SMP
Crypto Tokens on a smartphone
July 11, 2017 Briefing

Tax treatment of crypto tokens in Germany

Nowadays, the terms “crypto tokens”, “blockchain” and “ICO” are widely talked about. Ever-increasing funds are raised in the context of initial coin offerings (ICOs), and on a weekly basis crypto tokens such as Bitcoin, Ether, Litecoin or Ripple (to name just a few of the best-known ones) reach new, albeit volatile, highs.

With similar speed, new and promising fields of application for the underlying blockchain technology are being identified. At least when it comes to Germany as a place to invest, the long-term perspective for crypto tokens is influenced, inter alia, by how gains from token‑related transactions are treated in terms of tax because experience shows that one factor in investment decisions made by market participants is the expected tax burden. This SMP briefing discusses the key tax issues and summarizes the current state of debate.

1. Taxes on income: tax-free vs fully subject to tax

According to initial statements made by the German Federal Government (see response to what is known as a ‘brief enquiry’ [Kleine Anfrage] dated June 20, 2013, Bundestag document no. 17/14062), Bitcoin – the best-known and, measured against its market capitalization, (currently still) most important crypto token – is, as a starting point, an economic asset; as such, its tax treatment is, in the first instance, comparable to that of coins, vintage cars or stamps. For private investors, this gives rise to the following consequences: Bitcoin-related gains which are realized by using capital (rather than by ‘mining’) and disposed of at a later point are tax-free, provided that the period between acquisition and disposal is at least one year (ten years if a token is capable of being used as an ongoing source of income) – a pretty interesting result considering that, in Germany, ever since the introduction of what is known as flat-rate withholding tax (Abgeltungsteuer), only very rarely is it still possible to achieve capital gains that are tax-free in Germany.

By contrast, any disposals made before the aforementioned period has lapsed are fully subject to tax. In that context, a disposal is considered to have taken place not only where tokens that had been acquired are sold for a price denominated in euros but also where tokens are exchanged for other economic assets. In this connection, almost anything can constitute “other economic assets”, e.g. a coffee but also another crypto token paid for in Bitcoin on the occasion of that crypto token’s ICO (many smaller tokens can only be exchanged for other, better-known tokens but not for what is known as fiat currencies). From a tax perspective, the moment of exchange is a realization process with the effect that ‘exchange-rate’ increases, if any, which occur within one year between acquisition and exchange of Bitcoin are capital gains that are subject to tax. In the context of the coffee example, the German taxpayer benefits from an exemption threshold (Freigrenze) of up to EUR 600 per annum, much to the envy of the US taxpayer (see “Bitcoin taxation is broken. Here’s how to fix it” in which the author, Jerry Brito, proposes a de-minimis rule like the German one for small gains, https://coincenter.org/entry/bitcoin-taxation-is-broken-here-s-how-to-fix-it). However, as far as the acquisition of tokens by means of Bitcoin is concerned, such a threshold is likely to be quickly exceeded. At the very least, gains from Bitcoin disposals may be offset against losses from other transactions (including previous loss-generating Bitcoin disposals), and losses may be carried forward. How is it possible, however, to determine whether a token that was sold had been held for more than one year?

It would seem fair to say that, for tax-law purposes, the most straightforward approach would be to apply the FIFO procedure (first in, first out), which in many cases would also be likely to be advantageous for the investor. In factual-technological terms, the blockchain technology is helpful in that it irreversibly records each and every transaction. At this point it is important to link up the provision of tax advice with that of technical advice because there are measures which ensure that the ‘right’ tokens are being disposed of. To this end, however, it is necessary to have a basic technical grasp as to the functioning and effects of blockchain transactions and blockchain wallets.

(German) corporations are not eligible for tax-free gains in this connection. Quite on the contrary: for them, proceeds in the context of directly holding and disposing of tokens are subject to tax; what is more, in contrast to disposal proceeds in connection with corporate shares, 100 % of such proceeds are subject to tax.

2. No VAT on transactions involving tokens

The question of whether Bitcoin transactions are subject to VAT has already been clarified at EU level. The European Court of Justice (case C-264/14) considers Bitcoin to be a means of payment, and, with reference to the underlying EU Directive, the transactions to be VAT-exempt.

True, the judgment specifically concerned Bitcoin; in our view, however, this exemption should apply to transactions involving all types of tokens. Even if “modern” tokens often involve additional applications (e.g. swapping of memory space), this does not stand in the way of their nature as a means of payment; rather, it further corroborates it (paying for memory space using tokens rather than money).

3. Specific issues regarding fund investments in crypto tokens

The yearning for profit which has given rise to the ‘exchange-rate’ developments of Bitcoin and other crypto tokens has led to managers of tech-savvy VC funds, among others, wondering whether they should not use part of the funds under their management towards acquiring such tokens. In this context, a number of specific tax issues arise which managers should take into account before deciding whether to buy.

