The blockchain phenomena has grown explosively in the public consciousness this financial year. Previously the realm of futurists, developers and technology enthusiasts, a significant portion of the Australian population has now participated in the ‘cryptocurrency’ ecosystem in one way or another. The Australian Tax Office (ATO) updated their guidance on the tax treatment of cryptocurrencies on 13 March 2018 and sought consultation and feedback both in relation to that guidance, and the legislative treatment of cryptocurrencies in general.
The below submissions were provided to the ATO as a constructive critique of the current regulatory guidance and environment overall. The overall conclusion was that the current regulatory approach is woefully inadequate, and that a unique asset class like blockchain requires unique, well-informed legislation to match.
At present, guidance from the Australian Tax Office holds that ‘cryptocurrency’ is considered a Capital Gains Asset. The nominal definition of cryptocurrency under current taxation guidance is as follows:
“Bitcoin, or other crypto or digital currencies that have the same characteristics as Bitcoin.”
Under Section 108.5(1) of the Income Tax Assessment Act 1997 (Cth) (the Act), a Capital Gains Asset is defined as the following:
A CGT asset is:
(a) any kind of property; or
(b) a legal or equitable right that is not property.
Examples provided include land, buildings and shares in a company.
Section 104.5 of the Act sets out the various ways in which Capital Gains Tax may be applicable through a CGT event. For the purposes of the current definition of cryptocurrency, a CGT event would most likely occur via a disposal of cryptocurrency with the same characteristics of Bitcoin, or the assigning of rights, as dealt with in Section 104.10 of the Act.
As the ATO guidance to this juncture only includes “Bitcoin, or other crypto or digital currencies that have the same characteristics as Bitcoin,” it is necessary to consider what the characteristics of Bitcoin actually are. Based on both the Bitcoin whitepaper and a general look at the current Bitcoin blockchain, it could be summarised as follows:
This would seem to categorise most distributed ledgers. However, Bitcoin could just as easily be categorised as follows:
Using these metrics, it would be difficult to find many other distributed ledgers that have similar or the same characteristics as the above. Ethereum, another major blockchain, shares almost no similarities at all with the above list. Further, there are many additional features specific only to Ethereum that Bitcoin does not, and will never, realistically share.
Two positions could therefore reasonably be taken. The first is that all distributed ledgers, by their basis in blockchain architecture, share the same essential characteristic as Bitcoin, and are therefore assessable. The second is that most distributed ledgers have significant characteristic differences to Bitcoin, so are excluded from the current definition of ‘cryptocurrency’ and not assessable. If nothing else, this point should be clarified – and until it is, a temporary exemption from assessment to all ‘cryptocurrency’ transactions which may represent a CGT event would be prudent.
However, deeper issues must still be settled, as the onus is usually on the individual to comply with legislation over and above (or in the absence of) ATO guidance. Therefore, for the sake of these submissions, we will assume that the ATO intends for all distributed ledgers to be subject to CGT legislation. This is incredibly problematic. Not only would it represent an overwhelming compliance burden to individuals, it would be both an improper application of the Act and indicative of a misunderstanding of the technology itself.
The overall submission of this paper is that distributed ledger technology must have its own legislation, asset class and tailored regulatory guidance, commensurate with the varied and nuanced nature of ecosystem. It will be shown that to label all distributed ledgers as ‘cryptocurrency’, and to define all ledger entries, information and states as capital assets, is both impractical and inaccurate.
To understand why ‘cryptocurrency’ cannot fit solely into a definition of capital asset, it is first necessary to establish what ‘cryptocurrency’ actually is. When boiled down to fundamentals, ‘cryptocurrency’ may most reasonably represent a discrete entry (or entries) in a distributed ledger, to which an individual claims entitlement by way of private and public key pairs (or their equivalent, as the case may be). These entries can take many forms and are growing more complex with time.
For example, cryptocurrency on the Bitcoin ledger could be a ledger entry which corresponds to a public address and is secured by ownership of a private key which can ‘sign’ transactions. This value can be altered by using the public/private key pair to send a transaction to the network and cause a new entry in the ledger to be recorded. This is not too dissimilar from our current banking ecosystem and was how the term cryptocurrency was devised – an encrypted currency. Indeed, the Bitcoin whitepaper describes the ledger entries as “digital cash”.
Ethereum on the other hand is a more complex ledger. Ledger entries in Ethereum are accounts, which each have a state. An account can send a message to another account, via the Virtual Machine running on top of the network, and update the state of both itself and another account. These accounts do not merely hold values but can hold a considerable amount of code. Indeed, the second (and probably more important) type of account on the Ethereum network is a ‘contract’ account, which can send, receive and monitor ledger states by way of automated code.
Blockchain platforms such as DASH, NEO, NEM, PIVX and Bitcoin Cash all have further differences, quirks and characteristics that vary wildly in functionality and applications. Distributed Applications (dApps) built on top of many of these platforms utilise tokens to provide additional functionality while maintaining personality on the ‘parent’ blockchain. Private blockchains spin up and spin down based on enterprise needs through management layers such as Microsoft Azure and Hyperledger. New entries in the ledgers can be generated algorithmically via various block generation methods, entirely separate to any human input or transactions.
