Introduction

Cryptocurrencies have become a headache for tax practitioners and tax auditors given their ambiguous nature and the technical expertise required to understand the complexity of their system.

From the beginning in 2009, Bitcoin and altcoins’ different approach to finance, generated a never ending challenge to the traditional legal framework.

The crypto environment evolved continuously over time adding complexity and advancement, introducing crypto assets, smart contracts, Decentralized Finance and Game Finance.

The analysis of these systems cannot be made jointly and it is necessary to clearly define and understand various types of cryptos. A different kind of asset could lead to different taxation or to different document collection best practices.

Therefore it is first necessary to delimitate the field of analysis by setting up the basic definition.

A cryptocurrency is a digital representation of value that has no other function than to serve as medium of exchange, in the ecosystem it is built for.

Therefore, cryptocurrencies are native tokens that do not have any other features and/or characteristics outside their own systems.

Consensus Mechanism

These systems are decentralized and rely upon consensus mechanisms which are the basis of the whole infrastructure and whose understanding is of fundamental importance.

The database of all transactions is not based on individual balances anymore, but on unspent transactions held in a distributed ledger technology.

Blockchain is a specific kind of distributed ledger technology, which underpins many different applications, including many of the cryptocurrencies.

“A ‘blockchain’ is a particular type of data structure used in some distributed ledgers which stores and transmits data in packages called ‘blocks’ that are connected to each other in a digital ‘chain’. Blockchains employ cryptographic and algorithmic methods to record and synchronize data across a network in an immutable manner” (Houben and Snyers, 2018 [10])

The most commonly-used consensus mechanisms are:

   - Proof of Work (PoW): the PoW system is based on a mathematical challenge, hard to solve but whose solutions can be easily checked. This system was introduced to reduce spam connected to email and it is based on solving a mathematical problem that involves some degree of computational effort. This effort leads to an economic rather than technical immutability, thanks to energy consumption which assures consistency to the database. The activity of the miners (validators) consists in making calculations on a competitive basis to find a computational solution on a block of transactions. A block contains the reward for the miner who finds the solution first.

   - Proof of Stake (PoS): the PoS system assigns shares of validation rights to users according to the stake committed. In such a system, validators are not called miners – but ‘forgers’ or ‘stakers’. The amount of the cryptocurrencies staked could be fixed in different ways according to the design of the algorithm. Forgers or stakers must have a minimum stake to be able to have the right to “validate” the transactions, receiving fees or new tokens. The activity does not consist in mathematical equations, but on a cryptographic signature to validate the transactions.

   - There are other consensus mechanisms, including ‘delegated proof of stake’ – whereby stakers vote to designate the block validator – and ‘proof of authority – whereby validators stake their reputation.

While each cryptocurrency is unique, the life cycle could be typical, with the possibility to enact the main activity that could raise tax issues.

Emission of Cryptocurrencies

The genesis of the creation of cryptocurrencies could be different according to the design scheme and with the main distribution purpose to the users.

In this case, the user receives cryptocurrencies and could have an increase in personal wealth, giving space to a tax liability.

The emission can occur with different systems:

   - Mining: the miner (PoW) is a person (or a company but in this case, the taxation will follow the rules of corporation tax) that acts on the network to verify and add the transaction to a blockchain-based ledger, undertaking the necessary computer processes for being the first to solve the challenge. The reward typically consists in (i) a mining reward, through a new transaction containing new cryptocurrencies, and/or (ii) transaction fees, which is the amount that users decided to spend to accelerate the processing of the transaction.

   - Forging: the forger (PoS) is the person that validates the blocks and/or the transaction and is entitled to the fees.

   - Forks: the decentralized systems could evolve with forks, creation of new altchains and altcoins through the modifications of the script. The modifications start from the developer that may suggest, on an open source philosophy, a proposal for modification of the protocol that could lead to (i) acceptance of the modification, (ii) refusal, or fork of the protocol with the birth of multiple chains as Ethereum and Ethereum Classic or Bitcoin and BitcoinCash. In those cases, the users who owned cryptocurrencies would have been entitled to the forked cryptocurrencies, without doing anything.

   - Airdrops: an airdrop is the distribution of cryptocurrencies without compensation, generally undertaken with the scope to create and/or increase a community of a new cryptocurrency, and/or to increase liquidity.

