The first month of 2021 saw more than its fair share of turbulence and change: a chaotic US presidential transition period, the continued spread of the coronavirus against a backdrop of unprecedented numbers of people being vaccinated, and a new breed of activist investors organising on social media forums, causing havoc for hedge funds.
With this extreme volatility, there has been a matching extraordinary price increase in one of the most volatile investment asset classes: cryptocurrencies, and especially Bitcoin. This is likely to trigger ever-increasing future investment by both individual and institutional UK resident investors.
Here, Withers’ UK crypto legal experts consider 4 of the most commonly asked questions by novice and experienced UK resident cryptocurrency investors and in doing so comment on some of the fundamental legal and regulatory issues that concern such cryptocurrency investment in the UK.
1. I recently invested £10,000 in a basket of different cryptocurrencies via a cryptocurrency exchange (e.g. Coinbase, Binance, Kraken, eToro). What happens if my investments become worthless?
UK investors have flooded the market since Bitcoin started rallying in December, with almost £1bn traded for Bitcoin in the first week of January alone. Many are novice retail crypto-investors seeking to turn a quick profit and not wanting to miss out on the proverbial gold rush.
In response, the UK financial services watchdog, Financial Conduct Authority (‘FCA’) raised the alarm on 11 January warning that investing in crypto assets, or investments and lending linked to them, generally involved taking very high risks with investors’ money. If consumers invest in these types of products, they should be prepared to lose all their money.
Previously, the FCA in October 2020, had banned the sale of derivatives and exchange-traded notes to retail investors that reference certain types of crypto assets. Consequently in the UK, retail investors are only able to invest in the underlying crypto asset itself, not through a financial product indexed to crypto exchanges.
In its January 2021 warning, the FCA reminded investors that they will not be protected by the Financial Services Compensation Scheme (‘FSCS’) in most cases. Exchange tokens (such as Bitcoin and Litecoin) are not regulated by the FCA hence the FSCS does not apply. Whilst some cryptoassets such as security tokens may be covered by the FSCS, this will need to be assessed on a case-by-case basis.
From a UK tax planning perspective, should the value of your crypto investment fall, you may still be able to crystallise your losses (which you can then set off against any other gains you may have made) if you can establish that your cryptoassets are no longer able to fetch a price on an open market. This can be done by making a negligible value claim to HMRC.
2. I tried to sell a number of Bitcoin after the price went up in January but due to delays with the broker, I could not liquidate my position before the price dropped again. Do I have any recourse against the broker?
It has been frequently reported that some users experience delays cashing out their cryptocurrency, particularly at times of high market activity when the prices spike. Even the largest exchanges can also crash for technical reasons from time to time.
Different cryptocurrencies also have different transaction times (ie the time taken from using your private key to authenticate a transaction to a miner completing the transaction and writing it into the blockchain), depending on the type of cryptography used, the maximum size of each block, the incentive provided to the miner by the transferor (ie fees) and overall network activity.
Legal recourse against crypto exchanges may be difficult. When you create an account with an exchange you agree to their User Terms. Many of the popular exchanges used in the UK expressly limit their liability to users in respect of delays or service problems.
Coinbase, one of the largest crypto exchanges, suffered ‘performance degradation’ on 29 January after the price of Bitcoin surged by 20%. Any delays to service when the price of the currency is so volatile will inevitably leave some users out of pocket. Coinbase expressly states in its User Terms that access to its services ‘may become degraded or unavailable during times of significant volatility or volume’. Coinbase does not guarantee that orders will be executed or even that accounts will remain open during such periods.
Kraken suffered a similar service outage on the same day. Its User Terms also limit liability for ‘failure of performance’ and like many other exchanges, it limits its liability for loss of profits. For example, if you were unable to buy Bitcoin during a 20% price surge, you would not be able to claim for the 20% increase. With Kraken, the maximum you can claim is the aggregate of the fees you paid to them in the preceding 12 months.
