On 4th January 2019
By Kathy
Blockchain

Understanding Cryptocurrencies

Greater transparency, enhanced security, traceability and efficiency, all come to mind when contemplating over the advantages that distributed ledger technology (“DLT”) has to offer. The main objective behind public and open-source currencies is typically that of creating a decentralised environment whereby inessential intermediaries are eradicated and indirectly reducing unnecessary costs.

It all revolves around the element of trust, whereby the involved parties on a particular platform would not have to rely on a central authority to carry out their own affairs.

When all is said and done, public blockchains rely exclusively on nodes to function and survive, distributing data across a network not owned by any 3rd party. In turn, a node would need to be sustained by a legal or physical person who would have interest in the problem the platform is attempting to solve.

A significant amount of resources go into maintaining a node on a proof of work protocol, taking into consideration the costs of renting or purchasing physical space and the expenses relating to electricity.

In order to grow a decentralised network, there needs to be some form of incentive for participating nodes, and as can be seen with all POW currencies, users who are mining or validating transactions are rewarded with the underlying asset of that particular chain.

Bitcoin is the prime example of such underlying assets, commonly referred to as the ‘mother of all cryptocurrencies’. Persons owning and operating nodes, which verify transactions and add them to the shared digital ledger, are rewarded depending on their success.

All  have a pre-determined number of assets which they produce, ensuring that the value is sustained and the market cannot be manipulated by a central authority, primarily the founding team.

As time progresses, less DLT assets are typically be rewarded to miners, which should increase in value as adoption of the technology and currency increases. If the price of the reward is lower  than the resources required to successfully validate a transaction, then it would not make sense for that particular person to continue with mining.

The intention of this article is to draw a distinction between the different types of underlying assets that exist, paying particular attention to the benefits of holding, or transacting, cryptocurrencies. A brief analysis is also presented vis-à-vis any legal or crypto tax implications which might arise out of such activity.

 

 

tokens

 

Cryptocurrency Coins – Payment Instruments

Typically, when DLT assets are deemed to be coins, they would be designed in a way which would allow them to be utilised as a means of payment, a medium of exchange or otherwise to function as a store of value.

The main objective behind founding such platforms is to provide a cryptographic alternative to fiat currencies and legal tender. Prime examples of such classification include Bitcoin, Bitcoin Cash, Litecoin and Dash…and the list goes on.

These types of coins all aim to provide a new medium for executing payments and transactions. They all have distinguishing features as their selling points, which range from fast transaction speeds, security and privacy, scalability and resources.

From a legal perspective (particularly from a European standpoint), the fact that a DLT asset may qualify as an instrument of payment would under normal circumstances automatically disqualify the same from being classified as a financial instrument under the Second Markets in Financial Instruments Directive (“MiFID II”).

This would be the case only when the DLT asset would be utilised, either to function as a medium of exchange or as an established means of payment to initiate or conclude transactions, to buy goods or services as agreed between two or more parties.

This conclusion has had positive implications in several jurisdictions, given that such assets would fall short of being classified as a financial instrument. Apart from not having to undergo a rigid licensing regime, it also meant that in certain jurisdictions, no tax would be paid on profits derived from capital gains.

By way of example, in Malta, capital gains derived by a person from the transfer of a capital asset are taxed when such asset would meet one of the exhaustive criteria outlined in article 5 of the Income Tax Act. Payment instruments do not form part of such an exhaustive list and hence it follows that, capital gains derived from the sale of DLT assets not qualifying as financial instruments, would under normal circumstances, not be taxable under Maltese legislation.

The tax treatment of transactions involving such coins should typically mirror the treatment involving transactions with traditional fiat currencies. Any profits realised from the business of exchanging such DLT assets, or through the sale of coins which are generated through validating transactions, shall under normal circumstances be represented as income and be taxed accordingly.

Financial Tokens

As noted above, traditional financial instruments in Member States of the European Union (“EU”) are regulated by the MiFID II. In other jurisdictions, such would be regulated by their own legislative framework. When issuing such a token within the EU, one must first obtain the required authorisation from that jurisdiction’s regulator.

Likewise, when one provides certain types of services such as the execution of orders on behalf of others or that of a cryptocurrency exchange, one must ensure that the DLT assets that are dealt with would not qualify as a financial instrument.

One can quickly begin to realise that such tokens are the most burdensome when it comes to obtaining the required authorisations. National authorities are not yet equipped, both from a technical and legal standpoint, to deal with tokens that have characteristics of a financial instrument.

The current licensed exchanges, mainly dealing in stocks, do not yet have the capability of listing such tokens. The cumbersome process of going through the traditional financial services framework tends to deter several investors and/or entrepreneurs from going down this route, especially due to excessive costs and long expectation times.

This has resulted into such parties looking towards offshore jurisdiction which do not have rigid frameworks in place to issue such tokens. With that being said, the same issues crop up whenever such organisations would want to tap into EU or other regulated markets.

In terms of taxation, transfers that are made in the daily operations of a business tend to be treated as trading transactions (the nature of which might not always be that evident). If it is not a trading transaction, then one must determine whether such would qualify as profits arising out of capital gains, which would then be taxed accordingly to the provisions of that particular jurisdiction.

Utility Tokens

The most issued type of token has to be none other than the ‘utility token’. This type of asset is typically issued by businesses, including prospective ones, in order to raise capital to sustain its future operations, to finance client acquisition and to facilitate investment technology development. In return, the holder of such issued tokens would be eligible to exchange the same for goods and/or services rendered or to be rendered by the issuer.

Up until very recently, such tokens found themselves in a bit of a grey area, whereby no legal framework catered for this type of asset. It would not make sense for such assets to be treated as payment instruments, as their intention is not to serve as a means of payment or medium of exchange.

Moreover, such assets could not be classified as financial instruments because the rights arising out of such do not meet the applicable criteria.

This lack of legal certainty triggered certain jurisdictions to take action and formulate their own framework over such crypto-assets and their offerings. Gibraltar, Estonia, Switzerland and Malta are among such countries who have become known to cater for such assets.

The tax treatment for such transactions is not all that clear, particularly in jurisdictions which have steered clear of providing any guidance. Typically, one would expect that the similar to the rest, income tax would apply when dealing with such assets on a daily basis as part of a larger operation.

In terms of profits arising out of capital gains, the same approach depicted above for the other types would apply.

Hybrid Cryptocurrencies

The beauty behind this technology is that it allows the creators to implement the protocols desired as to their liking and preference. The rights and benefits are designed as per the vision of the developers and founders, which are typically depicted in the whitepaper of the project.

Hence, despite the existence of different categories of DLT assets which have been examined above, it is possible for such an asset to have characteristics associated with more than one type. By way of example, a token may provide access to the holder to a set of goods and services, whilst simultaneously entitling the holder to a share in the profits of the issuer.

The determination of such tokens has to be carefully assessed to ensure that compliance is achieved with all applicable legislation. However, with over 1600 cryptocurrencies currently in circulation, we can only but expect more tokens to come out. This will provide something new and different from what is already on the market.

Founders have to strive to create something original and which fulfils a need, by providing a solution to an existing problem that can be adapted by the general public.

The above information is for information purposes only and does not constitute legal advice. This information should not be relied or acted upon without seeking appropriate professional counsel. It is important that when designing your own token, careful attention is given to legal, tax, accounting and regulatory implications.

Overlooking a little factor may end damaging the prospect of your project and having the right, experienced advisor in place, it can potentially end up saving you endless amount of money, which could have been invested elsewhere.

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