Bitcoin in the sights of regulators

Bitcoin is making news again. Angry investors in the virtual currency are joining a class action to recover nearly US$500 million “lost” when Mt. Gox, a Tokyo-based Bitcoin exchange, crashed at the end of February 2014.

The collapse of the exchange is reported to be the result of theft by hackers. In another recent story, US magazine Newsweek claims to have tracked down the mysterious founder of the “crypto-currency”, a Mr Nakamoto in California. Bitcoin’s website names “Satoshi Nakamoto” as the currency’s founder but many believe that is a pseudonym.

Bitcoin is associated with some high profile criminal investigations, including the shutting down of the underground trading website, Silk Road, late last year – in a US investigation into drug trafficking, money laundering and other alleged crimes.

The growth of bitcoin is pushing it onto the radar of regulators and law enforcement agencies around the world. The Australian Taxation Office is reported to be monitoring the growth in Bitcoin users and is planning to “provide further advice” before the end of June 2014. The application of Australia’s anti-money laundering legislation to digital currencies has been under review since 2012 and ASIC’s website has information about the risks of trading or investing in bitcoin and other virtual currencies.

Officials from the ATO and ASIC have been invited to speak at Australia’s first global bitcoin conference to be held in Melbourne on 28 and 29 March, 2014.

What is it?

Bitcoin allows users to transfer money on the internet without using a bank, credit card issuer or a third party like PayPal. The network is controlled by those using it, on a platform of encrypted software maintaining security and anonymity. A user installs a bitcoin “wallet” on their computer or mobile device. Like a bank account, the wallet is used to store bitcoins and transact with other users.

Bitcoins can be purchased with traditional currencies through online digital currency exchanges – businesses that seek profits by being part of the computer processing network and charging fees for transactions. Bitcoin transactions are recorded publicly and permanently on a register called the Blockchain, which means anyone can see the balance and transactions of any bitcoin address. However, the identity of the user behind an address is not easily revealed.

The benefits of Bitcoin include transacting directly with the other party without the need for financial intermediaries and their high fee structures. Bitcoin transactions are faster, cheaper and users can be anonymous. However, the bitcoin price is volatile, payments are irreversible and there is concern over the security of the system and its vulnerability to hackers. Even the Bitcoin website advises users not to entrust their savings to it.

Despite the risks, Bitcoin grew strongly in 2013, with the value of the market estimated at US$10 billion in February 2014. Bitcoin is marketed at individuals and businesses. In the US, larger businesses have been accepting payments in bitcoin in addition to cash and credit. These include internet retailers like overstock.com and TigerDirect. eBay is considering accepting bitcoin payment capabilities as well as its traditional  PayPal facility. The take-up of bitcoin payments in Australia is reportedly occurring among smaller to medium sized businesses. Australian online legal services provider LegalVision announced that they had received their first bitcoin fee for a service in February 2014.

Tax issues

Many of the taxation issues raised by bitcoin have analogies in older systems like barter, virtual world currencies and internet payment systems like PayPal. However, Australians holding or trading with bitcoins may have existing liabilities for taxes on transactions over a number of years. A ruling or guidance from the ATO would help to reduce uncertainty.

Some of those tax questions include whether bitcoin is an asset, a commodity or a currency, and how the various regimes applying to these, like CGT, foreign currency conversion and financial arrangements, may apply. It would seem that the ordinary tax rules should apply in the usual way where goods and services are paid for by bitcoin but even straightforward transactions raise potentially difficult record-keeping and valuation issues.

Bigger issues

Some of the tax issues can be resolved fairly easily. But that will only affect those who choose to pay tax and apply the rules to their transactions. The bigger issues may be posed by those who want to opt out of compliance and remove their assets and activities from the Tax Commissioner’s gaze.

Virtual currencies like bitcoin set the bar higher for regulators than traditional tax havens because intermediaries are taken out of transactions and because of the enhanced secrecy and anonymity of the networks.

Existing rules will need to adapt. AUSTRAC, Australia’s anti-money laundering and counter-terrorism financing regulator, stated in 2012 that digital currencies not backed, either directly or indirectly, by precious metal or bullion are not regulated by the financial transaction reporting legislation. Similarly, there is uncertainty in the US about whether bitcoin held by a US citizen through an entity not located in the US is subject to reporting under the Foreign Account Tax Compliance Act (FATCA).

Expect to see more from regulators around the world attempting to tame this emerging challenge.

Cautionary tale: valuable rubbish?

Feel sorry for British IT worker, James Howells, who threw his old computer hard drive containing approximately $7 million worth of bitcoin out in the rubbish. Years earlier, James bought 7,500 bitcoin when they were worth almost nothing, and stored them in a bitcoin wallet on the computer. He forgot about them and threw out the hard drive in 2013. His $7 million hard drive is lying somewhere under a pile of garbage in a landfill in South Wales. He committed a major computing 101 error as he did not have a back-up.

About the Author

Edwin Carr, Tax Writer, CCH Australia

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