Cryptocurrency has moved rapidly from the margins of the financial system into mainstream discussions about investment, regulation and taxation. What remains considerably less settled is how governments should treat an asset class that does not fit neatly within traditional definitions of currency, property or financial assets.

I recently came across an interesting discussion of cryptocurrencies and tax regimes in Wealth Management. It is worth reading because the underlying issue extends well beyond cryptocurrency itself: as capital becomes increasingly digital and mobile, governments are being forced to reconsider how traditional tax rules apply to new forms of wealth.

Cryptocurrency and the Tax System

The central difficulty is that cryptocurrency does not fit comfortably within the traditional tax framework.

Bitcoin and other cryptocurrencies can be used as a medium of exchange, held as an investment, transferred between individuals or exchanged for other digital assets. Depending on the transaction, the same asset can therefore have characteristics resembling money, an investment asset or property.

The United States had already addressed part of this issue. In 2014, the Internal Revenue Service determined that virtual currency would generally be treated as property rather than currency for federal tax purposes. Consequently, established principles governing property transactions could apply when cryptocurrency was sold, exchanged or used to purchase goods or services.

That approach provided a degree of certainty, but it also demonstrated the limitations of applying an existing tax system to a new asset class.

Taxation Follows the Transaction

The important point for investors is that the tax consequences generally depend upon what the taxpayer does with the cryptocurrency.

Buying and holding an asset is different from selling it.

Exchanging one cryptocurrency for another can also constitute a taxable event under U.S. rules, because the transaction can be treated as a disposition of property. Similarly, receiving cryptocurrency as compensation can produce ordinary income rather than simply creating an investment gain.

The IRS reinforced these principles in 2019 when it issued additional guidance concerning virtual currency transactions, including the treatment of cryptocurrency received through certain hard forks.

This illustrates an important characteristic of cryptocurrency taxation: the tax treatment cannot necessarily be determined simply by asking what the asset is. The nature of the transaction is equally important.

Different Countries, Different Approaches

The United States was not alone in confronting these questions.

The OECD’s October 2020 report, Taxing Virtual Currencies: An Overview of Tax Treatments and Emerging Tax Policy Issues, examined the approaches being taken across more than 50 jurisdictions. The report identified significant differences in the treatment of cryptocurrencies for income, consumption and property-tax purposes and highlighted the fact that policymakers were still developing appropriate frameworks.

This divergence is important.

Traditional investment assets are generally subject to reasonably established principles within each jurisdiction. Cryptocurrency, by contrast, presents governments with a relatively new set of questions concerning classification, valuation, reporting and enforcement.

The result is a fragmented international landscape.

One jurisdiction may treat cryptocurrency primarily as an investment asset. Another may take a different approach to capital gains. A third may impose specific rules relating to exchanges or digital-asset businesses.

For internationally mobile investors, those differences can become highly significant.

The International Tax Dimension

Cryptocurrency also exposes a broader problem in international taxation.

The traditional tax system developed around concepts such as residence, source, physical assets, financial institutions and identifiable intermediaries.

Cryptocurrency can operate across borders without necessarily requiring the same traditional infrastructure.

An individual can hold digital assets through an overseas exchange, transfer assets directly to another person, exchange one digital asset for another, or maintain digital wealth without holding it through a conventional bank.

That does not mean that cryptocurrency exists outside the tax system.

It means that enforcement becomes more complicated.

Governments have therefore increasingly focused not only on how cryptocurrency should be taxed, but also on how transactions should be identified and reported.

This trend fits within the broader movement toward greater financial transparency discussed in FATCA and Foreign Bank Accounts. The question is increasingly not simply where wealth is held, but how governments can obtain sufficient information to identify and tax it.

Transparency and the Digital Asset

This issue is particularly important because cryptocurrency can challenge traditional assumptions about financial intermediation.

A conventional bank provides governments with an identifiable institution through which transactions pass.

A decentralised digital asset can operate through a distributed network rather than a conventional financial intermediary.

The OECD specifically identified tax administration, compliance and the potential for tax evasion as important policy questions in its 2020 analysis.

The European Commission was examining similar questions.

In a February 2021 discussion concerning the EU’s tax transparency framework, the Commission noted that the use of crypto-assets and e-money created difficulties for tax administrations because traditional reporting mechanisms did not necessarily capture these assets or the intermediaries through which they moved.

This was an important indication of where the debate was heading.

Regulation and Taxation Are Becoming Connected

Taxation cannot be considered separately from financial regulation.

In September 2020, the European Commission proposed a comprehensive framework for markets in crypto-assets as part of its Digital Finance Package. The proposal sought to provide greater legal certainty while addressing risks to consumers, investors and financial stability.

The regulatory question and the tax question are closely connected.

