Leigh Sagar looks at the mechanics and tax implications of cryptoasset disposals in the light of the UK Jurisdiction Taskforce Legal Statement on cryptoassets and smart contracts
In November 2019, the UK Jurisdiction Taskforce published its legal statement on cryptoassets and smart contracts.1 The publication of the UKJT Legal Statement was important because it stated, amongst other things, that “cryptoassets are … to be treated in principle as property”. Although this had been accepted by HM Revenue & Customs (“HMRC”),2 it was not yet the subject of an authoritative ruling by an English court. There was a 2019 interlocutory decision by Moulder J,3 who was asked to make an asset preservation order over bitcoin having a value of more than £1m, which was fraudulently obtained in a “spear-phishing” attack,4 and accepted for the purposes of the application that the cryptocurrency was an asset. The decision of the Singapore International Commercial Court in B2C2 v Quoine Pty,5 in which it was conceded that bitcoin was a property right and capable of being held on trust,6 was cited.
Since the Legal Statement was published, the assertion in it that bitcoin is property has been accepted by Bryan J as being an accurate statement as to the position under English law in AA v Persons Unknown.7 This case involved a ransomware attack, in which a computer system was encrypted by a hacker, who demanded USD 950,000 for a tool that could be used to unencrypt the data.
Cryptoassets and tokens
Although Bitcoin was the first cryptoasset project to be successful at preventing double spending in a decentralised system,8 many others have since been developed, with varying sophistication. Generally, cryptocurrencies, which have also been called “coins” and “exchange tokens”, operate at the protocol level,9 transacting value from and to addresses on the relevant blockchain and the transactions can be viewed using a blockchain explorer.10 Other intangibles, which are known as “utility tokens” or “security tokens”, are created in more sophisticated blockchain systems, such as Ethereum. They operate above the protocol level, without any direct link to it, using sets of programming instructions known as “smart contracts”.
Focus on bitcoin
In this article, the discussion will primarily be about the Bitcoin system, including the bitcoin blockchain. Although there are many other cryptoassets, whose systems are different and may be more sophisticated, the Bitcoin system was the first and has been the most successful; bitcoin has the highest capitalisation value and almost all other cryptoasset systems are derived from, or based on, technology that is derived from the Bitcoin system. Bitcoin can be referred to as “BTC”.
Bitcoin exists and functions, and can be accessed and operated, only in and by software systems running on computers. Bitcoin transactions are the most important aspect of the Bitcoin system and everything else ensures that they are carried out effectively.11 After its creation, propagation through the network and validation, information about a transaction is added to the ledger that makes up the blockchain. The entry in the ledger is the reduction into code of the transfer of value between the participants in the transaction. It does not involve any coins, senders, recipients, balances, accounts or addresses: in the blockchain and the system software, the word “bitcoin” is not mentioned; it is predicated by the system. These abstractions, which represent elements of a coin metaphor, are constructed for human engagement by computer software from information contained in the bitcoin blockchain. There are two important software applications that can assist in this way: the bitcoin wallet and the bitcoin blockchain explorer. Both are designed to access the information on the blockchain and to represent that information in a form that can be understood by humans, using the coin metaphor. In addition, the wallet is able to manipulate the information for the purpose of viewing the transferable value of bitcoin and allowing the user to transfer it.
In the operation of the Bitcoin system, transactions move value from what are referred to as “transaction inputs” to “transaction outputs”. The fundamental building block of the transaction, however, is the transaction output. The transaction output consists of two elements: an amount of bitcoin and a cryptographic condition that needs to be resolved in order to spend it. The amount of bitcoin (or what is being transferred) is denominated in “satoshis”, which are the smallest units of bitcoin: 100 million of them make up 1 bitcoin.12 The cryptographic condition includes the bitcoin address to which the transfer is being made and its satisfaction involves the application of the corresponding private key.13
If the cryptographic condition of an output has not yet been satisfied, that output is transferrable, or spendable, and is described as “unspent”. It is referred to as an “unspent transaction output” or “UTXO”. If a user’s wallet has detected that an UTXO can be spent with one of the keys that the wallet controls ( that is, the wallet is able to satisfy the cryptographic condition using a private key it controls)it registers a receipt of bitcoin. The user’s bitcoin balance for that wallet is the sum of all UTXO that the wallet can spend and is produced by the wallet application scanning the blockchain and adding together the values of all such UTXO that it finds.
