How to Tax Stablecoins?

How to Tax Stablecoins?

Author: Christophe J Waerzeggers, Irving Aw, & Jess Cheng

Introduction

Neutrality is widely regarded as a fundamental principle of good tax design. In simple terms, the tax system should remain neutral, ensuring that economic decisions are based on economic interests and other non-tax factors, rather than being influenced by tax considerations.

While tax systems can be effective tools for achieving policy goals beyond taxation, most jurisdictions have thus far relied on neutrality when taxing transactions involving crypto-assets.

Under this approach to taxing transactions involving crypto-assets, jurisdictions seek to maintain a level of neutrality comparable to conventional transactions or activities, relying on the primary principles in their domestic tax legislation. This approach requires a case-by-case understanding of the facts, which is not always straightforward due to the nature and diversity of crypto-assets and the unique operations of the crypto industry. The rapid development of underlying technologies and their inherent global impact further complicates matters, as it transcends any single jurisdiction. Similar challenges exist in other legal and regulatory areas, including those aimed at designing sound regulatory and supervisory approaches for the treatment and statistics of crypto-assets.

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Stablecoins are a type of crypto-asset designed to maintain a stable value relative to a specific asset or pool of assets, such as sovereign currencies (IMF, 2021, 41; FSA, 2020, 5). In doing so, they aim to address the problem of price volatility that often makes these assets unsuitable as a store of value and a significant barrier to their wider use as a means of payment. Given the prospects of wider adoption of stablecoins, it is necessary to delve deeper into their tax treatment and related challenges.

This article argues that stablecoins, despite proving to have more stable value compared to other forms of crypto-assets, cannot serve as a means of payment and achieve wider adoption without higher tax certainty and neutrality than currently provided. Furthermore, the mismatch in tax treatment between jurisdictions creates opportunities for arbitrage and abuse, necessitating more comprehensive international cooperation and coordination to address these issues. Finally, regardless of whether the value of a specific stablecoin appreciates or depreciates, clear tax treatment is needed as taxpayers and tax authorities need to determine the appropriate tax treatment of profits and losses.

This article is divided into four parts. The first part provides an overview of stablecoins, including a classification of known circulating types of stablecoins. The second part discusses the specific value-added tax (VAT) issues related to stablecoins. The third part addresses the main income tax and capital gains tax issues arising from stablecoin transactions. The discussion refers to the practices of representative countries but does not provide a detailed summary of current practices or approaches in specific countries, nor does it cover all VAT or income tax issues that may arise from stablecoin transactions, as this would exceed the scope of this article.

1. Overview and Classification of Stablecoins

Cryptocurrencies have many advantages, including security through encryption technology, which may make them useful for payment purposes. However, the volatility of cryptocurrency prices significantly reduces their potential value as a medium of exchange and means of payment (IMF, 2020). To address this issue, stablecoins have emerged as a subclass of cryptocurrencies. Stablecoins aim to link their value to another more stable asset (such as the US dollar, precious metals, or even another cryptocurrency) or a pool of assets (such as a basket of commodities). Almost all circulating stablecoins currently attempt to mitigate price volatility through some form of pegging mechanism.

It is important to distinguish between the concepts of “pegging” and “backing,” which also depend on the nature of the claim that stablecoin holders have against the issuer. The former only requires the value of the stablecoin to be pegged to the value of the underlying asset or asset pool (e.g., requiring the issuer to redeem in US dollars). However, the latter also involves the reservation of assets by the stablecoin issuer (or a third party representing the issuer) and includes an understanding that the stablecoin has some form of claim on these underlying assets (e.g., collateralization or the use of a short-term government securities pool) as a means of supporting the peg. This distinction is important because some stablecoins may be explicitly pegged to the value of a specific asset or asset pool, but the holders lack any explicit, legally enforceable claim to the underlying asset itself.

