How can we say that an asset is located in a particular place when that asset’s existence derives purely from digital records copied across a network of computers spread out across the globe?
What sounds like a philosophical question becomes an important practical one when it comes to building a framework for taxing an asset or the person owning or dealing with the value of that asset. This is because one of the fundamentals of our present approach to taxation is that we know where the taxpayer’s asset is located (or treated as located).
Cryptoassets are decentralised, meaning they are specifically designed not to have a location. Ownership is generally determined by reference to a blockchain ledger, a public record of individual wallet addresses which is distributed across many thousands of computers around the world. Practical control over a wallet address is generally afforded by a private key (a string of numbers and letters) specific to a single address, although it is possible for someone to have indirect control over their cryptoassets through other means, such as through a dedicated custodian or an exchange. This poses a novel challenge to our system of taxation.
HMRC’s unorthodox position
After considering the question of where cryptoassets should be situated for tax purposes, in late 2019 HMRC arrived at a surprising conclusion. You can read our explanation and commentary on that conclusion here.
In summary, HMRC’s position is that exchange tokens (meaning cryptocurrencies like Bitcoin that are used as a means of exchange for goods and services or held as an investment) are located where their beneficial owner is resident. In March 2021, HMRC published a new Cryptoassets Manual which clarified that ‘residence’ means tax residence, not residence for other purposes. Practitioners have raised many concerns about the ways in which this rule does not reflect how cryptoassets are often held by owners in practice. The UK Technical Committee of the Society of Trust and Estate Practitioners (‘STEP’) has now published its views. This is first time there has been a substantive formal response to HMRC’s position from such a body and it brings together many of the practical and technical objections to HMRC’s position. So, where do STEP’s comments take us?
The alternative approach proposed by STEP
STEP highlights that the position taken by HMRC is unorthodox, describing the idea of determining the location of the cryptoasset by reference to the owner’s tax residence as ‘a completely new principle which has no precedent’.
STEP points out that English law already has methods of establishing the location of intangible assets, of which cryptoassets are one type. Those methods include, for example, considering where rights to the asset can be enforced, how the asset is transferred, the location of any associated physical assets and the place where ownership is recorded or registered. While some of these traditional methods are less relevant when confronted with the novel technology which underpins cryptoassets, others might be useful.
In particular, STEP refers to academic commentary and remarks from the UK Jurisdiction Taskforce (1) which lend support to a different approach. That approach would determine the location of the cryptoasset by reference to the residence of the ‘participant in the relevant cryptocurrency system’, rather than the residence of the ‘beneficial owner’, as HMRC currently proposes. The participant in the cryptocurrency system is the person who holds the public address and private key to the cryptoasset, both of which are necessary to deal with it. The address and key could be held directly by the beneficial owner, but they are also commonly held by third parties such as cryptocurrency exchanges, trading platforms, nominees, trustees or custodians. In such cases, the argument would be that the location of the cryptoasset is the residence of, for example, the exchange itself (being the holder of the private key to its reserves) or, in the case of a trust which owns cryptoassets, the trustee, if the trustee itself controls the private key.
However, STEP takes the view that in some situations, the beneficial owner (and not the relevant participant with control of the private key) would still be the most appropriate touchstone, such as when a nominee or custodian is holding an identifiable pool of cryptoassets which the beneficial owner can call for and effectively exercise complete indirect control over. This would be a contractual matter to be analysed in each case. STEP differentiates this from a situation where the third party holds an amount of cryptoassets on a pooled basis for its customers, providing each of them merely with an interest in an unallocated number of tokens associated with the private key.
The ‘relevant participant’ distinction is a helpful one and in our view would more accurately and fairly reflect the way that investors use, control and store their cryptoassets. One issue, however, that STEP does not appear to take into account is how this rule would apply where there are multiple relevant participants. While in some cases it may be relatively simple to state by whom a private key is controlled, private keys can be structured according to so-called ‘multi-sig’ arrangements, where multiple individuals are required to authenticate any given cryptocurrency transaction. For example, cryptoassets could be held in trust but both the trustee and the protector could be required effectively to ‘sign’ all transactions relating to a particular wallet. If it is not possible to determine a single point of access to the relevant cryptoasset system, it may be that the legal arrangements between the parties need to be examined in more detail.
In addition, whilst HMRC takes the view that residence should mean tax residence (which in the UK is judged by reference to statutory rules), STEP considers that residence should not mean 'tax residence' but residence according to common law rules (ie those set out in case law).
STEP also has explicitly excluded the treatment of other types of token from its analysis. A second rule was introduced by HMRC in March 2021 to deal with the location of tokens that have an underlying asset, ie tokenized assets. Where an asset has been tokenized, HMRC will look through the token to the underlying asset and apply existing tax rules to determine the location of the underlying asset. The guidance on how this rule should apply is scant and does not acknowledge the many practical challenges that may arise from this: eg what should happen if the underlying assets are held in multiple locations, or if the developers will not reveal where the assets are custodied? In addition, other categories of token such as NFTs, security tokens, utility tokens and some stablecoins appear to be excluded from HMRC's guidance entirely, which leaves many investors in an uncertain position.
STEP’s response is a helpful step forward and will hopefully prompt HMRC to reconsider certain aspects of its guidance (which may be developed or superseded in future by further guidance, statute or case law, if a case litigating these issues is heard before the Tax Tribunal). It may encourage taxpayers to file their tax returns on the basis of an alternative position, in the knowledge that there is growing academic opinion behind other reasoned alternatives to the position set out in HMRC’s manual. If taxpayers do take such an approach they should be prepared to argue their position if an enquiry is raised.
Under HMRC’s current position, remittance basis users whose private keys are kept entirely outside the UK and not accessed are nonetheless treated as if they held the cryptoassets relating to those keys in the UK – an approach that may conflict with the economic reality of how those individuals use their cryptoassets. STEP’s suggested alternative approach has the advantage of giving remittance basis users and non-domiciled individuals more flexibility to carry out standard tax planning by using third parties (in the same way that cash that is not needed by such individuals in the UK might be kept in offshore bank accounts) such as offshore custodians (depending on the particular contractual arrangements) or exchanges.
However, we also hope that STEP will extend its considerations and commentary to other types of token so as to retain the momentum of the debate and challenge to the practical implications of HMRCs approach.
Where the law is uncertain and developing it is particularly important to take advice in advance of any major transactions, estate planning or changes of tax residence. We can help clients plan around the uncertainties generated by HMRC’s position on the taxation of cryptoassets, particularly in an international context, and can advise you on the best way to structure your assets and transactions for the future.