As the public takes notice of cryptocurrency’s rapid growth in monetary value and trading volume, their frequent inclusion into a company’s financial statements will require proper documentation and disclosure. In such cases, how should the emerging asset class be accounted for? And how will gains be taxed?
Based on an agenda published by the International Financial Reporting Standards Foundation (IFRS) back in June 2019, holdings of cryptocurrency are to be accounted for as either intangible assets or inventory, depending on its intended purpose. As a prelude, the Committee defines ‘cryptocurrency’ as an asset that is:
(i) virtual in nature, recorded in a blockchain that uses cryptographic security measures,
(ii) not issued by a central authority, and
(iii) does not enforce a contract between the holder and another party.
More details on the Committee’s finalized decision of its accounting treatment are set out below.
According to IAS 38 Intangible Assets, the asset class is defined as an ‘identifiable non-monetary asset without physical substance’ — identifiable meaning that the asset is separable or is derived from a contractual/legal obligation. In this context, an asset is ‘separable’ if it can be traded or exchanged for individually.
Regarding the scope of what IFRS outlines as a non-monetary asset, IAS 21 The Effects of Changes in Foreign Exchange Rates states that a fundamental characteristic of a non-monetary asset is the absence of a holder’s right to receive (or deliver) a fixed or determinable monetary amount. All things considered; cryptocurrencies are considered a non-monetary asset and in turn, qualifies as an intangible asset.
When an entity holds cryptocurrencies for sale in the ordinary course of business (most notably, as a broker-trader seeking profits from price fluctuations), it falls under the jurisdiction of IAS 2 Inventories to be accounted as inventories of intangible assets. They are to be measured at fair value less costs to sell.
Financial Assets & Cash
Contrary to popular belief, cryptocurrency does not qualify as a financial asset or cash due to several conflicting reasons. First and foremost, two attributes of a financial asset outlined in IAS 32 Financial Instruments — Presentation are that the asset in question embodies the properties of cash and entitles the holder to certain financial obligations arising from it. Cryptocurrencies do not meet both conditions.
Within the same standard, cash/currency is only considered a financial asset due to its ability to represent a medium of exchange so prominent that it is used as the basis of measuring and recognizing transactions reflected in financial statements. As an emerging asset class, the adoption of cryptocurrency has yet to become mainstream and thus, are neither cash nor a financial asset.
Concerning matters related to taxation, the Hong Kong Inland Revenue Department (IRD)’s Departmental Interpretation and Practice Notes №39(DIPN #39) points out several key areas of focus, namely categorization and nature of holdings.
Having experienced significant technological advancements within the field, cryptocurrencies now come in different forms, each with fundamental distinctions in terms of the asset’s essence. Three categories — payment tokens, security tokens, and utility tokens — exist, and the IRD states that its taxation treatment would depend on which form of cryptocurrency is involved.
First, payment tokens are those mainly created (and used) as a means of transacting for goods and services. These do not provide the holder with rights or obligations of any sort and are considered virtual commodities due to its ineligibility to be classified as legal tender.
Second, security tokens — ‘security’ here referring to investment securities — represent a material ownership and interest in a business. As such, should the securities meet the definitions laid out by the Securities and Futures Ordinance, they are to be taxed in accordance with the existing provisions set out in Section 15E the Inland Revenue Ordinance (IRO).
Lastly, utility tokens are issued for the purpose of funding the development of a certain cryptocurrency and are obtainable through Initial Coin Offerings (ICOs). Rather than being used as a common medium of exchange, these tokens can only be accepted by the issuer as payment for their goods and services. Here, emphasis is placed on the rights and benefits holders are entitled to, which, from an accounting perspective, can be viewed as a prepayment for future goods and services. They are taxable so long as they are sourced from Hong Kong.
Nature Of Holdings
When it comes to holding cryptocurrencies, the IRD divides holders into two broad classifications — those holding for long-term investment, and those for carrying on a trade or business. For the former which mainly involves exchange platforms or ICOs, the tax eligibility of profits arising from a digital assets’ disposal would depend on whether the digital asset is capital in nature or meets the characteristics of trading stock.
In the case of holding for business, Hong Kong’s broad territorial principal source of taxation applies, subject to the type of business operation (e.g., trading, exchange, or mining of cryptocurrency) together with its underlying circumstances. In addition, following the judgement passed in the landmark case Nice Cheer Investment Ltd. v CIR on the 12th of November 2013, unrealized investment-related profits are not taxable due to its anticipatory nature. Case law has also clearly established that profits may only be taxed when realized. Unrealized losses however, when recognized to reflect a likely permanent diminution in investment value, are tax deductible.
Considering all that has been said, it is important to note that the accounting & tax framework(s) outlined in this article have yet to be set in stone. The asset class itself is still in its development stage, and as cryptocurrencies branch out into more complex structures and diversify in nature, prominent standard-setters would do well to continue monitoring its regulatory environment, establishing professional guidelines in tandem with the industry’s transition to a more technological and decentralized era.
As the accounting and tax issues on cryptos are constantly evolving, interested parties are best to consult the experts at Normsun CPA. for the latest development in Hong Kong and around the globe.
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