Why Capital Gains Tax does NOT work for Cryptocurrency
Disclaimer: I am a resident of Australia but many other countries like the US, Canada, NZ and the UK also tax cryptocurrencies in a similar fashion. I wrote this article because I am pained by the onerous tax rules and because I want these countries to succeed in breeding innovation for the good of everyone. Even if you are not subject to such rules, you still have an interest in this as it will affect crypto adoption around the world. If you resonate with this article, please share it around to spread the word.
For many crypto users, paying tax on their gains accurately is a headache. Even when you make a reasonable effort to comply, you are often left with too many unknowns and/or a transaction list that will take forever to decipher. Unfortunately, the tax office has been quick to tax crypto but slow to learn all the implications and nuances this technology brings.
For the users who simply buy bitcoin on an exchange, leave it there and then sell it; calculating the tax they owe is fairly simple and not much different to how they would do it for their shares and other assets.
If you are only using cryptocurrency as a speculative asset and not actually using it for any applications or purchases, then capital gains tax is easy enough to comply with. But the future of the industry is far more elaborate and exciting. If all we were doing was this, there would be little reason to be interested in the industry.
In this article, I will describe some sample use cases of cryptocurrencies like Bitcoin and Ethereum and show how compliance with the current tax rules becomes very difficult and impractical. The samples are shown in order from least complex to most complex.
Spending your crypto to purchase items
Let’s say you bought a Bitcoin in 2017 and withdrew half of it to your hot wallet with the intent to purchase items. You buy a computer for 0.5 BTC 6 months later and start making small purchases for 0.00X BTC.
Each purchase is a capital gains tax event. The computer you purchased for 0.5 BTC has a realised gain/loss that you must calculate and report on your tax return. Likewise, each small purchase of 0.00X BTC is also a tax event and they are realised at different price points with different capital gains/losses.
Any heavy user of crypto currency in this manner will begin to feel anxious about how to do the taxes for each and every transaction. As the transactions begin to pile up, this will get more and more onerous.
Imagine if every time you spent your money at the store, you had to do this. Without software automatically doing it for you, you would begin to get a headache and start thinking whether every single purchase you did was worth the effort it entailed. Even if you had such software, you would feel a bit resentful at the notion that every purchase could carry an obligation.
This example is still relatively simple but already more complex than managing the tax on your shares. After all, you can’t spend your Microsoft shares to purchase items.
Little help from the tax department and accountants run for the hills at the sound of Bitcoin
I have called the ATO on many occasions to clarify rules around cryptocurrency. While guidelines are published, they become muddied by all the nuance of blockchain technology.
Trying to get a crypto accountant is another hurdle, many will simply run away if you tell them you need help with your crypto taxes.
Furthermore, there is little infrastructure available to do the calculations accurately for the scenarios listed here.
Crypto to Crypto transactions using an exchange
Let’s say you want to buy coin x but to get it you must first acquire some BTC and then swap it for coin x.
This now involves two seperate tax events, first you acquire the BTC and then you convert it to coin x. The disposal of the BTC is a tax event and if you held BTC already, the tax office might consider that a disposal of your original coins instead of the BTC you just acquired. Furthermore, any fluctuation in the price of the interim is a tax event.
Stable coins are treated all the same
Stable coins are tokens on the blockchain that represent various fiat currencies like the US dollar. Despite this, the tax office regards them as all the same.
If you had a bank account with US dollars in it that you used to purchase various items, you wouldn’t need to worry about this despite them being of the same value.
Crypto to crypto transactions on a DEX
This starts to get even more tricky than the scenario above. If you try to acquire coin x on a smart contract exchange like Uniswap, your crypto currency can go through many conversions before it gets to the final result.
Let’s say you have coin y and you want to swap it for coin x, you decide that using Uniswap is better so you go there to swap your coins. To get to coin x, Uniswap automatically swaps your coin y for coin z and then coin x. Each time this happens you are incurring a tax event, despite not intending to. As I mentioned above, if you had any of the intermediary coins in your portfolio, the tax office could consider that a liquidation based on FIFO/LIFO.
Again, imagine if you had to worry about this when you sold your shares.
Airdrops, a potentially unintended taxable event
Airdrops are basically tokens that are deposited into your wallet for free. These airdrops can be dropped into your account without your knowledge/consent but still incur a tax liability, even if they drop sharply in value after they are received.
While capital gains tax will only apply in the event that you sell these airdropped tokens, the income tax implications still apply and these tokens can have such poor liquidity that their value is hard to establish or redeem.
Transaction fees for the network
Every time you use a decentralised cryptocurrency like Ethereum or Bitcoin, there is a transaction fee paid to the network, denoted in the native cryptocurrency.
Let’s say you send some ether to your friend and the transaction cost 0.1 ether. This transaction cost is actually a taxable event, and you are obliged to file it in your tax return. This means that you are not only punished by high fees during congestion, but you have also incurred a tax liability.