Once an output has been created, its value cannot be divided and can be spent only in a transaction involving the whole of that value. If the user wishes to transfer a value that is less than the value of the output, the wallet will generate an additional transfer to return the balance (the change)back to itself. Just as happens when a £10 note is used to pay for a £3 cup of coffee and change of £7 is returned to the purchaser, if an UTXO is worth 10 BTC and the user wishes to transfer only 7 BTC, two outputs will be produced by the wallet: one transferring 7 BTC to the recipient and another transferring 3 BTC in change back to itself.14 If the desired transfer is of a value that exceeds the value of an UTXO, the wallet will have to use more than one UTXO to constitute an amount greater than or equal to the desired value. The outputs created by the transaction will in turn be spendable units of UTXO.
Transaction inputs are created by the wallet software at the time that the user initiates a transfer. The software selects UTXO that it controls with an aggregate value equal to or more than the value of the transfer requested by the user. It may be that one is sufficient, but more than one might be needed.15 For each UTXO that is required, the wallet creates one input that points to, or references, that UTXO and unlocks it using a process that applies the relevant private key. Once the transaction is propagated through the bitcoin system, the other computers in the network follow the reference to the UTXO and inspect the unlocking result in order to validate the transfer. The validated transfer is finally processed by the mining operation and the result, which is a new UTXO, is written to the blockchain. The receiver’s wallet will be able to recognise that UTXO as one that it can control.
Figure 1 below shows a rendering of a random transaction taken from block 609341 of the bitcoin blockchain, written to it at 8:15 pm on 22nd December 2019.16
The transaction was of 30.41169628 BTC. This was the value of a single UTXO available to the transferor (who was represented by her bitcoin address, 12cgpFdJViXbwHbhrA3TuW1EGnL25Zqc3P;17 we can refer to her as “Alice”). For this transaction, the explorer software searched the blockchain ledger to reference the UTXO and create a transaction input for the transfer.
From the information on the blockchain, the software constructed the table that is shown of a transaction resulting in 4 transfers to different bitcoin addresses of varying amounts of bitcoin,18 together with a small amount for the processing fee. It is likely that each of the three smaller amounts was being transferred to one or more other bitcoin wallets and the larger amount returned as change to Alice’s transferring wallet.19
Figure 2 shows a rendering of a transaction that had taken place at 7:50 pm on 22nd December 2019, resulting in the UTXO referenced for the transaction shown in Figure 1. On the left-hand side are 41 UTXOs that were referenced to create the transaction inputs for the transfer.
These examples show that the purpose of the bitcoin system is the transfer of value from one address to another. The value is designated in bitcoin and written to the blockchain as satoshis. The chunks of value created as UTXO are created and used by the system to make the transfers, verify the chain of ownership and help prevent double spending.
Figure 3 shows the creation of bitcoin. It is the first transaction in block 609341. There was no transaction input as there was no UTXO to reference; the “coinbase” parameter was used to enable the miner to transfer 12.5 previously non-existent bitcoin to their bitcoin address, together with the total fees that were paid by users whose transfers were processed as part of the creation of the block.20 Here the transfer of value was purely of bitcoin (designated as satoshis).
The UKJT Legal Statement approach
In the UKJT Legal Statement the term “cryptoassets” was used to refer generally to the digital representation of assets that were involved in dealings transacted with commercial applications using cryptographic techniques. The authors stated that a cryptoasset was ultimately defined by reference to the rules of the system in which it existed and, functionally, was typically represented by a pair of data parameters, one public and one private. They described the public parameter as containing or referencing encoded information about the asset, such as its ownership, value and transaction history.21
This statement of representation of the cryptoasset by the pair of data parameters, with the public one containing or referencing encoded information about the asset seems to describe the transaction output–input relationship discussed above. This is confirmed by the Legal Statement’s description of a transfer of a cryptoasset:22
“Although one can describe and conceptualise the process as a transfer (and that is the word we have used in this Statement), it is not really analogous to the delivery of a tangible object or the assignment of a legal right, where the same thing passes, unchanged, from one person to another. Instead, the transferor typically brings into existence a new cryptoasset, with a new pair of data parameters: a new or modified public parameter and a new private key. The data representing the “old” cryptoasset persists in the network, but it ceases to have any value or function because the cryptoasset is treated by the consensus as spent or cancelled so that any further dealings in it would be rejected. The “new” cryptoasset is represented by new data and controlled by a new key.”
