Crypto Investing Basics - Bitcoin and Tax in Australia (Part Two – Capital Gains Tax)

How does capital gains tax effect my crypto currency portfolio?

Having dealt with personal use assets in the previous article, we can put those aside for now as I think it’s fair to say that most of us are investing for profit.

For information on claiming Bitcoin as a personal use asset, please see my previous article linked here.

This article will deal with the situation where someone is buying and selling crypto assets as an investment, and subsequently makes a profit when they sell. I will commence with some definitions and some technical references, before moving onto the implications of these issues in relation to tax. I will use several examples to help clarify the issues discussed. Once again, I will use the terms Bitcoin and Crypto currency interchangeably, as while the ATO rulings and papers use the term Bitcoin almost exclusively, you could substitute any crypto currency in place of Bitcoin and the principles would be the same.

For simplicity I have not included in this article any discussion of the discount that applies if you hold your asset for longer than 12 months. This will be dealt with in the third article in this series. For all examples used in this article, assume that the asset was held for less than 12 months. I have also excluded the Medicare Levy in all calculations.

Bitcoin and Capital Gains Tax

The Commissioner of the Australian Taxation Office (ATO) issued a determination in 2014 in the ATO document TD 2014/26. This determination is very clear and states:

Bitcoin is a 'CGT asset' for the purposes of subsection 108-5(1) of the Income Tax Assessment Act 1997(ITAA 1997)

This means that if you have made a capital gain on your Bitcoin, then you are subject to capital gains tax for any profits that you make. You are also able to claim deductions for any expenses that you incur in the course of making these profits. The most common example of an expense incurred would be commissions charged by the various Bitcoin exchanges. I would think it would also be reasonable to claim transaction fees where you are transferring money between exchanges in order to buy and sell crypto currencies.

The following section will quote directly from two references on the ATO website

• TD 2014/26 linked above; and

• ATO Website – Capital Gains Tax

I will list a number of points relevant from these references, and then discuss each in greater detail.

CGT consequences of disposing of Bitcoin

• The disposal of Bitcoin to a third party gives rise to CGT event A1 under subsection 104-10(1). A taxpayer will make a capital gain from CGT event A1 if the capital proceeds from the disposal of the Bitcoin are more than the Bitcoin's cost base.

• When you make a capital gain, it is added to your assessable income and may significantly increase the tax you need to pay. As tax is not withheld for capital gains, you may want to work out how much tax you will owe and set aside sufficient funds to cover the relevant amount.

• The point at which you make a capital gain or loss is usually when you enter into the contract for disposal, not when you settle.

• If you’re an Australian resident, CGT applies to your assets anywhere in the world.

The disposal of Bitcoin to a third party gives rise to CGT event

This point is fairly self-explanatory and flows directly from the point raised in the introduction to this article. To give a simple example, imagine your purchased 1 BTC for a price of $5,000 and then sold it at a later date for a price of $15,000. In the process of this you incurred costs of $200 in brokerage fees charged by the exchanges that you used to buy and sell. You would calculate your capital gain as follows:

Cost Base = $5,000 (A)

Proceeds from Sale (B) = $15,000

Gross Gain (C) = B – A

                = $15,000 - $5,000
                
                = $10,000

From this amount you would be able to deduct any expenses incurred in buying and selling the asset. In our case this is $200. Therefore our net gain is:

Net Gain = Gross Gain (from above) – Expenses

                = $10,000 - $200
                
                = $9,800

Although it's referred to as capital gains tax (CGT), this is actually part of your income tax, not a separate tax

This is an important point that is misunderstood by many people. Once you have determined your capital gain for any given financial year, this gain is not treated as a separate tax, but is simply added to your income for the purposes of calculating the tax that is owed. As most people will be aware, the level of income tax that you pay depends on the level of income that you earn. The more you earn, the more you pay. To use a technical term, capital gains are taxed at your marginal tax rate (MTR). The MTR will be different for each individual investor, based on what other income they have earned in the financial year in question. The marginal tax rate for individuals based on their level of earnings can be viewed at this link