When using your shares, you never pay the fees with the share itself. If I want to transfer/sell my Microsoft shares, I don’t do so by spending a bit of the share.
Converting your ether into L2 ether or side chains
Ethereum plans to migrate to a L2 solution to increase its scalability. To do so you must deposit your ether into a smart contract to get minted the same ether on another network. Is this a taxable event? It shouldn’t be, but the tax office might have other ideas.
Using dApps on Ethereum, a compliance nightmare
Now we start to get to the real meat of the issues with these tax rules. When you use dapps on Ethereum, such as the MakerDAO CDP platform to generate DAI, you start to get into very complicated territory.
Often when you use such dapps, you are required to do what is called “wrapping ether” this basically takes your existing ether and converts it into a different form, allowing you to do more features with your native ether.
Wrapping ether produces an ERC20 token, it is essentially the same asset (ether) but in a different form. This is analogous to having some dollar bills that you deposit into a bank. It is the same asset but in a different form and with different features.
Despite essentially being the same asset, the tax office deems this to be a tax event since you “technically” get a different asset in return.
Now back to dapps, many dapps require you to do such conversions to perform functions. If I want to mint DAI on the makerDAO platform, I need to convert my ether into wrapped ether and then another wrapping is performed to create pEther. These pEthers can then be used as collateral to mint DAI, another asset.
Each conversion is a tax event and you often don’t even know it occurs unless you are experienced enough to understand how to read transactions. Like I mentioned in the section referring to dapps like Uniswap, these transactions can get very complex and involve many different assets in one transaction. Each conversion is technically a taxable event and it gets more complicated the more you decide to play with these applications. An example of such a transactions can be seen here.
Furthermore, people and organisations HATE uncertainty. If they are unsure how to comply or don’t have the resources to do so, they will simply avoid using it.
If Crypto fulfils its potential, the capital gains tax on Cryptocurrency will have to be abolished
As you can now see with the above examples, the capital gains tax becomes far too onerous as soon as you start using crypto as it was intended to be used, especially on smart contract based blockchains like Ethereum. These are still the early days and the technology will only get more complex with time.
For this industry to succeed and become part of the mainstream, regular users will not be able to comply with the existing tax rules. This will result in countries like Australia falling behind the tech curve, giving other forward thinking countries like Singapore the advantage. Singapore, by the way, does not tax crypto gains. Likewise, many countries in the EU have taken a more wise approach, deciding to avoid taxing crypto gains. It is no surprise that these countries are hot spots for crypto innovation.
As someone who is a technologist and wanting to bring society forward with these technologies, I am pained to see how difficult it is to comply. It’s hard enough trying to build these technologies and I don’t want to have to worry about being audited because I couldn’t get my tax return to perfectly align with all the nuances this technology brings. I have already spent a lot of time and money trying to figure out all the implications and most people will not bother going as far as I have.
Some alternative solutions to the capital gains tax
Before you dismiss me as being a stupid libertarian who doesn’t want to pay his taxes, hear me out. Here are a list of alternatives that would make this scenario much more simple so that we can focus on productive work rather than wasting our time trying to figure out our tax returns. We can’t all afford to have a massive accounting team to manage our personal affairs.
No capital gains on base cryptocurrencies
This is the most simple and ideal alternative. Simply don’t tax crypto gains except for those that are securities e.g. a token on ethereum that represents a company share.
If cryptocurrencies like Ethereum and Bitcoin are simply not taxed as capital gains, we can use them like we do other fiat currencies and the process will be much simpler.
Naturally, if you earn cryptocurrency as salary, you would report these down as your ordinary income, like you would with dollars.
Wealth tax on cryptocurrencies
This tax is already levied in countries like Switzerland and actually works very well for cryptocurrencies like Ethereum and Bitcoin because they are very liquid.
This would work like the following, take the total value of your holdings as of a particular date and pay say 1% of it as tax. This is an effective way to tax cryptocurrency and doesn’t come with all the complexity and baggage that the capital gains tax does.
Only tax crypto to fiat transactions
Again, a much simpler approach. Simply calculate the gain at the time that it gets converted to fiat. France has taken this approach.
With these amendments, using crypto currency could become much less of a burden.
Why I am optimistic that reform will come
I am optimistic change will come in the long run as it is in the self interest of the tax department to eliminate these onerous taxes as the industry matures. When crypto becomes a mainstream affair, the amount of value creation from the technology will be massive and the tax issues I outlined here will be magnified as more and more people join the network and more services are created.
At that point, the tax office will have a choice: keep the same onerous rules and drive out innovation, jobs, income and industry from the country OR change the rules favourably to nurture the industry.
Furthermore, it is my belief that the best R&D incentive the government can provide to this industry comes in the form of getting out of the way. Instead of funding boring blockchain initiatives that get nowhere, the government could do far more by simply removing the capital gains tax on crypto…
So what do you think about the tax situation with regards crypto? Leave your comments below!