In this first article on cryptocurrency, I will seek to demystify the basic terminology surrounding virtual currency and then in subsequent articles explore the UK taxation issues affecting cryptocurrency.
How did it begin?
The first recorded transaction on Bitcoin was on 22nd May 2010, when two friends traded 10,000 Bitcoins for two Papa John’s pizzas. The nominal value of the bitcoin was then around $0.004.
In 2017, there was an explosion of ventures in London and Silicon Valley seeking to cash in on Bitcoins underlying technology, Blockchain. The price of bitcoin soared to $20,000, making the 10,000 bitcoins paid for the two pizzas back in 2010 now worth $20 million.
This stratospheric rise in bitcoins value has attracted investors who are making large gains and large losses, resulting in taxpayers and HMRC grappling with how these transactions should be treated from a UK tax point of view.
Before we try and answer the above questions, we need to understand some basics.
There is no generally recognized definition of what a cryptoasset is. However, there is the following categorization based on their economic function:
· Payment Tokens – tokens which are intended to be used, now or in the future, as a means of payment.
· Utility Tokens – tokens which are to be used to provide access digitally to an application or service.
· Asset Tokens – tokens that represent assets such as debt or equity on the issuer. Asset tokens promise, for example, a share in future company earnings i.e. similar to ordinary shares in a limited company.
Bitcoin is a payment token.
What is cryptocurrency?
Cryptocurrencies have no value deemed by law. Their value is determined simply by what someone is willing to pay for them.
The key feature of cryptocurrency is that it is not issued by a central bank and is not deemed by law to be legal tender. Bitcoin is the most well-known example of a virtual currency, and it was the first cryptocurrency.
The role and problem with traditional banks and trust
Generally, two parties doing business need a third-party intermediary to build trust between them so they can transact. Two parties would not generally inspect each other’s financial position before they do business. They would trust a bank to do this, as the bank would verify that each party has the resources to complete the transaction.
In order to build trust, the bank must maintain an accurate ledger system, to prevent inaccurate or fraudulent transactions. This is often referred to as the ‘double spending problem.’
This trust is reinforced by having the entire banking system overseen by regulators, such as a central bank.
How does Bitcoin solve the double spending problem?
A paper published by Satoshi Nakamoto best summaries this issue:
“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”
For this reason, Bitcoin is sometimes referred to as a trustless system.
How are bitcoins acquired?
To acquire bitcoins and participate in the network, you must acquire a digital wallet. A digital wallet is normally acquired when you download any bitcoin software, and is where you sign in and authenticate transactions.
Then it is simply a matter of purchasing your cryptocurrency using a credit or debit card, usually via a broker.
In my next article I will explore the taxation consequences of cryptocurrency gains and profits.
Should you have any queries on the UK taxation issues surrounding cryptocurrency, contact us at email@example.com