   - Minting: the minter is the person who can issue or create a new cryptocurrency system by the emission of new cryptocurrencies.

These activities performed by a person, consciously (Mining, Forging, Minting) or unconsciously (Airdrops, Forks), increase the wealth and raise direct tax issues.

The main problem lies in the words that each national tax system uses to define and to give interpretations about what cryptocurrencies are. The increase in the wealth might be in assets that have no official valuations, and in some cases, have no price (some airdrops have no value and/or some forks lose the “quotation”).

Storage

Cryptocurrencies are managed through private keys, public keys and public addresses, using a wallet.  The International Standard Organization (ISO 22739:2020) defined “3.84 wallet: application used to generate, manage, store or use private (3.62) and public keys (3.65) Note: A wallet can be implemented as a software or hardware module” and National Institute of Standard and Technology (NIST-NISTIR 8301) “Wallet [20] An application used to generate, manage, store or use private and public keys. A wallet can be implemented as a software or hardware module”.

Therefore, a crypto wallet is a tool that allows users to interact with a blockchain network, and send and receive cryptocurrencies or access decentralized applications (DApps). In a nutshell, wallets do not contain cryptocurrency but they generate the information needed to use crypto.

The main distinction is between custodial and non-custodial wallet, based on the person that is in control of the private keys needed to sign transactions.

In the case of a custodial wallet, the keys are kept by the service wallet provider, and under some circumstances (and in some countries) the cryptocurrencies are “deposited”: the provider is a new form of intermediary.

A non-custodial crypto wallet is a wallet where only the holder possesses and fully controls the private keys. Since there are no intermediaries, the users can trade crypto directly from their wallets.

Other classifications could be in (i) hot wallet, that is connected in some way to the internet through a software application to create the wallet on their own device, or (ii) cold hardware wallet, that is physical device (USB/flash drive) that is kept offline (i.e. “cold”), connectible to an online computer when needed, (iii) cold paper wallets, that are pieces of paper on which the address and private key are printed.

Users could be eligible for filing to monitor assets and/or be eligible for wealth taxes, with different obligations (and data flows) in the case of custodial wallets, given the presence of an intermediary.

Use of Cryptocurrency

The users could sell and purchase crypto, or use them to buy goods or services, or donate. The purchase could take place, in a:

   - Virtual currency Centralized Exchanges: an (online) service provider allowing customers to purchase and exchange cryptocurrencies, fiat currency or other crypto-assets.  These services are custodial (e.g. Coinbase, Kraken), although some non-custodial exchanges (essentially online “peer-to-peer”) exist

   - Virtual currency Decentralized Exchanges: an (online) service provider allowing customers to exchange cryptocurrencies with other crypto-assets.  These services are non-custodial.

   - Over the Counter (OTC) broker: an “off-market” exchange of cryptocurrencies that may either be offline “peer to peer” exchanges or by a third-party intermediary.

   - Use as medium of exchange: cryptocurrencies could be used to pay (or to be paid) for goods and services, peer-to-peer or through service providers or to enter into an Initial Token Offering (ITO), also known as an Initial Coin Offering (ICO), in which the issuance of a new token is exchanged for one of the major cryptocurrencies.

   - Loss or donate

Conclusion

The life cycle of cryptocurrencies, from the emission to holding/loss, through the trading could raise tax issues and a potential tax liability.

The use of a medium of exchange does not place the user outside tax law because the personal wealth could increase for (i) the value, or (ii) the conversion of the cryptocurrencies.

The possible relevant events are:

1. the receipt of cryptocurrency via mining, staking, forging, fork, or airdrop
2. the purchase of cryptocurrency with fiat currency
3. the storage in a custodial wallet
4. the exchange of one cryptocurrency for another
5. the purchase of a good or service with cryptocurrency
6. the payment or receipt of cryptocurrency as compensation
7. the gifting of cryptocurrency (subject to gift tax)
8. the loss of private key cryptocurrency
9. the donation of cryptocurrency to a charity
10. the transfer of cryptocurrency between one’s own accounts or wallets

Each country is trying to find solutions and to monitor the cryptosystem, but it lacks a common approach, starting from the definition.