OPINION | Crypto investors face a minefield of taxes

Crypto investors face an uphill battle to prove their gains or losses are capital in nature due to the high risk and volatile nature of the asset class, he writes. joon chong.

The gyrations of the crypto markets have given a first wake-up call to crypto traders and investors who thought it was an easy way to make money. The second alarm bell is about to sound as the South African Revenue Service (SARS) is looking at how to tax as much crypto activity as possible.

Work has already begun on new tax and financial regulation laws that will apply to crypto assets, with the South African Reserve Bank (SARB) taking the lead.

In a recent filing, the Lt. Governor said the SARB was busy with various work streams, including a regulatory framework for cryptocurrency exchanges that will ensure compliance with anti-money laundering and anti-terrorist financing measures, regulations exchange control and tax laws. . This would take anywhere from a year to 18 months to complete.

In South Africa, the term cryptoasset, not cryptocurrency, is used as the SA regulatory framework moves towards uniformity. According to the SARS website, a crypto asset is “a digital representation of value that is not issued by a central bank, but is electronically exchanged, transferred, and stored by individuals and legal entities for the purposes of payment, investment, and other forms of utility.” , and applies cryptographic techniques to the underlying technology.”

The Income Tax Law 58 of 1962 (ITA) defines a financial instrument to include any crypto asset. The ordinary meaning of crypto asset includes cryptocurrencies and non-monetary assets, such as non-fungible tokens, security tokens, and utility tokens, all items that are stored in a distributed ledger on decentralized networks.

Fundamentals of taxation of crypto assets

The ITA does not contain any special rules for crypto assets. This means that the tax treatment of crypto assets would be determined in terms of the usual income tax rules for financial instruments such as equity shares or investment funds.

The disposal of crypto assets is a taxable event. The purchase of goods or services using cryptocurrencies results in the disposal of crypto assets with income equal to the market value of the goods or services purchased. The disposal of crypto assets therefore generates taxes to be paid and a cash outflow.

When considering whether gains or losses from the disposal of crypto assets are capital or income in nature, the question, according to case law, will be whether the taxpayer was involved in a profit-making scheme. Was there realization of an asset for capital gain, or sale of an existing asset for the purpose of generating income?

Section 9C: consideration of earnings if held for three years

If a taxpayer has owned an interest for at least three years, section 9C treats the gains from the disposition of the interest as capital, regardless of intent. The definition of an equity share includes shares in companies or a participating interest in a portfolio of a collective investment plan. Does not include crypto assets.

Arguably, Section 9C does not apply to holdings of crypto assets, making it difficult for taxpayers to prove that their crypto gains are capital, rather than income in nature, and therefore subject to capital gains tax ( CGT) instead of income tax.

Intent in crypto disposal

Below, we present three scenarios to illustrate how the intent behind crypto gains could be determined.

Scenario 1

AB, which is completing papers at a medium-sized auditing firm, used personal savings to buy cryptocurrency as an investment, intending to hold it for at least a year. However, AB sold the crypto two months later, for one of two possible reasons: 1a) AB sold because he needed the funds to repair his car when he had an accident. AB took a small loss but was happy to get back most of the capital invested. 1b) AB sold and made a small profit on the sale as its risk appetite diminished at the first signs of a downturn. He also did more research and realized that he wasn’t as comfortable with the risks as he thought he would be.

We assert that these losses (1a) or gains (1b) are capital in nature. However, AB may find it difficult to meet the burden of proving a capital intent, especially if the coins were held in an exchange wallet and not a personal wallet. In an exchange wallet, crypto assets are stored on a platform that lends itself to easy settlement and trading. A third party, namely the exchange, is given the right to dispose of the coins. In contrast, coins stored in a personal wallet cannot be easily exchanged.

If AB is in the higher marginal bracket (R1 731 601 for FY2023), assessed crypto asset losses could also be earmarked only to offset future crypto asset gains.

scenario 2

In this second scenario, CD works full time at a bank. She spends every spare moment researching and observing the cryptocurrency markets with a view to buying and selling cryptocurrencies as a long-term investment for her retirement. She realizes that one has to be quick and agile to make a profit when investing in cryptocurrencies.

CD had 200 disposals in the first year of 10 different cryptocurrencies (testing the waters), and 1,000 disposals in the second year of 30 different cryptocurrencies.

In our opinion, all gains/losses in both years are likely to be considered income.

Scenario 3

In this third scenario, EF works full time as a YouTube content creator, dog trainer, and social influencer. EF also has some machines in a spare room that he uses to mine cryptocurrencies.

In our opinion, the gains from the disposition of the mined crypto assets would be capital in nature. EF’s situation is similar to that of a homeowner who owns a house and builds another house on the land which he then sells after subdividing the land.

However, profits would be more akin to income from a profit-making scheme if the value of coins minted were converted to a few million rands and the number of coins minted counted in hundreds, not fractions. When EF requires an infrastructure upgrade or has to rent more space for the machines and install a cooling system, then in our view EF has crossed the Rubicon and is pursuing a profit plan.

Intent can be difficult to prove

The intent of the taxpayer is key to determining whether the gain or loss from the disposal of crypto assets is capital or income. However, taxpayers face an uphill battle to prove that their gains or losses are capital in nature due to the high risk and volatile nature of this asset class.

Joon Chong is a partner at Webber Wentzel. Opinions are the author’s.