The implication of this however is that capital gains tax is often significantly less than most people initially expect. It is common to assume that the capital gains tax rate is 50% of any gain that you have made. In order to be taxed at this rate you would need to earn more than $180,000 in addition to your crypto currency gains. Very few investors will fall into this category. Continuing with our example shown above, let’s assume that our investor is employed full-time, and earns $50,000 per annum. An employee earning $50,000 per annum has a marginal tax rate of 32.5%. This means that in our hypothetical example above, where our investor has made a net gain of $9,800, this investor would be required to pay tax at a rate of 32.5%. This is equivalent to $3,185. If you’re income is higher or lower than the example used, then your amount of tax payable may be higher or lower depending on your circumstances.

As tax is not withheld for capital gains, you may want to work out how much tax you will owe and set aside sufficient funds to cover the relevant amount

This is a really important point, but may easily be overlooked. When you earn income from an employer, that employer withholds tax from your paycheck that is equivalent to the amount that you owe the ATO for that pay period. Ignoring deductions and other variations, this should mean that when you lodge your tax return, you should have already paid the correct amount of tax, and should not owe any more. Capital gains tax does not work like this, as there is no one to withhold the tax on your behalf. What will happen is that at the end of the financial year when you complete your tax return, you will add your capital gains to your other income and the tax office will determine how much additional tax you owe. If you have made capital gains, this will result in you owing the tax office money.

If you have not considered this, you may find yourself in a situation where you have a significant amount of tax to pay and no cash with which to pay. This would result in you having to either find the money from other sources, or sell additional crypto to raise the cash to pay your tax bill. This in turn generates more tax. It is important to be aware of the level of capital gains that you have made as you conduct your trading, so that you can ensure that you set aside a sufficient amount of money to meet this tax obligation when it falls due.

The point at which you make a capital gain or loss is usually when you enter into the contract for disposal.

The cashing out myth

This next section is possibly the most important section of this article, and will contain information that may be new to many crypto currency investors. A term that is used commonly in the crypto community is cashing out. Quite often people will use this to mean that point in time where they finally convert their crypto back into fiat currency and deposit it into their bank account. The assumption based on this, is that tax is not due until you finally withdraw money and physically deposit it into the bank. This is incorrect.

Every time you make a crypto currency transaction, if you have made a gain on that transaction, then you have accrued a tax liability for the financial year in which the transaction occurs. I will go through a number of examples to demonstrate the complications that this introduces, and why it is important for everybody to be aware of these issues.

The first example I will use will continue from our investor above. Let’s assume that in our above example, the investor sold his Bitcoin for $15,000 in December 2017. This means that this transaction occurs in the 17/18 financial year (FY). Let’s extend the example by assuming that instead of selling this Bitcoin for fiat, he instead uses it to purchase Steem. He then holds the Steem for the long-term.

In this example, despite the fact that he has not physically converted his Bitcoin into cash, the use of this Bitcoin to purchase Steem is considered a disposal of Bitcoin from a capital gains tax point of view. Therefore, even though no money has physically hit his bank account, he has still accrued a tax liability for the current financial year (FY 17/18). Even if he continues to hold the Steem for a long period of time, at the end of the current financial year, the ATO will expect him to pay tax on the disposal of the Bitcoin. In this scenario the investor has generated no actual fiat cash with which to pay this bill.

Perhaps more importantly the flow on effects of this are significant if you are trading on a regular basis. Let’s extend our example further and imagine that our investor sells his Bitcoin for a profit and exchanges it for Steem, then after the recent run-up in Steem sells that at a profit, and purchases an additional crypto currency. This investor has now triggered two capital gains tax events, and an associated tax liability for both transactions, once again without having ‘cashed out ‘any of his crypto for fiat. For regular traders who are attempting to follow trends within the markets this leads to a very messy situation. It’s possible that the original Bitcoin that you purchased may have been traded eight, 10, 20, or any number of times in a given financial year, each time incurring a capital gains tax liability. The fact that you have not physically converted crypto to fiat has absolutely no impact on whether or not you owe capital gains tax. The capital gains tax liability is accrued at the time that the transaction takes place.