  • Investor level: Are investors (private or institutional), too, in a position to realize token-related gains free of tax?
  • Asset management: Does a fund continue to be asset-managing (vermögensverwaltend) from a German tax perspective if it participates in ICOs? If so, does this also apply if, in the context of the ICO, mere claims/certificates rather than tokens are acquired initially?
  • Carried interest I: Does an investment in crypto tokens “infect” the entire fund, thereby preventing the 40 % tax exemption for carried interest as provided for by statute; i.e. is the management of a “mixed fund”, which invests in both tokens and equity shares, obliged to subject 100 % of its entire carried interest to tax (including the carried interest derived from sales of participations)?
  • Carried interest II: Are 40 % of the carried interest which arises from token-induced return flows tax-free?

With regard to these fields in particular, statements by the tax authorities and/or tax offices are still few and far between. Our first experiences and consultations – which relate to specific individual cases – point to the following:

a) Consequences for investors

Typically, VC funds engage in asset-managing activities. In substantive terms from a German tax perspective, an asset-managing fund is a non-entity because, owing to what is known as ‘fraction view’ (Bruchteilsbetrachtung), it is not fund units that are attributed to investors for tax purposes but, pro rata, the assets held by the fund. Accordingly, the above comments continue to be applicable, i.e. individuals who invest in a fund (possibly via an additional asset-managing partnership) are able to take advantage of the tax exemption for gains once the speculation period has lapsed. This fact can be a major selling point when fundraising! But note that this only works if a asset-managing fund directly invests in tokens. If the transaction is structured by interposing a corporation which makes the investments in tokens and in which the fund in turn holds a participation, then this prevents eligibility for the tax exemption and, under the same investor constellation, triggers application of German flat-rate withholding tax. Moreover, technical measures must once again be put in place to ensure that the management is in a position to prove that the tokens had been held for a minimum of one year before they were sold.

Corporations are fully subject to tax in relation to any token-related gains attributable to them under a fund participation. Needless to say, this does not change if a (German) corporation is interposed – true, in this scenario the investing corporation may be eligible (depending on the individual structure) for the
95 % tax exemption; at the level of the intermediate company, however, a corporate-income-tax and trade-tax burden arises.

This shows that, depending on the investor structure, different holding structures may be advisable. Funds that involve only tokens may be in a position to consider parallel-fund structures in order to ensure a tax-optimized treatment of the return flows for each investor.

b) Asset management

The acquisition of crypto tokens – whether non-derivative (by way of ICOs rather than by mining) or derivative (trading platforms) – does not necessarily lead to the fund being considered as ‘carrying on a trade or business’ (gewerblich) from a German tax perspective. Rather, in our view – with which the first tax offices would seem to concur –, for assessment purposes, the general principles are applicable; this can be seen in particular from the criteria set out in what is known as the PE decree issued by Germany’s Federal Ministry of Finance. This means that, just as in the context of VC investments, it is the specific circumstances of the individual case that matter, and the intended holding period in particular. A frequent turning-over of tokens and claims, as is considered typical of traders, might give rise to the fund being considered as ‘carrying on a trade or business’. As a result, ICOs in the course of which initially only claims to the later transfer are acquired require particular attention; the same holds true of ICOs in the course of which only payment by other tokens but not by fiat currencies is possible.

Care should be taken in cases where a fund decides against directly investing in tokens in favor of interposing a corporation. Here the fund must not ‘co-govern’ this corporation ‘from the outside’; more specifically, no one from the fund management should also assume the management of the corporation which acquires the tokens. This could lead to the entire fund being considered as ‘carrying on a trade or business’.

c) “Infection” of the carried interest

The ‘VC-typical’ part of the carried interest continues to be tax-privileged (provided that the requirements of sect. 18(1) no. 4 German Income Tax Act [Einkommensteuergesetz – EStG] {hereinafter ‘ITA’} are met) at least where the token-related return flows do not reach a significant level. Should this view prevail, then this would provide a considerable relief to fund managers. Provided that additional issues in terms of corporate and supervisory law have been clarified first, fund managers could make small-scale test investments in tokens without having to fear for their tax advantage.

d) Carry privilege for token-related return flows

To date, the tax authorities have shown reticence with regard to this issue. Indeed, the wording of sect. 18(1) no. 4 ITA would seem to be an argument against applying said provision to crypto carries. We disagree. According to the explanatory memorandum to the Act (Gesetzesbegründung), this privilege was specifically meant to do away with the necessity of apportioning the carry for tax purposes. Moreover, the explanatory memorandum identifies the prior repayment of the investors’ invested capital — and precisely not the origin of the funds — as the key requirement. Incidentally, the fact that the wording is an argument against an application should hardly come as a surprise given that the provision was passed approximately five years before Bitcoin was “born”. Even the most prescient legislator could simply not have anticipated that, in order to promote “venture capital”, it would not only have had to specify “shares in corporations” as source of the carry but also “digital-cryptographic units of value”.

The above assessments reflect our views on the subject, with which the competent tax offices have also concurred in specific individual cases. Notwithstanding the above, we have to point out that, as of yet, there are no comprehensive reliable statements by the tax authorities or the tax courts. That is why we recommend, prior to investing in crypto tokens, to have the tax consequences clarified beforehand, preferably by way of an advance ruling issued by the competent tax office.