On 9^th November 2023 the ATO has released web guidance in relation to decentralised finance and wrapping crypto transactions. I presented the below example over a year ago at seminars for The Tax Institute, private clients, and in submissions to Treasury. The ATO has confirmed the view that I predicted that they would take. I have also set out below the ATO analysis what I view to be the more correct tax analysis.

More detail about the reasoning behind my view is presented in my Treasury submissions and other papers, including the paper Problems in Cryptopia: Why Mere Information is Not Property presented at the Society for Trust and Estate Practitioners South Australia 11^th March 2022 Trust Symposium.

In order to show the difficulties with the present tax treatment of crypto it is helpful to use an example that is more realistic than the common “A uses BTC to pay B for goods C” or so on. Instead, the most predominant use for crypto is to purchase or invest in other crypto. This example is economically analogous to depositing money in a bank and gaining an interest return – and act which has certain and well defined tax consequences.

Scenario Background

1. The taxpayer Jarod (an individual) chooses the following investment options and pathways to earn a yield on his assets. The background is as follows:

Starting Assets

1.1. Jarod initially has the following assets:

1.1.1. Start Date 1 July 2021: Asset Prices: 1 BTC: $50,000 USD

1.1.2. Holdings:

1.1.2.1. 2 BTC ($100,000 USD in value) – All held “off chain”;

1.1.2.2. $100,000 USD – All held in Jarod’s bank account;

Option 1

1.2. Earning interest on this BTC and US by depositing them with a registered financial services provider, “BlockFi” and keeping his BTC on the BTC Blockchain;[1] BlockFi Interest APY – Paid Daily (Natively):

1.2.1. 2% against Jarod’s BTC, in BTC; and

1.2.2. 4% against Jarod’s USD, in USD;

Option 2

1.3. Participating in some variant of “Yield Farming”/”Liquidity Pooling” on another blockchain. Jarod decides to use the Ethereum blockchain.[2] The Ethereum dAPP used offers a 100% APY;[3]

Decision

1.4. Jarod decides that he would like to split his risks up by trying both investment options simultaneously: 50% on Option 1 and 50% on Option 2. Jarod also decides that he will use two different methods of exchanging his BTC for Wrapped Bitcoin on Ethereum, WBTC (ERC – 20):

Option 2.A

1.4.1. Half of the allocated BTC will be swapped for WBTC (ERC – 20) on the Ethereum network on a registered cryptocurrency exchange;

Option 2.B

1.4.2. The remaining BTC will be bridged to the Ethereum network with a “cross-chain bridge” application. This is done by Jarod depositing his BTC with the bridge protocol as collateral and receiving his WBTC in return;

Strategy

1.5. Jarod decides that he would like to split his risks up by trying both exchange options simultaneously: 25% (total) in Option 2.A and 25% (total) in Option 2.B. All $50,000 of the USD allocated to this half of the strategy is converted to the “stablecoin” USD (Tether) using the same exchange in Option 2.A. This cryptocurrency “version” of USD allows it to be used on various DeFi dApps.  There are numerous alternatives.

Transactions and Tax Analysis

2. The steps to complete each of the transactions and the tax implications thereof are as follows. The “Current Tax Policy” is based on the publications of the ATO, and the “Correct Tax Analysis” is my view based on the legal principles set out earlier in this submission:

Option 1 – Earning Interest in BlockFi

2.1. In relation to Option 1:

Step 1 – Deposit Into BlockFi

2.1.1. BlockFi is a third-party custodian and operates like a traditional bank that KYCs its customers. Jarod sends his BTC from his BTC wallet to a BTC BlockFi address that he controls through his online portal.