If you are like me, this means that you have made multiple trades this financial year and have accrued capital gains tax liabilities on each individual trade. This could amount to a significant amount of money. The possible permutations of these examples are endless. To extend the same example further, imagine that our hypothetical investor had used his Bitcoin profits to purchase both Steem and Cardano, and then subsequently sold both that Steem and Cardano to buy additional coins again. There are multiple transactions taking place at multiple points in time, each of which accrue tax liabilities. You will owe the tax on these transactions at the end of the financial year in which they occur. Once again, I repeat: the fact that you have not ‘cashed out ‘any of these transactions for fiat is not relevant.

The situation becomes even more complicated if you are using international exchanges such as a Bittrex, Poloniex or Binance. I will deal with this complication in a subsequent section.

If you’re an Australian resident, CGT applies to your assets anywhere in the world.

Once again this point is relatively self-explanatory. It is worth noting however that the use of overseas exchanges does not shield you from the requirement to pay tax as an Australian resident.

Overseas exchanges -An additional complication.

The use of overseas crypto currency exchanges significantly complicates your calculations from a taxation point of view. That said, using overseas exchanges is a necessary evil as the vast majority of Australian exchanges will only allow you to trade in a relatively small number of crypto currencies. If you have only ever used Australian crypto exchanges then your tax situation is significantly simplified. Most of us will have used overseas exchanges however, so I will go through the following example to illustrate the complications that this introduces.

I have used a number of different Australian crypto currency exchanges, one of which is BTC Markets. A standard transaction for me would be to deposit Australian dollars into my BTC Markets account, convert that into Bitcoin and then transfer that Bitcoin to Bittrex, an American based exchange. I would use my Bittrex account to purchase the crypto currency that I was interested in holding.

In this situation I have purchased Bitcoin, transferred to an overseas exchange and most likely made a gain or loss in the time that this transaction took place. I have then purchased an asset on Bittrex in exchange for my Bitcoin. I will then hold this asset, let us assume again that it is Steem, and at some point in the future dispose of it (sell it), incurring another capital gains tax event. So, in the process of attempting to purchase Steem, I’ve had two events take place. The first is the gain or loss on the Bitcoin that I purchased. The second is the gain or loss on the Steem that I purchased. Complicating this even further is that Bittrex will provide you a transaction record which will tell you how much Bitcoin you paid for the Steem, but will not tell you what this is worth in Australian dollars. With the price of Bitcoin or any other currency fluctuating so frequently, it becomes almost impossible to know what the Australian dollar value of this transaction was. Regardless of this the ATO will require you to record the purchase price of the Steem that you have purchased in Australian dollars. Unless you are incredibly detailed in your record-keeping, and record the Australian dollar equivalent of your purchase at the time of the transaction, it is very difficult to know what the Australian dollar value of this Steem transaction was. If you are like me, you have not done this and are now faced with the issue of going back and attempting to work all these details out historically. So not only do we have the problem that we have potentially made a capital gain on the initial Bitcoin transaction, but it is also very difficult for us to determine what the actual disposal price was in Australian dollars because this price is not recorded anywhere. It will require manual calculation.

Similarly, when you sell your Steem, then the same level of detail will need to be recorded. If you are like me, you are also no longer using Bitcoin for inter exchange transactions, due to transaction fees. So, a potential series of transactions could look like this. You have purchased Bitcoin, transferred that Bitcoin to Bittrex, used that Bitcoin to buy Steem which you have held for a period of time, sold that Steem into something such as Litecoin, transferred that Litecoin back to an Australian exchange that will accept it, and then sold that Litecoin into Australian dollars. You may then withdraw to your bank account should you choose to do so. The complications of the above transaction are enormous.

Further complicating this potentially is that your average tax accountant in Australia will have no idea how to approach this, and you will be required to carry out these calculations yourself and provide Australian dollar equivalents for all of your purchases. You could certainly try to find an accountant to do this for you, but if you consider that accountants charge by the hour, the more complicated you make the task, the more expensive your tax return becomes.

