In Part 1 of our Insights | Bitcoins and blockchains series we introduced the concepts of Bitcoin and blockchains; we also discussed some of the commercial reasons why Bitcoin surged in popularity as a digital currency and alternative means of settling transactions.
Parts 2 to 4 of our series will explore potential applications of blockchain technology to the banking, corporate governance applications and specific areas of law. We also consider the legal and tax implications from adopting blockchain technology.
Revolutionising the banking sector
By definition, trades involve a process of input-output valuations, counterparty risk assessment and authorisation. All these elements can involve human intervention which can be subject to manual error or manipulation.
As we see it, the role of blockchain applications in the banking sector will be to reduce the level of human intervention (and with it operating expenses) to facilitate a “frictionless” economic exchange by standardising commercial terms and minimising counterparty risks (the latter perhaps by screening or gating market participation with entry criteria). Moreover, a departure from exchanges in different currencies has an advantage of standardising trade valuations such that one might expect less arbitrage opportunities (or possibly more in cases of asymmetry in programming and computing efficiency) as computer algorithms transact on common measures of value and at virtually instantaneous speeds.
Further, blockchain technologies could result in a disruptive environment of increased economies of scale and reduced capital raising costs in the automation of loan aggregation and syndication, effectively resulting in the demise of traditional lending models. Just as how Uber has disrupted taxi industries worldwide, Blockchain technology is an existential threat to the Big 4 banks, with the CEO of Commonwealth Bank recently quoted saying “If we don’t innovate successfully we’re toast”.
With all the potential applications to the banking sector, it is little surprise that the world’s banks are now taking blockchain technology seriously and are heavily investing in this emerging technology.
Insight: with automation comes the risk of systematic market failure and the possibility of stop-loss meltdowns all occurring beyond the speed of human intervention. From a risk management perspective, it will also become even more essential to build safeguards, checks and balances and external review processes (external advisors will need to increase their technological capabilities) to minimise the probability of runaway scenarios, aberrant trading outcomes and loopholes capable of exploitation. There are also prudential banking considerations to incorporate into Smart Contracts to avoid inadvertently breaching capital market rules.
Income tax profile of blockchain commercial paper trading
Tax practitioners may be familiar with the Taxation of Financial Arrangements (TOFA) Stage 3 & 4 legislation which applies to certain entities (such as banks and other financial institutions).
A profit or loss on a blockchain transaction, assuming the taxpayer is caught by the TOFA provisions and has elected to rely on their financial reports, will simply be included in their financial reports and equally their assessable income. Should the transaction involve a crypto-currency, it must be converted into an Australian dollar equivalent, which may also give rise to taxable currency conversion gains or losses.
The taxation of blockchain commercial paper trading for taxpayers outside the TOFA Stage 3 & 4 provisions will depend upon a range of factors:
- if the taxpayer is in the business of buying and selling securities and instruments such as commercial paper, gains and losses are most likely caught under the trading stock provisions;
- if the taxpayer is not in such a business, but nevertheless engages in commercial paper trading in its ordinary business operations, we expect such trades will be taxable under the ordinary income provisions;
- if the taxpayer does not ordinarily buy and sell commercial paper, the Australian Taxation Office holds the view that cryptocurrency is a CGT asset and therefore any trades will realise a capital gain or loss to be brought to account in the taxpayer’s assessable income (with the possibility of a CGT discount for eligible taxpayers).
We concur with the ATO’s current position. However we believe the greatest tax controversy will arise in taxpayers’ classification of trading gains or losses within the categories above, as trading stock elections can result in different year-end tax outcomes, as will the application of the capital gains tax regime.
Insight: it will be necessary to appropriately document organisational intentions and transactions involving material amounts in order to arrive at the appropriate outcome (remember – taxpayers bear the onus of proving an assessment is excessive).
Taxpayers outside the TOFA Stage 3 & 4 provisions will also be required to bring to account the implications of cryptocurrency conversion to Australian dollar amounts.
GST profile of blockchain commercial paper trading
The ATO’s position is that transacting in cryptocurrency may result in a taxable supply for Australian GST purposes.
This brings into question the sophistication of Smart Contracts and the determination of whether a particular blockchain commercial paper transaction is subject to Australian GST. For example, the ATO accepts that the ordinary GST exemption for Bitcoin trading will apply to Bitcoin transactions with non-residents; to further consider the export scenario, from a computer logic perspective, the Smart Contract must embed a decision-making function to determine whether the counterparty is outside of Australia in order to ensure the price excludes GST.
Insight: failure to correctly apply GST on cryptocurrency transactions will result in over-charging counterparties (a competitive disadvantage) or under-reporting (a 10% cost to the supplier for failing to charge and remit GST).
International taxation of blockchain commercial paper trading
The domestic Australian taxation of blockchain commercial paper trading is, in our view, relatively settled in light of the ATO’s publications on Bitcoin transactions.
However, we consider there are significant uncertainties for offshore market participants in cross-border Cryptocurrency based transactions with Australian residents.
Australian (and international) taxation law has been struggling (and still struggles) to correctly assign taxation rights between competing jurisdictions involving intangibles and digital transactions. This difficulty arises due to principles concerning the source of profits, location of contract formation, server location and the location of traditional decision-making authority.
In the context of blockchain technology, cross-border transactions are further complicated by the maintenance of a central ledger of transactions (see for example how Bitcoin technology works) and the automation of transactions which could mean that existing legal principles will be inadequate when determining the taxation of cross-border cryptocurrency transactions.
Offshore cryptocurrency participants dealing with Australian counterparties will also need to consider the implications of applicable bilateral/multilateral tax treaties and trade agreements.
Insight: in practice, it will be necessary for offshore cryptocurrency participants dealing with Australian counterparts to seek professional advice as significant penalties may be levied against taxpayers which fail to reasonably act on their Australian tax liabilities. This is particularly the case where economic double taxation arises.
This article is intended to provide commentary and general information. It should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this article.
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Part 2 of our Insights | Bitcoins and Blockchain series was slightly delayed due to various circumstances. Part 3 will include a detailed critique of technological limitations to specific areas of law and we anticipate many readers will enjoy the article.