Bitcoin: too big not to tax / Bitcoin’s popularity is reaching fever pitch with the taxman equally excited over the potential for new revenue

Richard Asquith & AccountancyLive write: There is nothing quite like 5,600% growth in an industry within one year. At least that is what the UK’s HMRC believes as it starts to ponder whether it is missing a taxing opportunity with Bitcoins, the largest of the world’s digital currencies. HMRC is currently re-thinking its tax treatment of digital currencies, and is expected to announce a fresh approach this month. Other tax authorities around the world are doing this same. 

So what are virtual currencies, and what is there to tax and when?

Digital currencies like Bitcoin exist virtually on shared networks of computers. Bitcoin uses open-source computer code to create, ‘store’ and record currency trades on electronic ledgers held on the network’s computers. A new Bitcoin is created or ‘mined’ by having your computer solve an algorithm puzzle which can take several hours of processing. The owner can then sell this Bitcoin through the ledger for cash or goods. It’s an ingenious system which prevents the forging or simultaneous trading of the same unit of currency – a flaw which has undermined similar attempts at virtual payment currencies in the past.

The big advantage to Bitcoin is that it cuts out the need for clearing banks and expensive regulation which can add up to 6% costs to any transaction

The big advantage to Bitcoin is that it cuts out the need for clearing banks and expensive regulation which can add up to 6% costs to any transaction. The worry for governments is that fraudsters and terrorists can use the system to launder money. This concern however, is somewhat overblown as any Bitcoin transaction’s provenance can be traced by anyone through the electronic ledger. For example, the US Federal Bureau of Investigation (FBI) recently closed down Silk Road, a website caught selling drugs, by examining its Bitcoin ledger deals.

Make or break

HMRC first started taking Bitcoin seriously as a payment system last autumn as its price rocketed from $200 (£121) to over $1,000. Its first conclusion was that it was a single-payment voucher. Following the Finance Act 2012, which introduced new rules on the back of the Lebara phonecard VAT case (Lebara Ltd v HMRC C-520/10), this meant that 20% VAT must be charged on the entire value of each Bitcoin transaction. For Bitcoin traders, this threatened a massive compounding of VAT costs as the currency was traded many times a week, or even per day.

By the end of 2013, this approach had effectively shut down the UK Bitcoin industry. There followed an intensive round of lobbying, including lengthy explanations of the applications of Bitcoins and how they are actually closer to those of a currency than a voucher. This has paid off, with HMRC agreeing that their initial voucher interpretation was wrong. It is now taking legal opinion on a more suitable classification, and should publish its conclusions in the next month or so.

What is certain is that HMRC will not give Bitcoin a full currency status, in competition with fiat (national) currencies. This would have made its use and holding exempt from VAT, capital gains tax (CGT) or corporation tax. One option HMRC may consider, is classifying Bitcoins as a ‘private currency’, used for barter for goods and services. This would exempt the sale of Bitcoins from VAT (although traders’ commissions would be liable). It would also potentially mean CGT would be charged on any holding gains by small traders. They would though benefit from their normal annual CGT allowance, and HMRC may follow the German lead of giving holdings of Bitcoins a CGT exemption after one year.

If the UK does go this route, then it has a real opportunity to create one of the more favourable tax regimes in Europe for Bitcoin traders. Singapore has possibly captured the AsiaPacific trading hub title as it recently exempted Bitcoins from VAT and CGT. The US is on pause as its Internal Revenue Service (IRS) is reluctant to give any tax guidance.

There is little doubt that 2014 will be the make or break year for Bitcoin as it nears critical mass as a global currency, but is attracting the nervous attention of governments, regulators and the law enforcement authorities. But whatever happens, HMRC will be there ready to tax it.