How the hell am I supposed to do this?

Whilst the complications of the above situation are undeniable, there are number of ways in which you can simplify things so that it becomes more manageable. The first thing to note is that the tax department’s determinations are based on a taxation law and law is interpreted by the courts. In the Australian legal system most decisions are based on what is known as the ‘reasonable person test’. This means that as long as you can demonstrate that you have been reasonable in the way you have attempted to work out your taxes, then you should be clear from any allegations of tax avoidance. Part of demonstrating that you are taking a reasonable approach is to demonstrate consistency. This means that once you have chosen a method to calculate your tax liability, you should apply the same method consistently. Once again an example will assist to demonstrate this point.

If you go into any crypto currency exchange you can download a record of your trading history. For overseas exchanges this will give you the transaction price in Bitcoin. So, it will show that I bought a thousand units in XYZ coin, at a price of 0.001 Bitcoin per unit, and the date and time that the transaction took place. It will most likely not provide you with a value for Bitcoin at that time. To use a more specific example, assume that we made a transaction selling Bitcoin for another type of crypto currency at 1:13 PM on 21 September 2017. It would be possible to determine the price of Bitcoin at this exact point in time, but it would take a lot of work. If you had to do this for every single transaction that you had made, then this would be an incredibly complicated and time-consuming endeavour. This is where you can use the reasonable person rule.

The type of trading most similar to crypto trading is traditional share market trading. For individual shares there, is a daily closing price published, which can be used as an estimate for the price of that share on any given day. The problem with crypto markets is that they don’t have a closing time as traditional share markets do. The Australian share market closes at 4 PM Eastern Standard Time and each share has a closing price recorded, which is the price of that share at 4 PM on the day in question.

As crypto currencies are traded 24 hours a day, there is no specific closing price for any given coin. Crypto markets have adapted to this, and many traders have begun adopting the price of the coin at 2359 h UTC (Coordinated Universal Time) as the closing price for the day. 23:59 hours UTC is 11:59 PM London time. It’s possible to find historical data for the closing price for a variety of crypto coins. The following website lists historical data for BTC, ETH, and LTC amongst others.

https://au.investing.com/currencies/btc-usd-historical-data

So, if you did not know the exact dollar value of the amount of Bitcoin that you spent for any given transaction, a reasonable approach would be to take the closing price on the day that the transaction took place, and use this as your purchase or sale price. This website provides prices in US dollars, so you still have the problem of then converting the US dollars into Australian dollars to satisfy the ATO, however historical exchange-rate data for the USD/AUD exchange rate is also easily available. You now have all the information that you need to accurately record your buying and selling details.

I don’t want to pretend that that there isn't still quite a bit of work in this, however if you were to consistently apply this principle, then you would likely satisfy the ATO that you had acted reasonably in determining your tax obligations.

I mentioned above that in addition to being reasonable, you must be consistent. This is why adopting the daily closing price would be a reasonable approach. The website shown above will also give you the relevant highest and lowest points for that 24-hour trading period. You could hypothetically pick the price that gave you the best outcome in terms of minimising your tax, however if you were to do this, you would not be being consistent, and the ATO would not see this as being reasonable.

Why is this so important? Can’t I deal with it later?

The reason why people can potentially get themselves into significant trouble with capital gains tax relates to one of the points raised above.

The point at which you make a capital gain or loss is usually when you enter into the contract for disposal.

I will use an example which I would call the nightmare scenario, to demonstrate a potential worst-case example. This may not be the most likely situation that you may find yourself in, but it will illustrate the dangers of capital gains tax . The following figures are approximations only, as I’ve simplified the example to keep the mathematics easy.

Imagine that you had purchased US$10,000 worth of Ripple (XRP) on 1 January 2017 and subsequently sold it on 31 December 2017. Your purchase price would have been $0.0065, and your sale price would have been $2.47. This would have resulted in a capital gain of approximately $3.8 million. If you had taken the proceeds of the sale and reinvested into another currency, and that currency had subsequently lost a significant amount of its value, then the bulk of your profits from Ripple could be wiped out.