This characterisation of the transfer echoes the process described above, in which the UTXO is spent (or cancelled) and, after the transfer, one or more new UTXO are created. There is no mention of the actual asset that bears the name of the system and for which the system is designed: the bitcoin. It describes the processing package used for the transfer as the cryptoasset itself, rather than the computer-generated representation of value that is actually being transferred by the packages. In Figure 1, although the 0.0095 BTC was not transferred manually from Alice to the recipient (Bob), it is the contention of this article that that amount of bitcoin was transferred from Alice to Bob; there is no need to set up a fictional transfer using UTXO.
Capital Gains Tax
In the ordinary course of commercial transactions, this notional destruction and creation fiction presents no practical difficulty. It might, however, make a significant difference for capital gains tax purposes in commonplace transactions where the transferor and the transferee are the same individual and the transfers do not actually alter the ownership of the value being transferred. One example is the change returned to the transferor (as described above) where the value of the transaction input exceeds the amount being transferred by her. Another common example is a transfer for, security purposes, from a hot wallet to a cold wallet (or vice versa), both of which are controlled by the same individual.23 The question here is whether there has been a disposal for capital gains tax purposes of the “old” cryptoasset when it is cancelled. If there has been a disposal and a chargeable gain has accrued to the transferor, capital gains tax will be chargeable.24
In the Individuals Policy Paper, HMRC describe what constitutes a disposal of cryptoassets for capital gains tax purposes:
“A ‘disposal’ is a broad concept and includes:
- selling cryptoassets for money
- exchanging cryptoassets for a different type of cryptoasset
- using cryptoassets to pay for goods or services
- giving away cryptoassets to another person”.
If it is assumed that Figure 1 above represented a transaction that comprised a gift by Alice to Bob (first transfer), a payment by Alice to Carol for the acquisition of Ether (second transfer), a payment by Alice to David for the purchase of sterling (third transfer), and change returned to Alice (fourth transfer), the transfers to Bob, Carol and David would have been disposals under this guidance.25 The transfer of the change to a different bitcoin address, which was also controlled by Alice, would not have altered the ownership of the value. Even though a new UTXO was created and the old one became spent, Alice remained in control of the bitcoin, albeit exercisable by the use of a different private key.26
Section 24 of the 1992 Act provides that, subject to exceptions that do not apply here,
“… the occasion of the entire loss, destruction, dissipation or extinction of an asset shall, for the purposes of this Act, constitute a disposal of the asset whether or not any capital sum by way of compensation or otherwise is received in respect of the destruction, dissipation or extinction of the asset”.
The cancellation of the “old” cryptoasset can be described as the occasion of its destruction or extinction, so that there will have been a deemed disposal of the whole of it. As Alice was transferor and transferee, no consideration was received (or would be deemed to have been received) for the disposal but sums would be allowable as a deduction in the computation of the gain, including the consideration given for the acquisition of the “old” cryptoasset and any fees charged on the deemed disposal.27 This would likely have given rise to an allowable loss.28 It is unlikely that Alice would have contemplated that a capital gains tax event would occur by the transmission of change to herself. If the asset was the bitcoin, rather than the UTXO, there would be no destruction of the asset and no disposal would be deemed as a result of the transaction.
In the Individuals Policy Paper, HMRC advocated the use of the pooling provisions in section 104 of the 1992 Act for the calculation of the capital gains tax on a disposal of cryptoassets. They wrote:
“Instead of tracking the gain or loss for each transaction individually, each type of cryptoasset is kept in a ‘pool’. The consideration (in pound sterling) originally paid for the tokens goes into the pool to create the ‘pooled allowable cost’.”
Any sale of any tokens in the pool is considered a part-disposal, so that a corresponding part of the pooled allowable costs are deducted when calculating the gain or loss. The pooling provisions are used generally to deal with the problem of identifying fungible assets, such as shares of the same class in the same company, which are identical.29 For instance, if Alice buys 100 ordinary shares in A Limited for £100 and a further 200 a year later for £300, if she then sells 150 shares for £200, do the pooling provisions provide a way to calculate the base cost of those sold without having to identify them? The same can be said of bitcoin, if they are considered to be fungible, which would be the case if the cryptoasset was the bitcoin; but if the cryptoasset was an UTXO, which is unique and identifiable as the whole or part of a transaction hash in the blockchain and easily distinguishable from another UTXO, there is no need for the pooling provisions.