2.1.1.1. Current Tax Policy: CGT Event A1. It seems widely assumed that a transfer from a person individually to a third party that maintains an account for that person does not constitute a disposal. The ATO has confirmed that it does not agree with that position, and that it considers a disposal takes place. Some comments:

2.1.1.1.1. If the BTC is treated as an asset like shares then a transfer from an individual to a broker who does not hold as a bare trustee will be a disposal (see GSTR 2008/3);

2.1.1.1.2. A deposit of physical fiat currency into a bank is a disposal of the CGT asset that is fiat currency, but its cost base and market value are the same so no consequences flow therefrom. Although a bank deposit is likely the most economically similar transaction, this is instead a disposal of BTC in exchange for an increase in a right to receive a BTC when called upon;

2.1.1.1.3. It seems to be assumed that a person owns the crypto that is in their accounts,[4] but this assumption is incongruent with their proprietary rights as against the account provider. This difference is recognised in the Forex provisions in the distinction between a foreign currency and a right to receive a foreign currency;

2.1.1.1.4. There are no CGT rollovers that appear to apply;

2.1.1.1.5. Even if the account provider expressly held the crypto on trust for the account holder, this would cause difficulties because the crypto is not property that is capable of being the subject to a trust, and accordingly the trust would fail, except for BTC, which is foreign currency because it is recognised in El Salvador;

2.1.1.2. Correct Tax Analysis: Forex Realisation Event 1. There is no property being disposed of as crypto is not property. However, BTC is the one present exception as a foreign currency and therefore is a disposal of a CGT Asset:

2.1.1.2.1. There is no acquisition of rights in BlockFi because the account was opened before the BTC is transferred, so it will be for nil consideration;

2.1.1.2.2. As foreign currency, there is a disposal of BTC, which is Forex realisation event 1 under 775-40 ITAA97 in exchange for an acquisition of a right to receive foreign currency;

2.1.1.2.3. The market value substitution rule in s116-30 or 775-40(9) ITAA97 will apply to deem market value capital proceeds;

2.1.1.2.4. The treatment of BTC as a foreign currency is subject to the passage of Treasury Laws Amendment Bill 2022: Taxation treatment of digital currency. Once passed, the CGT provisions would apply instead;

Step 2 – Convert USD to USDT

2.1.2. Jarod is also able to send his USD to BlockFi as USD but is offered a higher APY if he exchanges his USD to USDT. Jarod decides to chase the yield and purchases USDT.

2.1.2.1. Current Tax Policy: acquisition of cgt asset usdt. with a cost base equal to the USD spent;

2.1.2.2. Correct Tax Analysis: no event. There is no property being acquired – the BlockFi account, being the relevant CGT Asset, is set up before the transaction and so is not acquired:

2.1.2.2.1. The disposal of USD is Forex realisation event 1 under 775-40 ITAA97;

2.1.2.2.2. The market value substitution rule in 775-40(9) ITAA97 will apply to deem market value capital proceeds;

Step 3 – Withdrawal

2.1.3. After 12 months of 2% against BTC and 4% against USDT, Jarod withdraws his 02 BTC to his original address and converts his $52,000 USDT back into USD before withdrawing it back to his bank account.

2.1.3.1. Current Tax Policy: pOSSIBLE ASSESSABLE INCOME of 0.02 BTC and $2,000 USDT. The intention is that the gains are treated as assessable income, however:

2.1.3.1.1. in order to reacquire the BTC Jarod must have it transferred back to him and this is an acquisition of a CGT Asset;

2.1.3.1.2. it is unclear what Jarod is disposing of to reacquire his BTC, and so potentially the cost base of the BTC will be nil;

2.1.3.2. Correct Tax Analysis: Assessable income of 0.02 BTC and $2,000 USD:

2.1.3.2.1. The 02 BTC Jarod acquires is an asset, being foreign currency recognised in El Savador, and it seems most reasonable to treat it as a revenue gain. Note that if it was another crypto then it would not be property and would no more give rise to taxation than would points in Space Invaders;

2.1.3.2.2. Jarod has acquired $2,000 USD when it is paid to him in USD, being income made under the contract with BlockFi;

2.1.3.2.3. The return of the $50,000 USD initial capital is not a taxable event;

Option 2.A – Exchanging BTC to WBTC and USD to USDT

Step 1 – Deposit Into Exchange

2.1.4. Cryptocurrency exchanges are third-party custodians and operate like traditional global asset exchanges that KYCs their customers. Jarod sends his BTC from his BTC wallet to a BTC exchange address that he controls through his online portal. To convert his BTC to WBTC, he finds the BTC/WBTC pair on the exchange and trades his BTC for WBTC.