If you consider historical Bitcoin markets, twice in the nine year history of Bitcoin, the market has experienced a 90% decline over a twelve-month period. So, using this as a doomsday scenario, if we imagine that your $3.8 million investment subsequently declined by 90% over the next 12 months, then your investment portfolio is only worth $380,000 (approximately) by the end of 2018. This is still a tidy profit, however your problem becomes tax.

If we assume that you pay capital gains tax at a rate of approximately 45% (note that I’m using this figure because it is easy to calculate and I believe is a reasonable approximation). Your actual tax rate may be higher or lower depending on what other income you earn in the 17/18 FY. While I use a lower tax rate in my previous example above, this is based on the investor earning $50,000 in other income. The more you earn, the more tax you pay, so on extremely large gains your tax rate is likely to be closer to 50%. We will use 45% in this example.

What are the implications of all of this? As you have sold your XRP in the 17/18 FY, you would be liable to pay tax, at the end of that FY on your total gain. We have estimated this to be $3.8 million. At a tax rate of 45%, you would subsequently owe the tax office approximately $1.86 million in tax. This tax bill would fall due when you lodged your tax return for this financial year (17/18). The fact that your remaining investment of $380,000 is still a significant gain on your original $10,000 buy in, will be of little satisfaction to you, as this is less than one quarter of the bill that you owe the tax office. You could sell your entire crypto portfolio, and still owe the tax office nearly $1.5 million. In all likelihood this would send you bankrupt.

The above scenario may seem unlikely, but it demonstrates a couple of key points:

• It is possible to make large amounts of money very quickly investing in crypto currencies;

• It is possible to lose large amounts of money very quickly investing in crypto currencies; and

• The tax office doesn’t care, they only care that the correct amount of tax is declared and paid at the end of each financial year. So, the fact that you subsequently lose significant amounts of money, is of no impact to the fact that you still owe the tax office a significant amount.

While I’ve deliberately chosen to use large numbers to illustrate the potential impacts in the above example, the same principles apply regardless of the size of any gain that you make. If you earn a relatively modest income outside of crypto, and accrue a significant tax debt, and subsequently lose money in crypto currency markets, then you will still be liable to pay the tax. Stepping outside of crypto world for a moment, I regularly work with clients suffering financial difficulties. It is not uncommon to see a large tax bill as one of the factors that causes these clients to get into financial distress. Many people have been bankrupted by tax debts. The implications of getting this wrong can be very serious.

Conclusion

Hopefully the above analysis gives you some understanding of the way that capital gains tax works in relation to crypto currency investment. Hopefully it also gives an understanding of the risks involved in not appropriately declaring your earnings. One way in which the above nightmare scenario could come about could be if you were to not appropriately declare your capital gains tax earnings and subsequently be subject to audit by the ATO. The ATO can go back seven years when they audit you, so you could potentially make a significant amount of money this financial year and then be audited three to four years from now. Whether you will still have the gains from your current investments three to four years from now is questionable. You could either lose them, as in the scenario above, or you could spend them. In either case you could find yourself in a situation you have a significant tax bill and no ability to pay it.

This concludes my discussion of a capital gains tax and crypto currencies. My next article will deal with legal ways to minimise your tax obligations. I got a fantastic response to my initial article, and I welcome all feedback both positive and negative on this article as well. I’m also particularly interested to hear from people who have either sought professional tax advice from a registered tax accountant, or who may be accountants themselves. Everything stated above is my interpretation of current tax regulations based on my experience with capital gains tax and traditional investments such as shares and property, plus some research into the limited guidance of the ATO has provided on crypto. If anyone has a different point of view, or has additional information that they can provide I’ll happily edit this article subsequently to reflect that information and potentially provide a more accurate picture.

Image courtesy of Gratisography.

This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal advice prior to acting on this information. The material contained in this document is based on information received in good faith from sources within the market, and on our understanding of legislation and Government press releases at the date of publication, which are believed to be reliable and accurate.

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