Stablecoins can be further differentiated based on the type of reference assets they are pegged to, which can be on-chain (i.e., another cryptocurrency) or off-chain (such as traditional currencies or commodities). A stablecoin can be supported by more than one asset. For example, Tether (issued by Tether Limited, initially claiming to be backed by one US dollar per token), TrueUSD (TrustToken platform), USDCoin (a collaboration between the Centre consortium, Circle, and Coinbase), and Gemini Dollar (Gemini exchange) are all pegged to the US dollar and purportedly correspond to various underlying assets in value. LianGuaiX Gold (issued by LianGuaixos Trust ComLianGuainy) is another example of a stablecoin with an off-chain reference asset (precious metals). Each token is described as “redeemable” and “backed” by one troy ounce of London Good Delivery gold stored in a professional vaulting facility in London. This off-chain backing inevitably requires some degree of centralization, such as custody of the underlying assets by a custodian, which can be seen as diminishing the decentralized advantages of blockchain-based cryptocurrencies. In the technical realm, there are also stablecoins that claim to be pegged to or backed by various cryptocurrencies, with some stablecoins claiming to be fully decentralized, meaning that the underlying cryptocurrency is managed by a smart contract system rather than a central entity. For example, Dai operates on the decentralized Maker protocol and seeks to maintain its value by being collateralized with Ether. However, the precise operational models of different stablecoins (including the legal nature of their backing mechanisms) can vary significantly.

Stablecoins can, in theory, achieve a certain degree of price stability without the support of underlying assets. Kowala’s kUSD is an example of such a stablecoin. It claims to maintain its peg to the US dollar by increasing or decreasing its supply based on algorithmic predictions derived from market-based “oracles” or data interfaces between the blockchain and relevant market data. This type of stablecoin relies on a fully algorithmic “monetary” policy that adjusts its supply by referencing the value of the currency it is pegged to. When the supply is too low, the algorithmic protocol issues new stablecoins, but when the demand is too low, the algorithmic protocol reduces its supply (“burns” stablecoins), ensuring that the price of the stablecoin remains within an acceptable range of its pegged value. Of course, there are more complex cases, such as stablecoins known as “hybrid stablecoins” that combine support mechanisms and algorithmic protocols to reduce volatility.

As mentioned earlier, it is important to note that holders of stablecoins pegged to a certain asset do not necessarily have ownership of that specific asset. Instead, stablecoins can be pegged to the value of one asset but backed by another. For example, the value of the Saga (SGA) stablecoin is pegged to a basket of currencies based on the value of Special Drawing Rights (SDRs) by the International Monetary Fund, but the stablecoin is backed by reserves of different currencies and assets, including cryptocurrencies. Therefore, those who choose to redeem the stablecoin can receive the economic equivalent of the asset the stablecoin is pegged to, but not necessarily the asset itself. In a narrow sense, stablecoins can be further divided into two types: those with and without recourse to underlying assets.

Figure 1: Classification of Stablecoins

If stablecoin issuers can make their stablecoins price stable and have a wide user network, and if they receive the support of an association that arranges stablecoin arrangements and has a reputation and market influence, such stablecoins would be ideal as a means of exchange and store of value to achieve economic objectives. They can serve as a more efficient method of settlement for retail payment transactions, especially in jurisdictions with high currency volatility, or they can reduce the cost of cross-border payments or enable them between jurisdictions that currently lack efficient interbank payment infrastructures (IMF, 2020, 14). However, at the same time, these stablecoins may also be used by investors as speculative financial instruments, with some investors willing to take risks and attempt to profit from the value fluctuations of stablecoins. Therefore, the current challenge is to determine the position of stablecoins within the existing legal framework, including considering them from a tax perspective (Cheng, 2020). In response to the rise of stablecoins, regulatory authorities have adopted various measures, and existing regulatory frameworks may be applicable to specific types of coins (for example, the Swiss Financial Market Supervisory Authority, FINMA, has issued stablecoin guidelines based on Swiss regulatory laws, stating that anti-money laundering, securities trading, banking, fund management, and financial infrastructure regulations may all be relevant to specific coins). For these regulatory purposes, the regulatory scope of stablecoins may overlap. Specific stablecoin arrangements may fall under different regulatory regimes and be subject to them simultaneously, but tax laws require that the treatment of specific coins be determined under a single or primary category—in other words, the treatment of stablecoins can only fall under one tax law category and regime.

II. Value Added Tax Treatment of Stablecoins

Value Added Tax and Currency

The majority of value added tax (VAT) systems do not impose separate taxation on the currency paid when providing goods or services. Instead, they generally achieve this by considering the supply of such currency as “outside the scope” or explicitly excluding it from the definition of “supply” (usually implicitly). Conceptually, currency itself does not fall within the scope of consumption; it is merely a measure of consumption expenditure. VAT taxation related to the supply of goods or services (excluding currency) is determined based on this measure. Therefore, for VAT purposes, providing currency as a medium of exchange and payment for goods and services does not constitute a separate taxable transaction. This approach, in practice, also has the benefits of reducing tax complexity and avoiding double taxation on individual transactions.

