accordingly, individuals are liable to capital gains tax on bitcoin gains at their marginal rates of 18 per cent or 28 per cent (assuming they are not trading as a business enterprise, in which case income tax or corporation tax would apply depending on whether the business is incorporated).

Losses are deductible. The capital gains tax computation should be conducted as per a disposal of any foreign asset by converting the value to sterling on both acquisition and disposal. This process is straightforward when bitcoin transactions are debited and credited into a Sterling bank account.

However, when making other chargeable disposals such as gifts, prints and screenshots should be kept to evidence the value of the holding at the date of disposal. Ideally, each bitcoin acquisition should be kept in a separate 'bitcoin wallet' (a function permitted by the applications) to avoid creating a mixed pool of bitcoin.

HM Revenue and Customs have indicated that excessively speculative cryptocurrency investments may, like gambling gains and losses, be exempt from CGT altogether. A list that differentiates between cryptocurrencies which HMRC consider speculative and non-taxable, and those which are reportable, would be welcome and may foster investment in 'altcoins' (i.e. cryptocurrencies other than bitcoin).
At this point, no such list exists.

VAT

Bitcoin miners will take comfort from a recent EU ruling in Skatteverket v David Hedqvist [2015] (C-264/14) that income generated through mining is outside the scope of VAT.

Similarly, services connected to bitcoin exchange transactions, for example the conversion of bitcoin to traditional currencies, are exempt from VAT.

Situs of bitcoin

UK resident but non-domiciled (non-dom) individuals will be interested in the bitcoin situs rules. Non-domiciliaries who claim the remittance basis are subject to foreign income gains only to the extent they are remitted to the UK. Similarly, non-domiciled individuals pay inheritance tax only on UK situs assets provided they do not acquire a deemed domicile.

Therefore, to the extent bitcoin is foreign situs property, gains made on disposals not remitted to the UK and inheritance tax on gifts and transfers on death, will generally be non-taxable on non-domiciliaries.

Traditional currency and debt are usually situated with reference to the location of the creditor bank - bitcoins have no creditor bank. In the absence of intermediaries, the issue of bitcoin situs is less clear.

For peer to peer transfers, a plausible approach would be to link situs to the physical location of the owner's private key, which might be recorded on a computer device, mobile phone or on a piece of paper.

Where bitcoin is held in a digital wallet, situs would logically be linked to the jurisdiction in which the host company is based. For example, bitcoin held using CoinCorner's wallet services is likely to be situated in the Isle of Man, where CoinCorner are incorporated.

HMRC's view on bitcoin situs rules would be welcome.

Is this the new tax haven?

Since its inception, bitcoin has represented more than a mere currency to its libertarian progenitors, dubbed the 'cypherpunks'. To them, it represents a means of evading the watchful eye of government.

In the original cypherpunk 1994 manifesto, The Cyphernomicon, the illicit cryptocurrency objectives were outlined: 'I see all this rise in money laundering as an incredibly hopeful trend, one that will mesh nicely with the use of cryptography. Why should export of currency be limited? What's wrong with tax evasion, anyway?'

Twenty-one years on, advisers need to be wary of the three potential illicit uses of bitcoin identified in the Cyphernomicon.

1. Money Laundering

Bitcoin exchanges will require the individual to supply identification for money laundering purposes. Once the authorities have verified an individual's bitcoin identity (in the form of the public key), the blockchain should enable them to identify each and every transaction conducted by that individual, as they are stored in one single ledger. The blockchain may actually make tracing easier.

Money laundering is potentially an issue where bitcoin is exchanged at a face to face meeting, where the purchaser furnishes the vendor with his payment address (the public key) before handing over the appropriate amount of traditional currency. However, this is equally true of any cash transaction and, in short, the ability of bitcoin to undermine anti-money laundering legislation is frequently exaggerated.

2. Capital Flight

The capacity for cryptocurrency to undermine capital controls and facilitate capital flight should not be underestimated. This is particularly the case with unregulated peer to peer bitcoin transactions.

In addition to evading capital controls in certain Latin American countries or China, bitcoin could also be used to obscure assets in divorce or bankruptcy proceedings. It would be difficult to enforce a freezing order against a bitcoin holding, particularly where the private key is not entrusted to a third party 'wallet' service provider. To provide additional opacity, certain wallets (such as the 'Dark Wallet') provide a 'mixing' function which effectively involves intermingling caches of bitcoins, which could frustrate tracing.

