Cryptocurrency: UK tax issues for fund investors

Building upon our recent Insight which looks at the taxation of cryptocurrencies across Europe, in this article we drill down into the specific UK tax issues which fund investors should be aware of when investing in cryptocurrencies.

What is cryptocurrency?

The term "cryptocurrency" emerged as a reference to a Bitcoin-style digital currency whose ownership (at issue and following any subsequent transfers) is recorded as a chain of digital signatures on a blockchain, secured by cryptography.  The "coin" carries value which can be transferred, although since that value is purely speculative (and not supported by underlying assets, economic activity or a central authority such as a bank), it can be very unstable.  For that reason it is often considered to be a digital or crypto asset rather than currency. However, the rights attaching to any particular cryptocurrency "coin" (including whether it is transferable) will depend on its terms of issue and not all "coins" are intended to operate as a form of money.  In some cases, a coin is simply equivalent to a voucher, which the holder can redeem for identified goods and services provided by the issuer. This article will focus on the former type of cryptocurrency.

Tax treatment of profits on sale of cryptocurrency

In 2014 HMRC published guidance on the treatment of profits realised on sale of cryptocurrencies. It essentially says that the profits are taxed in accordance with general tax rules, and that HMRC has not identified any need to consider bespoke rules applying to cryptocurrencies.

It is likely that the key tax issue for funds looking to invest in cryptocurrencies will be to determine whether the activity will be treated as an investment or trading activity. This will be a key issue for non-UK investors looking to invest in UK funds as UK trading activity can create a UK tax liability whereas investment activity will generally not. In addition, the alternative treatments will have a significant impact on the extent to which tax relief is available for losses. The normal "badges of trade" are to be applied in determining this issue, so that funds that buy and sell cryptocurrency frequently with a view to making a profit are likely to be carrying on a trade.

Investment management exemption

Offshore funds with a UK-based manager may rely on the investment management exemption in order to ensure that the manager does not create a taxable presence for the fund in the UK. In order to fall within the exemption, the investment manager must be carrying on "investment transactions" in respect of the cryptocurrency.

The UK tax rules set out an exhaustive list of "investment transactions", and the type investment transaction that the sale of cryptocurrency may fall under is a transaction in "securities". The question is then whether a unit of cryptocurrency is a "security" for tax purposes. "Security" has a specific meaning in UK financial services regulation covering shares, debt securities, warrants, certificates and units in a collective investment scheme, and while there is a separate definition of "security" for tax purposes based on case law, in practice the two definitions are similar. The thread running through both definitions is that a unit of cryptocurrency must create an obligation in order to be a security, but it is not clear whether any obligation is created in the case of a Bitcoin-type cryptocurrency.  In addition, many utility tokens which give holders preferential access to crypto infrastructure are structured so they do not usually create any obligations as against anyone. However, obligations that are "bolted on" to the underlying cryptocurrency (e.g. which include a return to incentivise investors to hold on the tokens for an extended period) may also create obligations sufficient to constitute a security. It will therefore necessary to look at the facts of each case in order to decide on the tax treatment.

Stamp duty and stamp duty reserve tax (SDRT)

HMRC's published guidance also does not address the stamp duty or SDRT treatment of transactions in cryptocurrency.

The stamp duty treatment turns on whether cryptocurrency comprises "stock or marketable securities". "Stock" is essentially share capital in a company, or units in certain unit trust schemes, and cryptocurrency does not fall in either of these categories. The comments made above on the meaning of "security" are therefore relevant to the stamp duty treatment as well as the investment management exemption.

However, stamp duty is a tax on paper instruments – but cryptocurrencies are not typically transferred in this way. Cryptocurrency exchanges are instead more akin to dematerialised trading platforms like CREST, where transactions in shares are subject to SDRT at a rate of 0.5% on the consideration. However, the scope of SDRT is different to stamp duty, and broadly is limited to transfers of interests in, or rights to subscribe to, stocks, shares, loan capital or units in a unit trust scheme which are issued by a UK company or held in a UK register. It may be possible to ensure that cryptocurrencies are not within these categories, so to that extent no SDRT liability would be expected to arise.

Remittance basis

UK non-domiciled but UK resident individuals are subject to UK tax on their income and chargeable gains if they have a UK source and, if they claim the remittance basis, on their overseas income and chargeable gains only to the extent brought in ("remitted") to the UK. The remittance basis is often claimed by overseas individuals working in the UK fund management industry, though in this context it is more relevant to individuals trading in cryptocurrency on their own account.

The test for whether or not income or chargeable gains have a UK source depends on whether the transaction is treated as investment or trading activity and where the underlying asset is situated for tax purposes. But where is a unit of cryptocurrency situated? In terms of income, cryptocurrencies do not tend to generate income returns (for example, they do not pay a dividend) except where they are being bought and sold in the course of a trading activity; and if the individual is carrying on a trading activity in the UK, they are likely to have a taxable permanent establishment in the UK and hence the income profits would be subject to UK tax.

However, as regards chargeable gains, there is no clear answer:

• Do you look at the online wallets in which cryptocurrency units are stored? If so, then the online wallet software could be hosted on multiple different servers in various countries.
• Do you say that the country in which the investor is personally tax resident is also where the cryptocurrency is situated?
• Or do you simply say that the chargeable gain has the same location as that of the investor at the time he logs into his online wallet and executes the trade? That would be the simplest answer, but might be regarded as capable of manipulation.

Will HMRC change its guidance?

HMRC's guidance is over four years old, which is a long time in the cryptocurrency world. The regulatory environment for cryptocurrency is changing quickly, and it may be that, as a parallel move, HMRC move to update or change their view on the taxation of cryptocurrency. It is therefore an area worth watching closely.