Matters are further complicated by the fact that many tokenised assets exist on the same blockchain, and often require use of the over-arching ‘token’ to gain access to the utility they represent. For example, Ethereum platforms based on the ERC-20 standard require Ethereum to be exchanged to gain access to the tokenised functionality on that platform (or the future right of that functionality), as well as Ethereum to act as the mechanism by which to pay computational fees for changing the state on the blockchain. These are actions taken within an ecosystem to trade potential for realised functionality – not for perceived financial benefit.
Currently, CGT legislation contemplates none of this minutia. To the understanding of the author, it labels all entries, accounts, tokens, smart assets and contract code as ‘cryptocurrency’, and attempts to force taxpayers to posit some form of contrived ‘value’ to their inter and intra-blockchain transactions when there is often no means by which to gauge that value.
Granted, some ledger attributions can be made by way of centralised exchanges that provide a common denominator (usually Bitcoin) as a barometer for relative rates of exchange, but these exchanges do not usually occur in a manner which includes a direct denomination in a fiat-based currency. Further, the varied characteristics of rights, utility, functionality and fungibility of these blockchain entries means that positing any kind of ‘gain’ from most of these centralised transactions is difficult, as a notional monetary value is only one element of the exchange (and may not be an element that is considered in the exchange at all).
Additionally, automated smart contract messages, ledger changes due to consensus and voting mechanisms, experimental atomic swaps, contract creation and token distributions are all blockchain events that cause changes in a ledger, but have no realistic frame of reference in a CGT regime. Yet these events are all ‘transactions’ that any individual following current ATO guidance must consider crystallising events.
A practical example is instructive to demonstrate the complexities of the blockchain ecosystem:
A theoretical individual, Sarah, purchases 1 Ethereum from Coinbase for an approximate fee of $700.00 AUD on January 1. On January 10, she sends the Ethereum to her wallet on Binance, losing .001 Ethereum in the process, leaving her with 0.999. On January 15, she trades 0.700 of her Ethereum with another user on the platform for 6000 DNT tokens. She has seen what District0x is doing, and wants to ensure she is able to ‘stake’ her tokens when the time comes. She transfers this to her Metamask wallet, along with her remaining Ethereum, and waits for beta.
On April 15, Sarah discovers the Aragon project, and notes that she can now begin a Decentralised Autonomous Organisation using the Aragon ANT token. With this, she can spin up an organisation, assign tokenised rights, and pay network fees for actions. She uses Shapeshift to convert half of her DNT into ANT so she can utilise the Aragon platform.
Sarah’s DNT and later ANT were acquired for utility, not for financial monetary gain. She has traded half of her utility right on one blockchain-based platform for another, but all that has essentially occurred is a shifting of subordinate entries on a ledger account.
Sarah then decides she wants to start a Decentralised Autonomous Organisation (DAO) with several of her colleagues, who all want to begin an open-source project. They use their ANT on the Aragon platform to form the organisation, tokenise their stakes, set their constitution and propose by-laws. This shifts some of Sarah’s ANT to ledger accounts held by the platform smart contracts, while giving her account additional personality on the both the Ethereum ledger and Aragon platform.
Soon, the DAO grows, and various resolutions for projects are voted on. A mandatory ANT contribution is required to improve the scope of operations, to which Sarah contributes. The DAO joins another DAO in a joint venture, governed by smart contracts. ANT, including some of what Sarah contributed, is moved to the joint contract. Her account, through the DAO, now holds a 5% voting stake in decisions regarding the combined contract, and a 10% stake in decisions on the DAO.
Concurrently with this, she stakes her DNT on the District0x platform in a new District created for Decentraland, a blockchain-based virtual reality game. Her DNT is used to participate in discussions, vote on resolutions for building various public amenities within Decentraland, and even to purchase several virtual items herself using the built-in auction feature, all of which require the use of DNT and result in her Ethereum ledger account state being updated many times.
In the above scenarios, we witnessed countless events that would be considered CGT events under current ATO reasoning. Blockchain transactions occurred, rights were exchanged, ledger entries altered. However, no reasonable metric could be used to ascertain how these events are to be considered for taxation purposes, and Sarah is now going to have an incredible headache (and be placed in an impossible situation) come tax time.
According to the Act, a CGT ‘gain’ will occur upon the ‘disposal’ of the asset or when the ‘use’ of the asset passes. The barometer for a ‘gain’ is the ‘capital proceeds’ minus the asset ‘cost base’.
Capital proceeds are defined in Division 116 of the Act as:
(a) the money you have received, or are entitled to receive, in respect of the event happening; and
(b) the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).
Such a definition could apply in any scenario where an individual obtains a distributed ledger entry directly using Australian Dollars, waits for a period (say 6 months) and then sells the right to that distributed ledger entry to another, again for Australian Dollars. In that case, the taxpayer has made clear capital proceeds.
