The volatility of crypto-assets forces a lot of users to pay attention to the tax implications of any holdings. Unlike most other investments, the fact that these assets can move by 50% in a matter of days, it’s really important that tax implications are kept front of mind.
It’s not just the volatility of crypto assets that’s dangerous
In addition to this price volatility, when you throw airdrops or payments in crypto into the mix, it’s all too easy for companies and individuals to get stung with hefty tax bills that were generated during the boom times, but need to be paid for during the bust times.
None of what I’m discussing here is tax advice. However, it is important to keep in mind these implications if you or your company is based in a jurisdiction such as the UK, EU or America which treat crypto asset holdings in a similar manner to other investable assets.
E.g. when you buy and subsequently sell an asset if its price has appreciated, there may be a tax on the gain, but conversely, if it has depreciated, there may be a loss you can use to offset other taxes.
Keeping tabs on your capital gains is standard for most investors, and a number of crypto tax solutions have emerged in the past few years to make this experience seamless for anyone investing or trading in cryptocurrencies.
Take one of the aforementioned sports stars as an example. Imagine one of them is paid a $1m bonus in crypto. It’s not unfeasible they’d need to pay 36% in taxes on that income. If that crypto had since dropped 50% (which Bitcoin and other cryptos did do in the past 12 months), they’d be left with just $140,000 after paying their $360,000 tax bill. There is a loss in a future tax year that may enable them to claim some of it back, but it’s a far from ideal situation to be in.
During bull markets only the disciplined tend to sell their investments, hence it’s highly likely that a number of firms and people find themselves in similar positions. The cruel irony is that many of these crypto holders are long-term investors and are forced into selling holdings when they want to do it least. There are other options such as relocating to a more crypto-tax-friendly jurisdiction, but depending on your own circumstances, such a move simply may not be possible.
There is however some potential upside during these downturns, and this is due to the various crypto assets that exist that are either equivalents or derivatives of one another. In the equivalents category, we have wrapped tokens and tokens that exist on multiple blockchains. For instance, you have WETH and WBTC tokens on the Ethereum network, which are ERC-20 compatible tokens that can be used for transacting with bitcoin or Ether with smart contracts. The advantage of using these wrapped versions is that as they are compatible with the ERC-20 token standard on Ethereum, any applications that support them could potentially support these assets without having to develop bespoke code for these cryptocurrencies specifically.
These equivalent tokens are a grey area in terms of their tax treatment, as some jurisdictions have mandated that any time a token is exchanged for another it is considered a taxable event, which in theory could include going from Ether to its wrapped equivalent WETH. However, it’s likely that these types of tokens would be considered edge cases, otherwise every time someone was on the losing side of an investment or trade, they could simply sell into a wrapped version of the token to realise a loss, which I doubt any tax authority will be happy with.
This also causes issues for those users who have to transition to a wrapped token in order to bid on an NFT on OpenSea, this could trigger a capital event for them which may not be particularly fair if there’s price appreciation of the underlying asset they were using to place a bid in if they don’t end up winning the auction.
Lido alongside other protocols such as Rocketpool (which uses RETH) enables individuals to stake on Ethereum’s new network that facilitates proof of stake consensus without the overhead of providing 32 Ether which is the standard requirement to stake on the network natively. Each of these protocols has its own token which will be redeemable on a 1:1 basis for real Ether once withdrawals are possible after the Ethereum network has transitioned to proof of stake. As these are regular ERC-20 tokens, they are also tradable on DeFi platforms such as Uniswap and Curve, which means they are in some respects similar to futures.
They are priced currently at a discount relative to the future price of Ether, which is what they should be worth when they can be exchanged for Ether via the Lido or Rocketpool smart contracts down the line.
The merge to Ethereum hasn’t quite yet happened, and even when it does, it will likely be 6-9 months until staked funds can start being unlocked and withdrawn. Hence there is additional risk in these assets as if there were further delays to the unlock, holders will have to wait longer to redeem their stETH or RETH for real Ether.
Finally, there is also a delivery risk in the form of smart contract code. These Ether staking protocols hold staked Ether in smart contracts, were they to be compromised it could affect the ability of users to redeem staked ETH for real Ether. This combination of factors means that these derivative tokens such as stETH and RETH, whilst exhibiting discount pricing relative to Ether much like a bond, are not like wrapped tokens, as there is additional risk in holding them.
Like with wrapped tokens, the tax treatment of these derivative tokens isn’t completely clear. However, given the properties they exhibit are more analogous to a different type of token versus the underlying token they are derived from, I would not envisage them being treated as equivalent to the underlying. In much the same way as if you sell a Blackrock ETF for an equivalent Vanguard ETF, one hopes that moving from a cryptocurrency on one network to a derivative on another will enable you to crystallise some losses when they happen without moving out of your existing investment thesis.
Realising cryptocurrency losses is something that was not widely discussed during the most recent downturn. However, as with other aspects of investment management be that for a treasury or personal funds, it’s important that people keep these opportunities front of mind.
The tax treatment of certain activities is unfortunately still a grey area in certain jurisdictions, but as long as one is forthcoming and does not try to obscure their activities, one should find themselves on the right side of the authorities and in a position to have used the market turbulence of the past few months to help reduce their overall tax bills.