2.1.4.1. Current Tax Policy: DISPOSAL of cgt asset BTC, acquisition of cgt aSSET WBTC. There will be two disposals, first upon the transfer of the BTC to the exchange (as described at 25.1.1.1 above) and then a second disposal when the BTC is exchanged for WBTC:

2.1.4.1.1. The exchange of BTC for WBTC is as problematic as it is straightforward under the current policy. Economically, BTC and WBTC are practically identical. The disposal of BTC in exchange for WBTC merely enables different software integration;

2.1.4.1.2. An economically analogous transaction is the transfer of an asset to a custodian trustee. No taxing event is triggered as the beneficially retains beneficial interest in the asset;

2.1.4.1.3. However, the exchange of the BTC for a WBTC does not create and legal or equitable relationship between the issuer of the WBTC and the donor of the BTC that has the ability under software to force the exchange of the WBTC for the BTC;

2.1.4.2. Correct Tax Analysis: Forex Realisation Event 1. There is no property being disposed of as crypto is not property. However, BTC is the one present exception as a foreign currency and therefore is a disposal of a Foreign currency that is also a CGT Asset:

2.1.4.2.1. As foreign currency, there is a disposal of BTC, which is Forex realisation event 1 under 775-40 ITAA97

2.1.4.2.2. There is no acquisition of rights in exchange because the account was opened before the BTC is transferred so it is in exchange for nil consideration;

2.1.4.2.3. The market value substitution rule in s116-30 or 775-40(9) ITAA97 will apply to deem market value capital proceeds;

2.1.4.2.4. The treatment of BTC as a foreign currency is reversed by the Treasury Laws Amendment Bill 2022: Taxation treatment of digital currency. The effect of this is that the CGT provisions apply instead;

2.1.4.2.5. The disposal of BTC in return for WBTC changes the rights that Jarod has against the exchange, but does not constitute a CGT Event. There is not acquisition or disposal or other Event;

Step 2 – Convert USD to USDT

2.1.5. Jarod is also able to send his USD to the exchange as USD and then trades for USDT, as he did with the BTC/WBTC pair. See 25.1.2 above;

Step 3 – Transfer to MetaMask

2.1.6. To prepare to use his new USDT and WBTC assets on an Ethereum dApp, Jarod sends his assets from the exchange to decentralised (“hot”) wallet called MetaMask, that he controls. MetaMask is able to integrate with multiple blockchains and multiple dApps.

2.1.6.1. Current Tax Policy: Unclear. The transfer of the USDT and WBTC from one wallet to another is intended not to trigger a disposal:

2.1.6.1.1. However, there is no relation between a MetaMask account and the person who is using it. There is no KYC, no user identification, nor indeed any legal relationship between MetaMask and Jarod. There is no way of knowing for certain whether the MetaMask account belongs to Jarod, or another person, other than the control of the 12 word seed phrase that is generated at the creation of the account;

2.1.6.1.2. Presumably this is treated as akin to a transfer to an address controlled with a public and private key;

2.1.6.1.3. The existing ATO commentary deals only with transfers from one address to another, and does not consider the difference in rights between an exchange and a decentralised address;

2.1.6.1.4. In any event, it must be analogous to the reverse of the analysis at 25.1.1.1 above, and therefore is a disposal by the exchange (which does not hold the WBTC and USDT as bare trustee for Jarod) back to Jarod personally (or perhaps some other entity if ownership by Jarod cannot be sure);

2.1.6.2. Correct Tax Analysis: Non-taxable. There is no property being disposed of as crypto is not property. Neither the WBTC or USDT are recognised as foreign currency. There is simply a debiting of Jarod’s account at the exchange and crediting of the MetaMask account;

Option 2.B – Bridging BTC to WBTC

Step 1 – Swap BTC/WBTC

2.1.7. Cross-chain bridges are applications that swap assets on one blockchain for the same asset, native to another blockchain 1:1. In this case BTC from the BTC blockchain to WBTC on the Ethereum blockchain.  These applications do not KYC their customers like a centralised exchange or financial services provider is required to.  These decentralised finance platforms form the “DeFi” ecosystem.