As seen in our example with Sarah above, many situations are not that simple. Sarah’s exchanges did not entitle her to any ‘money’ – Australian Dollars – in respect of those events. Her entitlements were entirely on-chain and completely detached from fiat currency.
Similar can be said of perceived ‘market value’. The ‘market’ in blockchain situations could be accurately described as entitlements in elements of blockchain ledgers and the smart contracts/tokens/code on those ledgers. It is not a ‘market’ in the sense we are accustomed to in traditional financial transactions. Further, the most logical argument is that until an individual seeks to exchange a blockchain entitlement for Australian Dollars in one of the few forums available, the only appropriate market metric is what ledger entitlements an individual could receive in exchange for their entries/accounts/contracts.
When we take a step further and begin to attempt positing capital proceeds in respect of decentralised exchanges, voting, atomic swaps, contract creation and execution, blockchain forks or automated smart contract functions, the mental gymnastics required to apply some consistent market value become so far detached from reality as to be nonsensical.
For example, if an individual deploys a series of smart contracts that provide blockchain personality to digital assets and an ability to transfer them between ledger accounts, an efficient implementation may be to ‘tokenise’ those assets. These could, under current guidance, be construed as ‘cryptocurrency’ in their own right. Assigning a market value to these would be impossible – but any individuals holding those assets would be required to try. If these assets were changing hands regularly, or in some automated manner, applying some nominal value each time they entered and left accounts would be near on impossible.
Therefore, for a blockchain transaction to be captured by the Division 116 definition, it must have a monetary (fiat currency) element to it. The only reasonable way to attribute a monetary element is to assess the capital proceeds at the time a distributed ledger entry is exchanged directly for Australian Dollars. Until that time under the current legislation, no true assessment can be made of ‘market value’, save possibly for where a ledger-to-ledger exchange is made on a market which provides a means of direct exchange for Australian Dollars, and denominates the exchanges in AUD at the point of transaction.
The above does not begin to contemplate the myriad other blockchain events that can result in further blockchain attributes, entries and rights being assigned to the accounts of individuals. For example, hard forks materially change blockchains, and may result in one (or several) copies of the same chain. ‘Airdrops’ are token attribution events which expand the functionality, utility or value of a ledger entry in a specific way, be it access to a new platform built on that blockchain or voting rights in some form of decentralised collective.
It is outside the scope of these submissions to consider these in detail, but they will also need significant consideration.
Given the above, it is reasonable to conclude that the CGT regime as it exists now is insufficient to handle the complexities of the blockchain. The guidance currently available for taxpayers also falls short of contemplating the consequences such blanket treatment on the many individual situations and use cases. A new legislative framework is therefore necessary; one which considers all elements of distributed ledger technology and implements a robust approach which the intricacies of blockchain requires.
As we move towards an age where many physical and digital items will hold some sort of ‘blockchain personality’, the approach taken by the Australian Government could very well determine whether enterprise adoption fails under the weight of an insufficient regulatory regime, or succeeds due to a robust and realistic legislative framework for distributed ledger technology.
The solution could most reasonably be achieved by the creation of a truly unique asset class, likely with its own discrete statutory instrument. Separate legislation would allow a proper classification of all types of blockchain ledger rights, assets and values, with proposed regulatory approaches to each.
It is outside the scope of this paper to investigate possible frameworks for any new legislation – this submission is merely designed to highlight the issues with seeking to apply the current CGT regime, and posit ‘gains’, to all ledger transactions. The author would be willing to provide further suggestions and advice on such a framework upon request.
A blockchain is a natural (and superior) record; but requiring a taxpayer to frame records which have such unique (and often complex) personality with reference to a ‘market value’ denominated in AUD becomes more difficult the more an individual participates in the blockchain ecosystem. Factors such as smart contracts, decentralisation, participation in distributed platforms, voting, governance decisions, network fees, soft and hard forks (among many others) all make record keeping to the requirements currently communicated from the ATO a practical impossibility. Given the overriding constitutional principle that law must be ‘good’ law, it is the submission of this paper that such an application would not represent good law.
The blockchain space is complex and varied. The technology is unlike any other innovation and continues to evolve at an incredible rate. It fuses financial, governance, utility, code, automation, permissions, rights and value in a plethora of ways. Such a collection of previously disparate elements was not contemplated by existing legislation, and therefore requires a re-imagined approach to regulation. Anything less will stymie progress, create confusion and likely cost considerable public funds in misguided enforcement efforts.
In that light, it would be prudent to exempt taxpayers from keeping records denominated in a contrived AUD value at this juncture, and to refrain from assessing any capital gains (or losses) this tax cycle with regards to cryptocurrency. Once appropriate legislation is drafted, complete with guidance regarding same, then fair implementation can occur. This approach will reduce taxpayer confusion, prevent inequitable application of the law, and circumvent what will likely be a daunting research and enforcement process for the ATO.
Want to learn more or get in touch? Subscribe to BlockSense+, a regular blockchain and technology prospectus delivered via email. Interested in audio instead? Subscribe to the FOMO Show. If you’re new to the blockchain, we have a Blockchain Basics series that begins here.