What are virtual currencies

Virtual currency is a digital representation of value that can be digitally traded and functions as: a medium of exchange; and/or a unit of account; and/or a store of value.

However, it does not have legal tender status (i.e., when tendered to a creditor, is a valid and legal offer of payment) in any jurisdiction. It is not issued nor guaranteed by any jurisdiction, and fulfils the above functions only by agreement within the community of users of the virtual currency.

Many digital currencies (also called crypto currencies) started in online gaming communities or on social media.

Part of the appeal of virtual currencies, such as Bitcoin, is that they allow users to remain anonymous.

On the downside, they can fluctuate significantly, they may not be accepted in many places and they are not guaranteed by any bank or government.

How do virtual currencies work

Users ‘earn’ or create virtual currency. For example, new Bitcoins are created using computer-intensive software known as Bitcoin Miners. There are usually only a fixed number of virtual currency units available.

Virtual currencies can be bought or sold on an exchange platform using conventional money. Trading fees are charged and are usually based on the trade value.

Virtual currencies are kept in a digital wallet and can be used to pay for actual goods and services from any person willing to accept them as payment.

What are the risks

If you want to buy, trade or invest in virtual currencies the risks include:

Virtual currencies have less safeguards

The exchange platforms on which you buy and sell virtual currencies are generally not regulated, which means that if the platform fails or is hacked, you are not protected and have no statutory recourse. Virtual currency failures in the past have made investors lose significant amounts of real money. Some countries are moving towards regulating virtual currencies, however virtual currencies are not recognised as legal tender.

Values fluctuate

The value of a virtual currency can fluctuate wildly. The value is largely based on its popularity at a given time which will be influenced by factors such as the number of people using the currency and the ease with which it can be traded or used.

Your money could be stolen

Just as your real wallet can be stolen by a thief, the contents of your digital wallet can be stolen by a computer hacker. Your digital wallet has a public key and a private key, like a password or a PIN number. However, virtual currency systems allow users to remain anonymous and there is no central data bank. If hackers steal your digital currency you have little hope of getting it back. You also have no protection against unauthorised or incorrect debits from your digital wallet.

Popular with criminals

The anonymous nature of virtual currencies makes them attractive to criminals who use them for money laundering and other illegal activities.

Taxation of virtual currencies

Tax season is usually a stressful time, as families and businesses perform all the necessary calculations to find out how much they have to give to Uncle Sam. However, when dealing with traditional assets, the rules are in writing. When dealing with something digital such as virtual currency, you have entered a gray area, which can be immensely confusing. However, we can find some guidance for this topic, despite the shifting nature of virtual currency regulation.

First, let’s look at an actual IRS frequently asked questions document, released last year. According to that document, “For federal tax purposes, virtual currency is treated as property. General tax principles applicable to property transactions apply to transactions using virtual currency.”

In addition, virtual currency does not generate foreign currency gain or loss according to the IRS. If you receive virtual currency as payment, you have to include it as part of your gross income by converting its value to U.S. dollars at the time you received the payment. Thus, if you keep bitcoin and its value drops dramatically, you might have to pay more in taxes than what your virtual currency is actually worth. This same principle applies to mined virtual currency.

One issue is related to tax evasion, as some could simply use virtual currency to evade paying taxes. Regardless of how virtual currencies are treated by nations for tax purposes, most individuals will pay taxes on these earnings but some will not — just as happens today with cash transactions.

However, the Commodity Futures Trading Commission declared that virtual currency is a commodity. Essentially, a commodity is a good that is produced and sold by many different companies and is uniform in quality. If the IRS adopts this definition, then taxation could change dramatically for bitcoin users and companies who trade bitcoin. We would see the profits taxed, 60 percent as long-term capital gains, and 40 percent as short-term capital gains.

In other countries, the issue becomes much more clouded and complicated. For example, in Russia, there has been a push by the central bank to ban virtual currency altogether and make it a criminal offense to even use virtual currency. China also has banned financial institutions from using virtual currencies, although individuals can utilize them.

On the other end of the spectrum, the European Union recently declared that virtual currency transactions will not be taxed by a value-added-tax. Instead, virtual currency will be treated in the same manner as fiat currency in EU countries. From three different regulatory bodies, we now have three different definitions of virtual currency: property, commodity and currency.

One key issue we have not explored is if governments are even equipped to enforce taxation of virtual currencies. It will be a difficult task to tax or regulate virtual currency, because it is easy for taxpayers to hide their transactions by using virtual currency. With decentralized peer-to-peer virtual currency systems, such as bitcoin, there is no central clearing house or central operation to shut down. Because there are no centralized clearing house records, no incorporated companies to search, and no corporate executives to question, justice may be thwarted because there is no ‘it’ to find, no ‘where’ to locate, and no ‘them’ to question.

Many economists believe this issue might be resolved if virtual currency exchanges began to work together and find common ground with the various taxation authorities of other nations. However, this will be difficult as it goes against the libretarian philosophy that started bitcoin in the first place. In addition, it goes against the principle of “banking secrecy,” which demands people’s banking information stays private. However, when international law demands that banks reveal certain financial information, the issue becomes cloudy.

One thing is sure: As banking secrecy protections evaporate internationally, the demand for virtual currencies, in general, and cryptocurrencies, in particular, will rise.

There is a genuine tension between the law and technology, as technology changes at a much quicker pace than the law. This can lead to contradictions and outdated information in tax codes. For effective virtual currency taxation, then, we clearly need something smart, flexible and consistent. Virtual currency cannot be a property, commodity and currency at the same time.

Endnotes

  1. Australians securities & investment commission: ”Virtual Currencies”, 17 Aug., 2015,<https://www.moneysmart.gov.au /investing /investment-warnings/virtual-currencies>;
  2. Virtual Currency Today: “Property, commodity or currency? Virtual currencies and taxes”, 26 Oct., 2015,<http://www.virtual currencytoday.com/articles/property-commodity-or-currency-virtual-currencies-and-taxes/>;
  3. IRS: “IRS Virtual Currency Guidance: Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply”, 25 Feb., 2015,<https://www.irs.gov/uac/Newsroom/IRS-Virtual-Currency-Guidance>;
  4. IRS: “Frequently Asked Questions and Answers”, 29 Jul, 2015, <https://www.irs.gov/Help-&-Resources /Tools-&-FAQs/FAQs-for-Individuals/Frequently-Asked-Tax-Questions-&-Answers>.

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