Crypto: nudge letters and tax treatment

Cryptocurrency is the name given to any form of currency that exists digitally and uses cryptography security for transactions. Each transaction in a particular cryptocurrency is recorded on a public ledger called a blockchain. Data is recorded in blocks and added to a chain on which all transactions form an irreversible timeline. This makes it very difficult to disguise or manipulate transactions.

Cryptocurrencies are still in their infancy but are intended to have many real-world uses and can be seen to be more widely accepted with each passing month. The most widely known of which is Bitcoin. Many cryptocurrencies have increased significantly in value over a short period of time as a result of their increased popularity.

The ‘nudge’ letters are based on information received relating to individuals with an interest in cryptocurrency or crypto assets, from crypto exchanges which do business in the UK. These exchanges are now obliged to share information with HMRC.

Cryptocurrencies are decentralised, with no regulating authority. Whilst many maintain they are a form of currency, HMRC’s view is that cryptocurrencies are a chargeable asset and transactions should be treated accordingly.

In some limited cases, cryptocurrencies are taxed under income tax provisions, such as when coins are being mined or where the number and scale of transactions mean HMRC consider an individual is trading. Due to the limited circumstances of income tax treatment this will not be discussed in any more detail here. HMRC has published a guidance manual on crypto assets detailing the taxation of such assets.

In most cases, trading in crypto is considered an investment and is liable to Capital Gains Tax (CGT) in the same way transactions in shares and securities are. A gain is calculated as the excess of the sale price after deducting incidental costs of sale and purchase. This also applies to Non-Fungible Tokens (NFTs) as another increasingly popular type of crypto asset.

Each tax year, an individual has a CGT Annual Exempt Amount (AEA) to set off against net gains, currently £12,300 for the 2021/22 tax year. Only one AEA is granted per tax year, regardless of how many types of investment an individual has. Therefore, if an individual has other types of gains in the year, for example on disposals of shares or property, the AEA may already be extinguished.

With the significant increases in value many cryptocurrencies have seen over the last few years, an individual who may have previously invested a small amount of money could be facing a significant capital gain once a disposal is made, even with full AEA available.

Furthermore, the biggest potential pitfall is for those who have not taken professional advice. Multiple cryptocurrency transactions in a year, including the reinvesting of funds, is likely to trigger a capital gain. We expect the lack of awareness and knowledge of UK tax rules around crypto assets to create issues for many taxpayers in the future.

To illustrate this, if an individual bought Ethereum using Bitcoin, a disposal of Bitcoin would have been made and the gain on disposal would need to be calculated. An individual may make many such transactions in one day. It is easy to see how an accumulation of such transactions over a tax year could lead to gains exceeding the AEA.

Individuals who are trading in this way may not have obtained UK tax advice and may be completely unaware that crypto assets are subject to UK taxation rules. The first time they become aware may be when HMRC contacts them. HMRC would expect taxpayers to obtain a full understanding of how crypto assets are taxed and will not accept ignorance as an excuse.

In this situation, if any liability is discovered by HMRC, penalties and interest charges will arise. The penalty rates would be significantly higher than in cases where a voluntary, unprompted disclosure is made to HMRC.

Use of offshore structures, if it sounds too good to be true it probably is. The legislation is in place to combat those who wish to avoid or evade UK tax, these structures may not be effective in their aim, with the individual remaining fully taxable in the UK on their crypto asset gains. Such a structure could ultimately cost the taxpayer more in administration fees, interest and penalties. If you are considering such a structure or already have one in place, we strongly recommend obtaining UK professional advice.

HMRC take a very strong stance on unpaid tax when there is an offshore element present. In the worst-case scenario, Failure to Correct (FTC) penalties can be 200% of the tax liability. In addition, a further penalty of 50% of the tax could be levied for an ‘asset move’. This is where assets are considered to have been moved from the UK or other jurisdictions, to avoid UK tax or to disguise non-compliance with UK tax legislation.

We strongly advise considering your position with regards to cryptocurrency and taking professional advice to understand your tax position and ensure your filings are correct and up to date. HMRC has an ever-increasing interest in crypto assets, especially due to their steep increase in value. HMRC are receiving more information than ever on users of crypto exchanges and have set up a specific team to tackle non-compliance.

HMRC have the powers to recover funds directly from the bank account of an individual who owes it money. In November 2021 they issued a consultation taking views on HMRC updating their powers to extend to digital wallets. If this came to fruition this would obviously impact those holding cryptocurrency, with HMRC having the power to seize coins directly from a wallet.

If you have received a letter from HMRC with regards to your crypto assets or would like to discuss the potential UK tax effects of your investments in crypto assets, please contact Danielle Ford, Head of Tax Disputes & Resolutions.