If the destruction-creation fiction advanced by the UKJT Legal Statement represents the law, the inconvenience for users of having to notify HMRC of disposals every time a wallet sends a change transfer to itself could be remedied by legislation. But, viewed naturally, the asset is the bitcoin (designated in satoshis) and the change transfer takes place without any cancellation or destruction of that asset; there is no need for legislation. The position can be compared to the distinction between a £5 note and the £5 value that is represented by it. The note, which is a convenient chattel, is the mechanism by which the sterling—the asset—can be transferred.30 In the same way, an UTXO, which is a convenient digital unit, is the mechanism by which bitcoin—the asset—can be transferred by the Bitcoin system.
Leigh Sagar, New Square Chambers. As well as being a member of SCL, Leigh is Chair of the Society of Trust & Estate Practitioners Digital Assets Special Interest Group. © January 2020
1 The “UKJT Legal Statement”
2 See, for instance, the policy paper published by HMRC on 19th December 2018 entitled Cryptoassets: tax for individuals (“The Individuals Policy Paper”). The Individuals Policy Paper was updated on 29th December 2019 and can be found here. The policy paper entitled “Cryptoassets: tax for businesses” was published on 20th December 2019 and can be found here
3 Liam David Robertson v Persons Unknown, unreported, but many blog posts have been published; see, for instance, see Bilbow, “High Court tackles Bitcoin ‘property’ first”, Commercial Disputes Resolution. See also Elena Vorotyntseva v Money-4 Limited t/a Nebeus.Com, Sergey Romanovskiy, Konstantin Zaripov  EWHC 2596 (Ch)
4 This is an attack by which a deceptive email, disguised to look legitimate, is used to acquire sensitive information, such as a bitcoin private key, or as in this case to misdirect a payment of crypto
6  SGHC(I) 03, at para 142
7  EWHC 3556 (Comm), published 17th January 2020
8 See Chapter 2 of Au and Power, Tokenomics, Packt Publishing. The now legendary paper entitled “Bitcoin: A Peer- to-Peer Electronic Cash System”, attributed to Satoshi Nakamoto and to be found on the bitcoin.org site, is said to have been published on 31st October 2008 (see his archived newsgroup message)
9 The protocol defines the process that is, and is to be, followed by a cryptoasset from its creation, through validation and final confirmation
10 Some systems, such as Zcash, are designed to be private and transactions cannot publicly be examined
11 See generally Chapter 6 of Antonopoulos, Mastering Bitcoin, 2nd Edition
12 In wallets and explorers, this amount is invariably shown in bitcoin. For instance, 1,500,000 satoshis are shown as 0.015 BTC
13 The private key is created first by the wallet and from that the corresponding bitcoin address is determined using cryptographic processes
14 There will be a further transaction paying a fee to the miner for the processing of the transaction
15 Some wallets reference all UTXOs controlled by them, even if their aggregated value adds up to more than is needed for the pending transaction
16 This was UK time. It was accessed by using the blockchain.com bitcoin blockchain explorer. The transaction hash is the alphanumeric number next to the word “Hash” and represents the identification number of the transaction on the blockchain; it can be used to access and inspect the transaction with the aid of the blockchain explorer. The actual transaction can be found here and the block here.
17 The address is truncated and only the first few characters are shown
18 These were new UTXOs after their creation; the explorer now shows them with red icons, denoting that they have all since been spent
19 Some wallets send the change to the bitcoin address from which the transfer was made; other wallets are designed to send the change to a separate bitcoin address also controlled by the wallet
20 This UTXO created in using the coinbase parameter cannot be spent until at least 100 more blocks have been created, roughly 16 hours and 40 minutes. The OP_RETURN code indicates a non-spendable transaction, which might be an error or a message
21 See para 28
22 See para 45
23 The hot wallet runs on a computing device that is connected to the internet and potentially subject to hacking attempts, whereas the cold wallet runs on a computing device that is not connected to the internet except for short periods when transactions take place
24 Section 1 of the Taxation of Chargeable Gains Act 1992 (“the 1992 Act”)
25 For the gift to Bob, section 17 of the 1992 Act deems the gift to have been made for a consideration equal to market value
26 If the old UTXO was the cryptoasset, the disposal would have been a fractured disposition of the bitcoin (or the UTXO) that was transferred, but it is not considered would have been a part disposal within section 21(2)(b) of the 1992 Act; none of the referenced UTXO) remained undisposed of
27 Section 38 of the 1992 Act
28 See 16(2) of the 1992 Act; HMRC Capital Gains Tax Manual, para CG13120
29 See HMRC Capital Gains Tax Manual, para CG51500P
30 Moss v Hancock  2 QB 111