Cryptocurrency - The Basics

Written by Alex Ruffel, partner and Jess Fazzone, associate in the Tax,Trusts and Estates team

Recent research by the Financial Conduct Authority has found that while ownership of digital assets is increasing, as is the amount of media coverage, the level of understanding is declining, and many investors may not fully understand what they are buying.

Given that successfully understanding digital assets involves learning a new vocabulary that is constantly growing and evolving, this is not surprising.  We have therefore set out below some of the basic terminology.

• Digital assets - Cryptocurrencies such as Bitcoin and Ethereum and non-fungible tokens (NFTs) are digital assets. Digital assets can be broadly described as a collection of data that is uniquely identifiable, giving the asset value.
  
  
• Cryptocurrencies – A means of exchange that exists in the form of a digital token, or coin. Ownership records are stored in a ledger to ensure transactions are secure and verified. Cryptocurrencies are mainly decentralised, as opposed to being controlled by a third party, such as a central bank. Examples of cryptocurrencies are Bitcoin, Ethereum and Dogecoin.
  
  
• Bitcoin (BTC) – Bitcoin is a cryptocurrency with a decentralised system. Bitcoin can be stored in a digital wallet, and you can send and receive Bitcoin. Transactions are recorded by blockchain technology.
  
  
• Blockchain – Blockchain is a type of technology that underlies digital assets. Transactions in cryptocurrencies are recorded with a cryptographic signature, known as a hash. Transactions are grouped into blocks, and each block includes a hash of a previous one, forming a blockchain. These are recorded and verified using distributed ledger technology (DLT). The blockchain for an asset contains data about the asset and all the transactions it has been through, making the asset impossible to forge.
  
  
• Distributed Ledger Technology (DLT) – the technology that enables a decentralised database of records or ledger of multiple transactions to be distributed across a network of computers (known as ‘nodes’). Instead of having a central register controlled by (for example) a central bank, records are stored on a network across multiple locations, joined together by distributed ledger technology.
  
  
• Key - a security feature of cryptocurrency is the use of public and private keys (code numbers), which are each associated with a particular user. The public key is open and tells other users where to deposit cryptocurrency. However, in order to access the cryptocurrency that has been deposited into their address, the recipient user must use their private key.
  
  
• Wallet – where holders of cryptocurrency receive, store and/or retrieve their digital assets by means of their public and private and public keys. There are several different types of wallet including cold wallets (offline hardware) and hot wallets (for example, apps or programmes that are connected to the internet).
  
  
• Ethereum (ETH) – Ethereum is a cryptocurrency. The Ethereum network is also an open-ended decentralised software platform running on blockchain. Ethereum was built to become a platform which can facilitate immutable contracts (smart contracts).
  
  
• Smart Contract – An agreement with contractual terms written into code which can execute and enforce performance automatically when certain predetermined conditions are met.
  
  
• Defi - Decentralised finance - a financial system that allows peer-to-peer lending and transactions using cryptocurrency and automated smart contracts. It is closely linked to Ethereum, due to the capabilities of Ethereum blockchain technology.
  
  
• Non-fungible tokens (NFTs) – NFTs can be anything digital, such as music and digital art. ‘Non-fungible’ means that each token is unique, and cannot be exchanged for another. Blockchain technology allows the owner of an NFT to confirm its originality through a blockchain-based digital certificate. NFTs are typically held on the Ethereum blockchain.
  
  
• Mining – this usually refers to the process by which new bitcoins enter circulation and blocks are verified.  It involves solving complex mathematical problems, for which successful miners are rewarded with cryptocurrency.

Given that the crypto-world has evolved from mathematical concepts and relies upon modern technology, rather than evolving from tangible or material transactions, it can be extremely difficult to conceptualise.  An analogy (that will probably irritate every person with a true understanding) is a bank note. 

Every bank note has a serial number. As the serial number is unique, it would be possible to prove that you own a bank note by simply providing the serial number.   Serial numbers would then become accepted as an asset in themselves – if I wanted to transfer £10 to a friend, I could email them a serial number rather than handing them the physical £10 note. However, if I offered you a serial number, how could you be sure that it was in fact a valid number (and that I hadn’t sent the same serial number to five different friends)? 

Blockchain technology could do this: a unique serial number would be generated by a complex mathematical calculation (mining) that would then be checked by multiple miners.  If the serial number was valid, it would be recorded on a ledger that would be held on a network of multiple computers and systems across the world connected through distributed ledger technology.  When I sent the number to my friend, the number would be subject to an irreversible cryptographic process, using a hash that would change the number.  This would be checked and, if it was valid, would be accepted and recorded in the ledger, forming a block in the chain. This new, more complex number, might then be sent by my friend to someone else and again, would be subject to a cryptographic process, which would be checked and another block would be added to the chain.  The result would be a blockchain-based asset that has been verified and is recorded on a ledger that is held on a worldwide network.

Legal and tax challenges 

The fact that cryptocurrency and NFTs are digital does not take them outside the tax and legal system – as with any other asset there are tax and legal implications to consider if you are holding and/or dealing in them. Some of the key points to consider are:  

• Tax – Capital gains tax may need to be paid if you sell your digital assets, exchange your tokens for a different type of digital asset, use your cryptocurrency to pay for goods or services, or gift digital assets to another individual. Income tax may need to be paid if you are carrying on a trade (such as mining) and/or your employer has paid you in cryptocurrency. Inheritance tax may also be levied if your estate contains digital assets. Unexpected tax liabilities can arise where individuals hold digital assets of significant value and unwittingly believe that the exchange of digital assets does not fall within the UK tax net.
• Tax compliance – Individuals can face severe penalties for failing to report capital gains correctly and on time. HMRC have the power to make inquiries in this regard. A popular digital currency platform, Coinbase, previously received notice from HMRC to provide disclosure in relation to their customer base. More recently, HMRC has announced that it is sending ‘nudge’ letters to holders of cryptoassets. Please no do not ignore a ‘nudge’ letter. Our specialist advisors can assist with the completing tax returns and ensuring any historic tax liabilities are dealt with.
• Estate planning – Leaving digital assets such as cryptocurrencies and NFTs within your estate when you pass away could cause practical difficulties for the executor or administrator of your estate. The duty of an executor or administrator is to identify and distribute the assets within the estate. However, it can be difficult to locate and access digital assets, especially since such assets can be owned anonymously and require a private key.  Individuals holding digital assets should seek the assistance of a solicitor in preparing a Will and a Letter of Wishes. A Letter of Wishes can be particularly helpful as it can be updated regularly with details of the assets owned and serve as a guide for the executor or administrator of their estate.

Contact our Tax, Trusts and Estates team for more information.