2.1.8. Jarod sends his BTC from his BTC wallet to the bridge as “collateral” and receives his WBTC 1:1 as a receipt of his deposit. He is able to reverse the transaction and take back his BTC.

2.1.8.1. Current Tax Policy: CGT EVENT A1 for BTC and acquisition of wbtc. Given that there is no exchange in this transaction, and instead it is from one address to another, it appears that there is a disposal of the BTC and an acquisition of the WBTC under current policy;

2.1.8.2. Correct Tax Analysis: Forex Realisation Event 1. There is no property being disposed of as crypto is not property. However, BTC is the one present exception as a foreign currency and therefore is a disposal of a Foreign currency that is also a CGT Asset:

2.1.8.1.1. As foreign currency, there is a disposal of BTC, which is Forex realisation event 1 under 775-40 ITAA97

2.1.8.1.2. There is no acquisition of rights in the WBTC as it is not property and so it is in exchange for nil consideration;

2.1.8.1.3. The market value substitution rule in s116-30 or 775-40(9) ITAA97 will apply to deem market value capital proceeds;

2.1.8.1.4. The treatment of BTC as a foreign currency is subject to the passage of Treasury Laws Amendment Bill 2022: Taxation treatment of digital currency. Once passed, the CGT provisions would apply instead;

Step 2 – Transfer

2.1.9. As he did in Option 2.A, to prepare to use his new WBTC assets on an Ethereum dApp, Jarod sends his assets from the bridge application to his MetaMask.

Option 2 – Liquidity Pooling & Yield Farming

Step 1 – Connect to dApp

2.1.10. Jarod has now consolidated his Ethereum-based assets in his MetaMask wallet.

2.1.10.1. 1 WBTC (value $50,000USD)

2.1.10.2. $50,000 USDT

2.1.11. He now connects his MetaMask to his preferred Ethereum dApp, so that he is able to commence his investment strategy on the dApp platform. This connection has no tax consequences.

Step 2 – Liquidity Pooling

2.1.12. Jarod deposits his WBTC and USDT assets from his wallet into the dApp’s corresponding “Liquidity Pool” for the WBTC/USDT pair at a 1:1 ratio in value. At the time of investing, this ratio is (conveniently) 1 WBTC : 50,000 USDT and Jarod is returned 1 WBTC/USDT LP (Liquidity Pool) Token as a receipt of his contribution to the pool.  This token is deposited from the dApp into Jarod’s MetaMask.  The token has a value equivalent to the underlying assets it represents the receipt of  1 WBTC ($50,000 USD) + 50,0000 USDT ($50,000 USD) = $100,000 USD

2.1.12.1. Current Tax Policy: CGT EVENT A1 for WBTC and USDT and acquisition of LP Token;

2.1.12.2. Correct Tax Analysis: NO EVENT. There is no property being disposed of as crypto is not property.

Step 3 – Yield Farming

2.1.13. Jarod how has his 1 WTC/USDT LP Token in his MetaMask wallet. To participating in earning a yield on his LP Token, he connects it with the dApp’s corresponding yield farm and sets it to work.

2.1.14. Jarod is paid his 100% APY rewards in the form of additional LP Tokens and after 12 months has 2 WBTC/USDT LP Tokens in his MetaMask wallet. These rewards are paid daily (though, these can be as often as hourly on some dApps).