3. Tax Evasion

The ascension of bitcoin in recent years has coincided with the onset of the Foreign Account Tax Compliance Act (FATA), and the OECD's Common Reporting Standard. While banking secrecy is finished, the rise of bitcoin as a potentially opaque asset class is all the more striking.

For bitcoin users conducting face-to-face transactions, whether or not bitcoin financial activity is reported to tax authorities can be left to the trader's discretion. These types of transactions can be very difficult to trace.

Online peer to peer transactions, or transactions conducted through bitcoin exchanges, are more traceable. A bitcoin purchase of £50,000 would be displayed in a bank statement like any other transfer - '£50,000 to Mr Smith'. The choice of wording in the bank reference is left to the purchaser. Transactions conducted through bitcoin exchanges are likely to state the name of the exchange.

Thereafter, the gains made on the asset or the goods purchased can be difficult to trace, unless they are later sold and the proceeds are credited to a bank account. Outright gifts and transfers of bitcoin would be difficult to trace.

The crucial questions are twofold. First, whether all bitcoin exchanges can be treated (and compelled to act) as fully compliant Financial Institutions for the purposes of FATCA and the Common Reporting Standard. Second, whether unregulated peer to peer bitcoin exchanges created by libertarian code-writers can continue to develop within this regulatory environment.

What practical benefits can bitcoin bring to clients?

Individuals may be attracted to the benefits of holding bitcoin, which include:

• Increased privacy. Private clients do not need to entrust their details to third party institutions;

• There is no foreign exchange commission on cross-border payments;

• Potentially quicker cross-border transfers;

• The ability to realise bitcoin in some cases prior to extracting a Grant of Probate; and

• Capacity to quickly make, and realise, gains or losses.

Blockchain technology

For all bitcoin's headlines, it is the underlying blockchain technology that has excited banks and venture capitalists. Specifically, investors are interested in whether the blockchain can store the ownership details of, and be used to transfer, other assets besides bitcoin.

Private client advisers will take an interest in at least three proposed functions of the blockchain:-

The blockchain as a depository for legal documents

I may have a dubious claim to being the first person to upload my will to the blockchain (although I will accept challenges to this claim). This is achieved by linking the digital version of one's will to a unique bitcoin transaction number which is recorded on the blockchain.

Therefore, on the day I executed my will, I uploaded the digital version to the blockchain. My will is registered to the blockchain, albeit in an encrypted form so no-one can view its actual contents unless they have access to my laptop and other details.

You can of course email a digital copy of your will to yourself, but by doing so you are entrusting the content of your will to a third party and the whims of their archiving policy (i.e. the email can be deleted).

Given that the blockchain is unalterable and interminable, it is a failsafe and confidential mechanism to corroborate the accuracy of a will. The corroboration takes place by certifying that the word document existed at the time the will was executed and that the sworn will reflects the version uploaded to the Blockchain.

The process is very straightforward (see www.proofofexistence.com) and cost me 5 mBTC (5/1000ths of a bitcoin, or £1.25).

Other useful ideas include a blockchain containing clients' AML documentation, which could be relied upon by practitioners across the world to verify new clients.

The blockchain as a commodities register

A common concern for private clients is that bitcoin is not linked to any tangible asset. That said, investors may now purchase cryptocurrency which is redeemable against a commodity. For example, investors can buy gold-backed-bitcoin.

Under this model, an investor will purchase cryptocurrency, but rather than just acquiring code, they will also acquire a commodity which is inextricably linked to that code. The physical contents of the gold can be stored by a third party in a vault, while the ownership can be easily transferred through a bitcoin transaction. Gold and diamonds can now be traded via blockchain in this way.

Some may raise security concerns over the physical asset, but the point is that commodities can be given serial numbers that are linked to the blockchain code. Therefore, it would be possible for everyone, with reference to the public blockchain record, to identify a stolen asset.

The blockchain as a securities register

The most ambitious proposal to date is to link assets traded in financial markets - equities, bonds, funds, insurance products - to the blockchain. Each asset would be linked to a bitcoin, or an equivalent cryptocurrency, and could be digitally traded on an entirely new trading platform.

Conclusion

Bitcoin and the blockchain technology have the potential to revolutionise private client affairs. However, the direction of travel depends on the extent to which bitcoin and the blockchain is incorporated into mainstream finance.

If the libertarian wing can achieve its goal of subverting regulation, the blockchain might present some unwelcome challenges to transparency initiatives.

James Brockhurst TEP is an associate at Gowling WLG

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