Once an asset class becomes more clearly regulated, governments are better able to identify the institutions and businesses operating within that market. Greater regulatory visibility can, in turn, make tax administration easier.

The result is likely to be a gradual movement toward greater integration between cryptocurrency regulation, financial reporting and taxation.

The Wealth Management Perspective

For wealth managers and private investors, the issue is therefore broader than whether cryptocurrency will appreciate or decline in value.

The important question is how digital assets fit within an individual’s overall wealth structure.

A portfolio containing cryptocurrency may have different tax consequences depending upon the investor’s residence, the location and nature of the relevant exchange, the frequency of transactions and whether the assets are held personally or through an entity.

This makes tax residence increasingly relevant.

The same cryptocurrency investment can potentially produce very different outcomes depending upon the jurisdiction in which the investor is tax resident and the rules applicable there.

That does not mean that investors should simply search for the lowest-tax jurisdiction.

It means that cryptocurrency reinforces a broader principle of international wealth management: the location and structure of wealth matter.

Cryptocurrency and Jurisdictional Choice

The growth of digital assets therefore adds another dimension to the discussion of international tax planning.

The traditional wealth-planning question might have been where to hold a bank account, establish a company or purchase an investment property.

The digital economy introduces another question: where should the owner of increasingly mobile digital wealth be tax resident?

That question is particularly relevant at a time when governments are examining broader changes to taxation.

The U.S. debate over wealth taxation, for example, was already gaining momentum in early 2021. As discussed in Democrats Push for a ‘Wealth Tax’, proposals were emerging that would seek to tax accumulated wealth rather than relying exclusively on conventional income taxation.

Cryptocurrency complicates that discussion further.

A digital asset can appreciate substantially without generating conventional income until it is disposed of. Yet its economic value may increase dramatically during the period in which it is held.

That creates difficult questions for any government considering a tax system based upon wealth rather than realised income.

The Broader Shift in Wealth Management

Cryptocurrency is therefore part of a much larger transformation in the way governments view wealth.

Financial transparency has expanded.

Beneficial ownership rules have become more demanding.

Tax authorities are increasingly interested in assets held outside traditional banking systems.

The United States’ expansion of beneficial-ownership and foreign-account enforcement mechanisms, discussed in US Ends UBO Privacy, reflects the same underlying direction: governments are seeking greater visibility over wealth that crosses borders.

Cryptocurrency does not reverse that trend.

In some respects, it accelerates it.

As governments become more familiar with digital assets, the expectation that cryptocurrency represents a form of wealth outside conventional taxation is likely to become increasingly difficult to sustain.

The Future Tax Question

The challenge for policymakers is to develop rules that are sufficiently clear to provide certainty without suppressing innovation.

Cryptocurrency represents a new technology and a new form of financial activity. Governments have an understandable interest in ensuring that taxable income and gains do not simply disappear because they arise through a digital asset.

At the same time, excessive or poorly designed regulation could discourage legitimate innovation and encourage entrepreneurs and investors to locate their activities elsewhere.

This is where international coordination becomes important.

If each jurisdiction develops entirely different rules, the result may be another layer of complexity and another source of regulatory arbitrage.

The OECD’s work demonstrated that governments were already examining these questions collectively.

The direction of travel was becoming increasingly clear even in 2021.

Cryptocurrency as Part of a Diversified Wealth Strategy

Cryptocurrency should therefore be viewed neither as a tax-free asset nor simply as another speculative investment.

It is an emerging component of the global wealth-management landscape.

For investors, the appropriate questions extend beyond price. They include tax residence, reporting obligations, asset ownership, custody, regulatory exposure and the treatment of gains when assets are ultimately realised or exchanged.

This is consistent with the broader theme running through international wealth management: diversification increasingly involves not only different asset classes, but also different jurisdictions and legal environments.

The discussion around cryptocurrency is simply another manifestation of that development.

Conclusion

The intersection of cryptocurrency and taxation is still evolving.

The technology has developed faster than many existing tax systems, leaving governments to determine how traditional concepts of income, capital gains, property and reporting should apply to assets that operate across borders and outside conventional financial intermediaries.

By March 2021, however, one principle was already becoming clear: cryptocurrency was not developing in a regulatory vacuum.

The United States was applying established property-tax principles to virtual currency. The OECD was examining differences in national tax treatment. The European Union was developing a regulatory framework for crypto-assets while simultaneously considering how tax authorities could obtain greater visibility over digital transactions.

For private investors, the implication is straightforward.

Digital wealth may be mobile, but it is not necessarily invisible.

As governments become more sophisticated in identifying, regulating and taxing crypto-assets, the question will increasingly become not whether cryptocurrency is taxable, but where, when and under what rules it is taxable.

That makes cryptocurrency not merely an investment question, but a tax and wealth-management question as well.