On the other hand, exchanging one currency for another, i.e., currency exchange, is generally considered a supply for the purposes of VAT, but it is usually exempt from VAT. It is reasonable to exclude such transactions from the tax base of consumption because there is no consumption involved in currency exchange; it is merely an exchange between one medium of exchange and another or a pure investment. Such exempt measures are also important for promoting seamless payments as they circumvent the practical difficulties of determining the taxable amount and deductible VAT on a per-transaction basis.

Considering the supply of currency as an exempt supply rather than a non-supply (or a supply outside the scope) does have consequences. Although no tax is payable in both cases, in the case of exempt supplies, taxpayers’ right to deduct input tax depends on the quantity of currency they supply, whereas when currency supply is considered outside the scope, they generally do not have such an impact. From a compliance perspective, jurisdictions generally require the separate reporting of exempt supplies in VAT returns, while supplies outside the scope usually do not need to be reported at all.

Finally, it should be noted that VAT is only not levied when currency is used as a medium of exchange or acquired as an investment. For example, if the provided currency is coins or collectibles, it should be subject to VAT as coins themselves have intrinsic value and should be treated as the supply of goods subject to VAT.

Trends in Value Added Tax Treatment of Non-Traditional Digital Payment Methods

Jurisdictions that impose VAT seem to be increasingly willing to subject certain non-traditional digital payment methods to VAT as if they were currency, even though they are not currency and do not have legal tender status (IMF 2020, 11-12).

In the case of Skatterverket v David Hedqvist, case C-264/14 (Hedqvist), the European Court of Justice, through an interpretative approach to the purpose of Article 135(1)(e) of the EU VAT Directive, held that for EU VAT purposes, exchanging traditional currency for non-traditional “currency” units, with the intention of making a profit from the difference (or vice versa), is considered a VAT-exempt financial transaction. However, the court explicitly stated that this VAT exemption should only apply to the following non-traditional “currencies”: (1) where both parties accept it as an alternative to legal tender currency, and (2) where it has no purpose other than being used as a means of payment.

The European Court of Justice believes that the difficulties faced by exchanges of this kind, which are subject to value-added tax (VAT) (this case involves exchanges between traditional currencies and Bitcoin), are the same as those faced by exchanges of traditional currencies, namely how to determine the taxable amount and deductible amount of VAT for each transaction. Therefore, not exempting exchanges involving non-traditional currencies such as Bitcoin from VAT would partially negate the effectiveness of VAT exemption. With regard to VAT, EU member states believe that such non-traditional currencies should be regarded as currencies as long as they are subjectively accepted by all parties as substitutes for currencies and objectively have no purpose other than being a means of payment. Although Hedqvist’s case involves exchanges between Bitcoin and traditional currencies, the ruling of the European Court of Justice also means that when using non-traditional currencies such as Bitcoin to obtain goods and services in the European Union, the supply itself does not need to pay VAT as using traditional currencies does.

In 2017, Australia amended the Goods and Services Tax (GST) Act, stipulating that when digital currencies are used to pay for other goods and services, their supply enjoys the same treatment as the supply of currencies with regard to goods and services tax, that is, they are not considered supplies for the purpose of goods and services tax. The purpose of amending the law is to ensure that the definition of “digital currency” “broadly corresponds to the characteristics of the national legal currency”. Apart from other matters, digital currencies must not (1) be denominated in the currency of any country; (2) have a value that depends on or derives from the value of anything else; or (3) confer the right to accept or direct the supply of specific items, unless such a right is purely an incidental right held or used as consideration. This practice is in stark contrast to the ruling of the European Court of Justice in the Hedqvist case, which does not explicitly prohibit digital means of payment from being denominated in the national currency or its value being derived from or depending on something else, but does require that digital means of payment have no other objective function besides being a means of payment. Therefore, according to Australian tax law, if a digital means of payment does not meet the definition of “digital currency” because its value depends on or derives from something else, it will be considered a “financial service supply subject to input tax” (i.e. exempt from output consumption tax and generally not allowed to deduct input tax).

