Demystifying Cryptocurrency Taxation in England: Insights from Fabrizio d’Aloia v Persons Unknown

On 12th September 2024, Richard Farnhill, sitting as a deputy judge of the Chancery Division, handed down a pivotal decision in the High Court case Fabrizio d’Aloia v Persons Unknown. For the first time in English law, a contested hearing confirmed that the crypto token Tether (USDT) could attract property rights. This landmark ruling has broader implications for other tokens, such as Bitcoin and Ether, and touches on essential topics like fraud, constructive trusts, and the following and tracing of cryptoassets.

While this decision breaks new ground in legal recognition, it comes as no surprise to HM Revenue & Customs (HMRC). The taxman has long treated cryptoassets as property, applying existing tax laws without hesitation. But what does this mean for the ever-evolving world of crypto, and how is HMRC keeping up with technological advances? Barrister Leigh Sagar breaks it down.

HMRC’s Stance on Crypto

HMRC operates on the assumption that crypto is just another class of property, subject to the same tax principles as more traditional assets. This approach is outlined in the Cryptoassets Manual, a growing online resource that dives into the technicalities of crypto transactions and their taxation. While comprehensive, the manual occasionally raises eyebrows with its interpretations, leaving room for debate among practitioners.

Currently, there’s no crypto-specific legislation in the UK. Instead, HMRC applies existing tax rules to crypto transactions, proving adept at navigating this modern frontier with minimal difficulty. However, the complex operations within decentralised finance (DeFi) have prompted HMRC to explore simplified approaches to taxing these innovative systems—more on that later.

Taxing the Basics: Bitcoin and Beyond

Let’s start with the original crypto tokens like Bitcoin, which serve as secure, albeit blunt, instruments for transferring value. Taxation here is relatively straightforward:

• Income Tax: Applicable if crypto activity qualifies as trading, an employee receives salary in crypto, or tokens are mined.
• Capital Gains Tax (CGT): Charged when a token is sold, exchanged, or gifted, with specific rules for calculating the cost base of previously acquired tokens.
• Inheritance Tax: Applies to gifts of tokens that reduce the donor’s estate.
• VAT: Due if goods or services are sold in exchange for crypto.

Tokens held on trust are subject to trust law, and while the majority of cases run smoothly, proprietary challenges do arise, such as determining the situs (location) of tokens.

The Situs Dilemma: Where Do Crypto Tokens “Exist”?

Cryptoassets don’t exist physically, creating hurdles when enforcing court orders or applying tax laws. English courts are wrestling with this issue, but HMRC offers a pragmatic solution: the location of crypto is tied to the tax residence of its beneficial owner.

For example, if a UK-resident taxpayer holds crypto via an exchange in New Zealand under a custodial agreement, HMRC considers the crypto located in the UK. This functional approach may not align with legal theory, but it simplifies taxation. However, some argue that crypto tokens should be treated like tangible assets—able to “move” globally, like art or jewellery.

DeFi: A Taxing Frontier

Enter decentralised finance (DeFi), where blockchain technology replicates traditional financial services like lending, trading, and derivatives in innovative ways. DeFi systems are complex, with intricate transactions that can create a tax headache.

Here’s an example:

1. A user deposits tokens into a DeFi platform for lending. If ownership transfers, CGT may apply.
2. When the platform lends the tokens to another user, additional tax implications arise.
3. Upon repayment, the platform compensates the original depositor with tokens—raising questions about whether the compensation is taxable as capital or income.

Recognising the unwieldy nature of taxing each step, HMRC is considering a simplification: ignoring intermediate transactions within DeFi systems and taxing only the final outcome. However, these changes won’t be retrospective, leaving early adopters to navigate the complexities of existing rules.

Embracing Technology

Modern technology aids compliance, with software that calculates taxes on crypto transactions and blockchain explorers that provide real-time valuations. HMRC accepts web-based valuations if they’re from reputable sources, adding a layer of transparency for taxpayers.

Looking Ahead

The legal and tax landscape for cryptocurrency is still evolving, but rulings like Fabrizio d’Aloia v Persons Unknown provide clarity and precedent. As crypto continues to integrate into traditional finance, practitioners and taxpayers alike must stay informed and adaptable.

Need Expert Advice on Crypto Matters?

Cryptocurrency and blockchain technology are transforming the legal and financial landscape, but navigating these complexities can be challenging. At Quartz Barristers, we specialise in cutting-edge legal issues, including crypto litigation, taxation, and decentralised finance.

Whether you’re a business exploring the potential of DeFi, an individual with tax concerns, or involved in a dispute over cryptoassets, our experienced team is here to help.

Contact us today to discuss how we can support you in this fast-evolving space.