Taxation issues for cryptocurrencies
Source: IMF Author: Katherine Baer, Ruud de Mooij, Shafik Hebous, Michael Keen Compilation: Zhu JueXiang
Since the appearance of Bitcoin in 2009, more than 10,000 types of encrypted assets that can be used as payment tools have emerged, and BTC is the first and largest currency. Their dazzling development speed and the pseudonyms they can provide have made it difficult for the tax system to keep up. This article discusses how governments can respond to new challenges of taxing these encrypted assets when their use is still limited, in order to prevent tax losses and protect the integrity of the tax system. The Financial Technology Research Institute of Renmin University of China compiled the core part of the research.
The controversy surrounding encrypted assets has been crazy and the pace of innovation involved is still dizzying. The market value of encrypted assets started from zero in 2008 and reached a peak of about $30 trillion (so far) in November 2021; from Bitcoin launched in 2009, there are now thousands of other cryptocurrencies. It is estimated that 20% of adults in the United States and 10% in the United Kingdom may hold or have held some encrypted assets. The situation in other places may be more significant, including some emerging and developing economies: the number of global users has exceeded 400 million. These developments need to be viewed from a certain perspective: for example, $30 trillion accounts for only about 3% of the global stock value. But the power of encrypted assets to disrupt traditional financial business methods (including taxation) and their potential to do more things has become apparent.
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Figure 1 Cryptocurrency market value (overall and partial currency)
For some people, these developments herald a beautiful new world, where people will get rid of government supervision and reliance on financial institutions, and instead trust the distributed ledger protected by encryption, and transaction costs will eventually be greatly reduced. In addition, cryptocurrencies are a precursor to decentralized financial forms, which will extend these benefits to the entire financial system. For others, these developments make the crypto market a “wild west”, where criminal activities are facilitated, and uninformed investors face huge price fluctuations (the $30 trillion has now fallen to less than $1 trillion), bankruptcy, fraud and fraud (FTX’s demise in November 2022 is a microcosm). For critics, the most serious fraud is that all of this is built on assets, the creation of which will cause serious environmental damage, and in many cases, there is no inherent value. In response, supporters may point out the emergence of “green cryptocurrencies”, pointing out that legal currencies also have no intrinsic value, and believe that cryptocurrencies have shown their potential advantages in transaction speed and convenience in providing support to Ukraine, and claim to have obtained continuing innovation benefits from them.
Regulators face a daunting task in finding and striking the right balance between promoting innovation, ensuring financial stability, and protecting investors. For tax authorities, the ultimate task is ultimately more mundane but no less important: bringing the development of crypto asset use into a well-functioning tax system. Whatever the future of cryptocurrencies, this task will still exist: the tax system will still need to deal with it, no matter how crypto fares.
Opinions on crypto assets are plentiful and passionate. The prospect of freeing financial transactions from government oversight and financial institution participation is a libertarian dream for some. El Salvador and the Central African Republic have even adopted Bitcoin as legal tender.
Critics, however, argue that crypto assets are not only inherently worthless but also a cover for crime, fraud, and gambling. They also point to dazzling volatility. For example, Bitcoin skyrocketed from $200 a decade ago to nearly $70,000 in 2021, only to fall to around $29,000 today.
Last year’s FTX crash and, more recently, the US Securities and Exchange Commission’s lawsuits against Binance and Coinbase have increased user anxiety, while the attraction to criminal activity is reflected in high-profile billion-dollar seizures. These developments have sparked growing scrutiny by policymakers and widespread calls for regulation.
However, whether crypto assets ultimately prosper or decline, there needs to be a coherent way to tax them.
A key question is how to classify crypto assets – should they be considered as property or as currency? Capital gains should be taxed on the sale of cryptocurrencies for profit, just like other assets. Purchases made with cryptocurrencies should be subject to sales tax or value-added tax (VAT) as cash transactions.
Therefore, an important task is to ensure the application of these principles, which requires clarity on how to describe cryptocurrencies for tax purposes: essentially, as assets for VAT and sales tax purposes as well as income tax. While this is not easy due to the constantly evolving nature of crypto asset transactions, it is entirely possible. Thus, the ultimate challenge lies in enforcement.
Rough estimates suggest that a 20% tax on capital gains from cryptocurrency would raise around $100 billion globally in a year of soaring prices in 2021. This is about 4% of global corporate income tax revenue, or 0.4% of total tax revenue.
But as the total market value of cryptocurrencies has dropped 63% from its peak at the end of 2021, tax revenue will shrink. If these losses were to completely offset other taxes, revenue would correspondingly decrease. In more normal times, with the current market size, global cryptocurrency tax revenue could be less than $25 billion per year on average. This is not a large number in a broader scheme of things.
Figure 2 Cryptocurrency price fluctuations (Bitcoin price, USD)
There is also an important fairness issue at stake. Although the anonymity of cryptocurrencies makes it difficult to determine who exactly holds them, there are indications that ownership is concentrated in the hands of relatively wealthy people – even though ownership of cryptocurrencies is also quite common among low-income people. Existing surveys suggest that about 10,000 people hold a quarter of all bitcoins.
There is also value-added tax. Cryptocurrency transactions are similar to cash transactions in that they can be hidden from tax authorities. Today, the share of purchases made with cryptocurrencies is still small. But if the tax system is not prepared, widespread use may one day mean widespread tax evasion of value-added and sales taxes, resulting in a sharp reduction in government revenue. This may be the biggest threat posed by cryptocurrencies.
The most fundamental difficulty in taxing crypto assets is that they are “pseudonymous.” That is, it is extremely difficult to link the public addresses used in transactions to individuals or companies. This can make tax evasion easier. Therefore, enforcement is the core problem for tax authorities.
However, reporting obligations may encourage people to make their asset transactions information inaccessible to tax authorities by using centralized exchanges overseas. To address this issue, the Organization for Economic Cooperation and Development (OECD) has developed a framework for information exchange related to cryptocurrencies between countries. However, enforcement still has a long way to go.
A more troubling possibility is that reporting rules (and failures by some cryptocurrency intermediaries) may lead people to increasingly trade through decentralized exchanges or peer-to-peer transactions that are not supervised by any central authority. These are still very difficult for tax administrators to penetrate.
Given the complexity of the fundamental challenges posed by the use of pseudonyms, the rapid innovation, the significant information gap, and the uncertainty about the future, the fight to properly incorporate cryptocurrencies into a broader tax regime has not yet been reversed. Some of the elements required to do so – such as clarity of classification for tax purposes – are clear.
But the challenges are fundamental, particularly the risks of value-added and sales taxes, which may be greater than is recognized. As many (though by no means all) governments are beginning to recognize, policymakers need to develop clear, coherent, and effective crypto-tax frameworks.