Similarly, since January 1, 2020, Singapore has in fact treated digital payment tokens as currencies for goods and services tax purposes; that is, payment with digital payment tokens does not constitute a supply, and the exchange of digital payment tokens for traditional currencies or other virtual currencies is exempt from goods and services tax. The proposed definition of “digital payment token” in the new Section 2A of the Goods and Services Tax Act is similar in general to Australia’s definition of “digital currency”, but there are two noticeable differences. First, the definition excludes tokens that (1) confer the right to accept or direct the supply of goods or services; and (2) no longer have the function of a medium of exchange after the right is used. This is more lenient than Australia’s practice, which prohibits digital currencies from providing any non-incidental right to receive or direct the supply of any goods. Second, tokens cannot be denominated in any currency, nor can they be pegged to or supported by any currency by their issuer, while Australia’s approach does not allow tokens to be denominated in any currency or have their value derived from or dependent on anything. However, despite the clear legislative wording, the Inland Revenue Authority of Singapore (IRAS) stated in its recent e-Tax Guide that tokens “pegged to or supported by any legal tender, basket of currencies, goods or other assets” should be regarded as derivatives, that is, their supply also constitutes a financial service supply exempt from consumption tax (IRAS 2022, paragraph 5.7).

VAT and Stablecoins

As mentioned earlier, the volatility of cryptocurrency prices often makes it unsuitable as a store of value and hinders its widespread use as a means of payment and medium of exchange. The emergence of stablecoins aims to address this issue by pegging their value to other relatively stable currencies or assets. However, the pegging mechanism means that, according to the approaches of Australia and Singapore, stablecoins will always be treated as derivatives rather than currencies. Therefore, their supply will be exempted instead of completely ignored, resulting in substantial VAT implications for the parties involved, both in terms of substance and administrative or regulatory compliance. Although Australia’s approach is more tolerant towards tokens that have purposes other than being used as a means of payment compared to the approach of the European Court of Justice, it does not change the fact that stablecoins can only be categorized and cannot be considered as currencies because they are inevitably pegged to other assets or currencies to maintain stability.

On the other hand, according to the approach of the European Court of Justice, the pegging mechanism, whether it is pegged to currency or other assets, does not in itself exclude the possibility of subjecting stablecoins to VAT as currencies, provided that the parties subjectively consider stablecoins as substitutes for currencies and objectively have no other purposes other than being used as a means of payment. Regarding the former requirement, the stability of coins or tokens can to some extent support the presumption that the parties are more likely to use them as substitutes for currencies. On the other hand, since the lack of stability itself does not prevent traditional currencies from being considered as currencies for VAT purposes, their relative stability should not be decisive. The strictness of the latter requirement – that tokens objectively have no other purposes other than being used as a means of payment – may exclude hybrid tokens, including hybrid stablecoins, which may have other objective purposes besides being used as a means of payment.

Pegging and/or Redemption Rights?

In the explanatory memorandum of the revised Australian Bill, it is considered that the value of digital currencies is the same as traditional currencies in the sense that “it must be derived from the evaluation of the currency value by the market for the purpose of exchange, although it has no intrinsic value.” Therefore, for goods and services tax purposes, pegging the value of digital payment instruments to another asset or currency will exclude such units from qualifying as digital currencies and will be treated as derivatives whose prices directly depend on the value of their underlying assets or currencies.

However, given that many traditional currencies in fact or legally also use one or more major currencies as exchange rate anchors, it is not clear why pegging to a traditional currency or a basket of traditional currencies itself automatically deprives non-traditional digital payment instruments of the qualification as currencies for goods and services tax purposes. In addition, the analogy between stablecoins and derivatives is not entirely correct. Most derivatives are financial contracts that generate rights and obligations between the parties based on the value of the underlying asset or currency at a predetermined date or event in the future. In contrast, stablecoin holders have open-ended rights or claims against their issuers or others, on demand, without involving fixed future dates or events, and for algorithmic stablecoins or seigniorage stablecoins, holders can only make unsecured claims against the issuers since there is no asset backing and no possibility of redeeming any other assets. Similarly, for stablecoins with asset backing but unclear or non-existent redemption rights over the underlying assets – including due to lack of consumer protection regulations – stablecoins do not provide any recourse to the assets for their holders, even if these assets in some way are used to maintain the value of stablecoins, regardless of their mechanisms.