Starting legal proceedings against an exchange can be costly and potentially difficult. For example, to bring a claim against Kraken you would need to start arbitration proceedings in California.
Consequently if you plan on investing a significant amount in cryptocurrencies, a number of different exchanges could be used to protect your position in the event that one of them suffers a service failure.
3. I recently transferred some cryptocurrency to my partner as a gift. Do I need to report it?
Most, if not all, cryptocurrencies, will be assets for tax purposes since they are not classified as legal tender or as a form of currency. Generally, this means that cryptocurrencies are potentially taxable whenever they are disposed of, eg by sale or gift. This is also the case when fiat currency or another type of cryptocurrency is received in return.
If you and your partner are married, then the gift to your partner is exempt from UK inheritance tax (IHT) and UK capital gains tax (CGT). Your partner will receive your cryptocurrency with your base cost and so when he/she comes to sell the cryptocurrency in the future, he/she will need to know the sterling price that you bought it at.
If you are not married, a possible CGT charge arises on the gift if the value of your cryptocurrency (determined by taking the sterling conversion at the points of acquisition and sale) has gone up since you bought it. All UK residents have an annual CGT allowance (currently £12,300 for the 2020/21 tax year) and so if the amount of the gain is above your remaining allowance for the tax year, you will have to declare a taxable gain (at either 10% or 20% depending on your income level). This needs to be done in your self-assessment tax return by 31 January following the end of the relevant tax year.
There may also be an IHT charge of up to 40% if you do not survive the gift by 7 years, and the total value of your estate plus all gifts made by you in the previous 7 years exceeds the nil rate band (currently £325,000). Technically, the liability to pay this charge falls on the recipient of the gift, unless a specific provision is made by the donor in his or her Will for the liability to be paid out of their estate.
4. I am an experienced crypto-investor and want to try to make a living out of full-time crypto-trading. I sometimes trade on behalf of friends and family as well. Do I need to be regulated to do this? What can I do to protect myself if things go wrong?
If you want to operate a crypto asset business that does not require direct authorisation by the FCA, then it must at least be registered with the FCA under the Money Laundering Regulations (‘MLRs’) before conducting any business.
An MLR application to the FCA will involve setting out and submitting your business plan, marketing plan, structural organisation, your governance and control mechanisms and explaining the ownership structure of the business.
Some crypto assets are directly regulated by the FCA, and so a full application to be an FCA authorised firm may be required. Fundamentally, if your activities could be regarded as being carried on by way of business (such as if you are looking to profit from managing the investments of others) then you will need to take advice as to whether you need to be directly authorised by the FCA, or if only a registration under the MLRs is required. The regulations in this area can extend to trading on behalf of friends and family and so you should be aware of the requirements before doing so.
If you are looking to set up a fund for professional investors that invests in crypto assets, then you will need to be regulated by the FCA to do this. You should also take tax advice before deciding how to structure a crypto business.
If you are planning on making crypto-trading your day job, it is worth setting up a limited company and a company account through which to carry out your trades. This is particularly the case if you are trading on behalf of others or borrowing money from a bank. This means that if things go wrong and someone tries to bring a claim against you, they could only enforce against the company’s assets rather than your personal assets eg your home.
If you are trading on behalf of others you should agree to the terms of your service. Your customers should agree that profits are not guaranteed and they stand to lose the amount they invested.
From a tax point of view, if you are making frequent trades and earning livelihood living from your activities, you may be considered to be trading, which means that your profits will be subject to income tax (at up to 45%, at the time of writing), rather than CGT (at up to 20%) like most non-professional investors. This is, however, highly fact dependent. If you form a company through which to carry out your trading activities, the profits will be subject to corporation tax instead (currently, 19%). You should also keep records of your trading expenses such as internet and electricity costs, transaction fees and any other costs you might have incurred, as these can be deductible in whole or in part.
You should bear in mind that any payments in cryptocurrency received for services provided (eg to third parties for whom you have carried out trades) will be subject to income tax or corporation tax as appropriate.