Virtual currencies – legal realities

The Japan-based Mt Gox, formerly the world’s largest Bitcoin exchange and bank, is currently in the midst of bankruptcy proceedings in Japan and the US.  In early 2014, after a series of alleged hacks against its protected servers, Mt. Gox announced that it had lost 850,000 bitcoins, approximately 7% of the world’s supply, then worth around half a billion US dollars.  Shortly thereafter Mt. Gox filed for bankruptcy.  Only 200,000 of the lost bitcoins have been recovered to date.  It would appear that the virtual currency movement is capable of great impact in the real world.

A bit what?

Bitcoin first traded in 2009 and remains the world’s pre-eminent virtual currency.  Bitcoin is a form of virtual currency, essentially a series of encrypted data points that can be transferred between the digital “wallets” of users to make payments.  A person or entity can acquire bitcoins by:

  • receiving bitcoins as a unilateral transfer (typically payment for goods or services);
  • purchasing bitcoins with “real” currency from an exchange; or
  • earning bitcoins through competitive “mining”.

Mining is the decentralised process by which bitcoins are issued, where a miner solves “blocks” of increasingly difficult math problems for a bitcoin reward.  As the universal number of bitcoins is capped at 21 million (as set at the inception of Bitcoin), the Bitcoin system automatically increases the difficulty of remaining minable problem blocks to mimic the economics of a finite resource.  Miners also receive transaction fees for the computer processing power (and thus security through encryption capacity) they contribute to the network.  These transaction fees are designed to become more frequent and valuable as transaction traffic increases, thus offsetting the decreasing viability of mining blocks as Bitcoin issuance shrinks.  Traditional currency, by contrast, relies on exclusive centralised supply and the legal regulatory system, giving it status as legal tender and its value through controlled scarcity.

Global uptake of virtual currency

While virtual currency offers numerous opportunities to the marketplace, it also presents many risks.  Virtual currency is inherently volatile as its value is determined by trader perceptions, not fiscal controls or any sort of established relationships to tangible goods (such as bullion).  The price of Bitcoin has fluctuated wildly since its inception, going through various and often extreme cycles of appreciation and depreciation.  In June 2010 a single bitcoin was only valued at US$0.08.  By 2013, the value peaked at US$1,216.73 on the Mt. Gox exchange.  At the time of writing the value of 1 bitcoin fluctuated between US$400-$500. 

Without extrinsic mechanisms, Bitcoin transactions are totally anonymous, irreversible and impossible to trace to the real-life identity of a registered account holder.  It is, therefore, unsurprising that virtual currencies, especially Bitcoin, have come under increased scrutiny from national regulators, with growing concerns of not only fraud and money laundering, but also in respect to taxation and corporate regulation.  The regulatory responses seen overseas have been varied.

Tax has seen the most comprehensive regulation, with the US, Japan, Germany, the UK, Singapore and other countries recently issuing guidance for the taxation of Bitcoin-based transactions, mostly treating them analogously to a form of barter exchange.  Corporate and financial crimes regulation has seen more sporadic treatment, but has indicated a focus on policing exchanges and banks such as Mt. Gox.  By contrast, the approach taken by emerging economies such as Russia and China has been to restrict Bitcoin transactions and deem them legally invalid.  Arguably, both positions are motivated by growing unease about Bitcoin’s dilution of traditional government control over currency, increasing amounts of lost taxation revenue and the potential for the circumvention of regulatory mechanisms over corporate entities.

Recent comments from ASIC’s Senior Executive of Corporate Affairs, Hilarie Dunn, and the ATO’s Senior Assistant Commissioner, Michael Hardy, indicate that both authorities may soon release guidelines on Bitcoin and its intended treatment under Australia’s existing regulatory framework.

Expectations on ASIC regulation

If ASIC follows the US in its Department of Treasury guidelines released 18 March 2013 (and focuses on monitoring exchanges), it will likely categorise bitcoins as a financial product.  A Bitcoin transaction would likely constitute a form of non-cash payment within the meaning of s 763D of the Corporations Act 2001 (Cth).  Such characterisation would therefore require Bitcoin exchanges, banks and trusts to hold an Australian Financial Services Licence and comply with the corresponding onerous registration, governance, disclosure and reporting requirements.

Expectations on security interests

The scope of personal property which can be the subject of a security interest under the Personal Properties Securities Act 2009 (Cth) (PPSA) is extremely broad and it is likely that bitcoins will be included as a form of collateral.  The definition of “personal property” under the PPSA includes any property other than land and Commonwealth granted rights, entitlements and authorities.  From a practical perspective, it would be expected that PPSA registration would be taken over a grantor’s digital wallet, much like a bank account, but even then, there are potential title and tracing issues if bitcoins were transferred away to another anonymous wallet.

Expectations on taxation

In guidance released 25 March 2014, the US Internal Revenue Service confirmed that bitcoins will be treated as a property asset for tax purposes.  Although this is the dominant position amongst developed countries, it is not without debate.  For instance, US Congressman Steve Stockman introduced a new bill, the “Virtual Currency Tax Reform Act”, on 7 April 2014, which, if passed, would tax bitcoins as currency instead of property.  Despite this uncertainty, it is possible that the ATO will follow the more common view and treat bitcoins as an asset.  Arguably, in such a case, Capital Gains Tax would be attracted when bitcoins are realised into Australian dollars.

Under the A New Tax System (Goods and Services Tax) Act 1999 (Cth) the definition of “money” under s 195-1 includes currency, promissory notes, bills of exchanges, postal notes and credit or debit transactions.  If bitcoins are deemed to be an asset, they will fall outside of this definition, and be effectively excluded from the “money” exception to taxable “supply”, as defined in s 9-10(4), being “any form of supply whatsoever”.  This means that, unlike “real” currency transactions, a Bitcoin payment could potentially be a taxable supply that is subject to GST.  There is a potential for multiple GST liabilities on a single transaction, both on the supply of goods or services and on the supply of bitcoins paid for those goods or services.  Additionally, users must also consider the GST payable on the original purchase of bitcoins using Australian dollars and also on the financial supply made when converting Bitcoin revenue back into Australian dollars.

Recognising such risks, the UK tax authority has taken steps to reconcile and balance some of these issues in its Taxation Brief dated 3 March 2014 which treats Bitcoin as "the world's first decentralised digital currency" and sets out to treat bitcoins in the same way as it does “real” currency, whereby VAT will only be applied to the supply of goods or services, not financial transactions.

Lavan Legal comment

It remains to be seen what direction Australian regulators will take in their approach to Bitcoin and virtual currencies generally.  Lavan Legal will follow developments in this space and keep you updated as they occur.