On the contrary, stablecoins pegged to sovereign currencies are more similar to transferable promissory notes, banknotes, or traveler’s checks, where the holder can redeem them on sight. They function as a substitute for fiat currency but are issued by private entities rather than sovereign nations and do not have legal tender status (meaning, unless otherwise specified in a contract, the law does not require creditors to accept redeemable stablecoins as payment for monetary debts). The fact that stablecoins are not issued by sovereign nations (through central banks) should not determine whether they are considered as currency for value-added tax (VAT) purposes. For example, bank deposits representing claims against commercial banks are privately issued but still considered as currency. Regardless, for VAT or consumption tax purposes, treating certain types of privately issued non-traditional digital currencies as currency implies that it is not a prerequisite for them to be issued by sovereign nations. Similarly, the fact that certain jurisdictions treat certain types of non-legal tender digital payment instruments as currency for VAT purposes implies that legal tender status is not a necessary condition for them to be primarily used as a medium of exchange and means of payment. In fact, VAT laws generally do not require items considered as currency to have legal tender status.

However, stablecoins pegged to assets other than sovereign currencies raise concerns about VAT leakage or tax avoidance, as the supply of the underlying assets may be subject to taxation. If the parties do not intend to use stablecoins as a medium of exchange but rather as a supply or substitute for underlying assets, there is a risk of tax leakage as long as the supply of the underlying assets does not fall within the scope of taxation or exemptions. The low barriers to token creation and issuance make this issue more complex, as individuals may potentially evade VAT on taxable supplies of goods by repackaging transactions as token issuances and transfers. The regulatory framework for financial technology is still in its early stages, and many jurisdictions have expressed the need to avoid impeding innovation and entrepreneurship when designing regulatory regimes. However, the absence or inconsistency of regulations may also make it more difficult for tax authorities to monitor any transactions involving underlying assets, or even the existence of underlying assets.

Therefore, the requirement that the value of digital payment units should not be linked to the value of any other goods, as seen in the approaches of Australia and Singapore, can be reasonably interpreted as a means to address this potential leakage and avoidance. The approach of the European Court of Justice does not impose this requirement but focuses on the subjective intention of the parties to the transaction and whether the tokens are used as a substitute for currency. While the subjective intention test allows for the consideration of different relevant factors as a whole and does not exclude tokens that are linked to the value of other assets, it may be more difficult to determine in practice, thereby reducing tax certainty for taxpayers and tax administrations.

Hybridity

Tokens may have more than one functional characteristic, which poses additional challenges for tax classification and other purposes. The objective test in the Hedqvist case by the European Court of Justice addresses the issues of leakage and tax avoidance by denying currency-like treatment for tokens that have any other use besides being a medium of exchange (i.e., pure payment tokens) for VAT purposes. Under this approach, any other type of token would not be considered as currency for VAT purposes and their supply would generally be subject to taxation unless they are sufficiently similar to financial transactions that enjoy existing exemptions.

However, many tokens with other built-in functionalities have the potential to be widely accepted as a medium of exchange and payment. In this regard, the Australian incidental benefits test seems to be less stringent than the EU approach, as it allows tokens primarily designed as payment tokens to be considered as digital currencies, as long as the non-payment functionalities of the currency are incidental to its primary purpose as a medium of exchange. As explained in the explanatory memorandum of the Australian amending bill, the purpose is to ensure that “many common incidental functionalities in the operation of digital currencies, such as updating distributed ledgers to confirm transactions, do not affect the status of these currencies as digital currencies.”

The payment instrument test in Singapore’s Goods and Services Tax legislation is the most lenient among the three methods, with no restrictions on the primary or incidental extent of non-payment functionalities of hybrid tokens. Instead, the ability to use the token as a medium of exchange and payment comes after the exhaustion of non-payment benefits or rights. However, this approach presents challenges in distinguishing between the supply of money and the supply of vouchers, as vouchers can continue to exist as payment instruments even after the exhaustion of welfare or rights. This can be illustrated by Example 2 in the IRAS e-Tax Guide:

Example – Digital payment token used to receive specified services and can be used as a medium of exchange

StoreX is a digital token designed to be the exclusive payment method for X Company’s distributed file storage network. According to its initial token issuance terms, StoreX grants holders the perpetual right to a specified amount of file storage space. The token can also be used to pay for goods and services from other merchants on the X Company platform, even after exercising a specific amount of file storage rights. If all other conditions for a digital payment token are met, StoreX would qualify as a digital payment token.

In this example, despite also having file storage rights, the StoreX initially issued by X Company is considered a supply of money as it falls outside the scope of goods and services tax. Assuming the token only had file storage rights, it would be treated as a product voucher and subject to goods and services tax upon issuance. However, since StoreX has payment functionalities, it is treated as money rather than a voucher and the provision of file storage services is not subject to tax.

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