2.1.14.1. Current Tax Policy: assessable income of LP Token;

2.1.14.2. Correct Tax Analysis: NO EVENT. There is no property being acquired of as crypto is not property.

Tax Policy Analysis of Example

3. There are a number of issues that are highlighted in the above example:

Currency Tax Policy

3.1. In relation to current tax policy:

3.1.1. The sheer number of taxing events to undertake a transaction that is economically analogous to depositing money in a bank and then transferring to a term deposit is astounding. The presents difficulties from an administration perspective given:

3.1.1.1. the volatility in the price of crypto;

3.1.1.2. the likely non-lineal series of actions to invest. That is, taxpayers are likely to move currency and crypto back and forth along the various stages in the above transaction; and

3.1.1.3. the lack of understanding of all of the disposals that occur – taxpayers will typically treat disposals as only occurring when there is a transfer to third party, rather than to or from an exchange;

3.1.2. if a taxpayer was actively trading crypto and the crypto was treated as being trading stock then the various gains and losses could be simply calculated as a net gain or loss at the end of the financial year. However, for the vast majority of taxpayers they are not running a business of trading crypto;

3.1.3. there is a tax timing problem that creates an artificial and improper taxing event in that if there were latent capital gains in the BTC before it transferred, then those gains will be crystallised and tax imposed. However the value of the BTC could quite easily go down in the remainder of the financial year and lead to a position where the tax payable is greater than the value of the asset. I have seen this in many real life examples in the financial year ended 30^th June 2022, where BTC decreased by about 70% from earlier in the year;

3.1.4. although this example produces a negative outcome for the taxpayer, it is quite easy to create a scenario in which tax is avoided altogether. In particular, if a taxpayer converts their holding to but one token (like the Liquidity Pool Token, or Wrapped BTC) the attributes of that token could easily change or increase without a disposal. That is, if the sub-attributes of a token changed, but without a disposal of the token, tax is avoided entirely under the present policy. There is no technological inhibition on such a tax avoidance token, it simply has not been created yet. It could easily evolve for non-tax related purposes, such as a token that is to act as an account or integration with other services;

Correct Tax Analysis

3.2. In relation to my preferred tax analysis:

3.2.1. There is an over representation of taxable events in the example because of the use of BTC, which is a foreign currency. In time, a handful of major crypto will also become foreign currencies. It may be the case that this encompasses the majority of the market value in crypto, because of the predominance of the largest crypto. However the vast majority of cryptocurrencies by number are not foreign currencies and hence not property;

3.2.2. That interactions of software do not trigger a taxing event should not be regarded as a loss of tax revenue. People value their points in Space Invaders. Other video game success benefits have been attributed large values – including a “Blue Party Hat” in the game Runescape.[5] When that software ledger is debited in return for real world property then there should, and is, a tax event. When tokens are exchanged for property there is an acquisition of an asset that is subject to taxation;

3.2.3. By recognising (and taxing) as property only rights that are correctly property at common law, the law becomes more robust against future technological changes, which are unpredictable; and

3.2.4. Despite the claims of the majority of participants in the crypto industry, the most accurate description of most crypto activity is gambling. Most participants desire, and expect, extremely high rates of return that are consistent only with gambling, and not some investment or economically substantive activity.

 [1] These providers are operated like a “TradFi” bank and returns are generated on deposits by the same provider charging an interest rate for customers who wish to lend against their BTC collateral.

[2] As the Bitcoin Mainnet does not have any native DeFi (decentralised finance) applications, this requires Jarod to take his Bitcoin off the BTC Mainnet by “wrapping his Bitcoin” and utilising this form of the asset on another blockchain with DeFi dApps (decentralised applications).

[3] The APYs offered change regularly and vary WILDLY.  Some APYs offered are as high as 86,000% (see: “Wonderland”)

[4] See for example PBR 1051820739965 where a taxpayer is assumed to have ownership of the crypto in their Binance account, which is contrary to the Terms of Service of Binance https://www.binance.com/en/terms which merely create a contractual right to direct Binance to conduct trades and not any purported interest in the underlying crypto.

[5] https://estnn.com/10-most-expensive-items-in-video-games-ever/