Bankruptcy Risk

Cryptocurrencies internationally

Bankruptcy risk for crypto investors

Many will be aware of the significant gains some individuals have made from cryptocurrency, with a $1,000 investment in Bitcoin in 2010 rising to over $700m at today’s value. What is less widely known is that, as well as capital gains, it’s possible to generate an income from such assets.

One of the more straightforward ways to receive such an income is for a cryptoasset “coin” to be “staked”. This broadly involves the coin being locked away for a certain period of time and the individual receiving rewards, paid in the form of additional coins.

The way in which the income is paid and taxed is similar to an individual holding unit in an accumulation fund. The investor receives further amounts of the same investment and these additions to the investment are subject to income tax, based on their value on the date of payment.

There are, however, a number of different routes that allow cryptoassets to be put to work and generate an income for investors. In particular, there has been a surge in Decentralised Finance (DeFi) activity over the last year.

The acronyms and language used in the cryptocurrency world can be bewildering but in simple terms, DeFi relates to financial services that are carried out on the blockchain rather than through traditional institutions like banks.

For example, a common DeFi activity is to make loans to others of cryptoassets. Individuals can lock their cryptoassets into DeFi projects like this and receive an income akin to interest. The risk associated with such activities can be high, but the potential rewards can be too. It is a space that is clearly gaining popularity, with the estimated value of cryptoassets locked into DeFi projects having risen from around $23bn to over $105bn in the last year.

Whilst the returns on such activities have attracted cryptoasset investors, those investors may be unaware of the additional tax risk that they are taking on. In particular, when an individual is paid in cryptoassets, they will be subject to income tax on its market value at that time. If the value of cryptoassets subsequently plunge, they may no longer have enough value to cover that income tax liability. Any loss made could represent a capital loss which cannot be offset against the individual’s income tax liability. This could leave the taxpayer in financial difficulty and potentially facing bankruptcy depending on the figures involved.

It is clear that cryptocurrency is higher up on HMRC’s agenda, who have recently written to some taxpayers to encourage them to declare and settle any liabilities regarding their cryptoassets. Given the lack of any specific legislation on cryptoassets, some investors are considering whether a company structure might offer them more protection for undertaking their crypto activities, as well as the potential opportunity to offset losses against income should they arise.

More guidance from HMRC is anticipated but as it stands, this mismatch in tax rules resembles a game of chance where if it’s heads, HMRC wins and if it’s tails, the taxpayer loses.