Blockchain and cryptocurrencies are such a new thing, and so much money has flowed into crypto investments in such a short period of time, that regulators around the world have been scrambling to understand the implications, determine tax and legal positions, neutralise fraud and block money laundering. Some countries, such as China and South Korea, have outright banned ICO’s while they consider their positions and establish regulatory frameworks. Other countries, such as Gibraltar and Switzerland, have moved quickly to create environments where ICO’s are supported and encouraged, but only under suitable due-diligence such that an ICO coming out of those countries can be considered the gold-standard. There are other countries, such as Germany and Belarus who have released tax-friendly policies for cryptocurrencies. In Belarus cryptocurrencies including ICOs and smart contracts are legal, and cryptocurrency mining, trading and capital gains on cryptocurrencies & ICOs are tax-free until January 1, 2023. In Germany, investors can buy cryptocurrencies and realise a capital gain, but if they spend that cryptocurrency with a retailer rather than selling on a exchange then no capital gains tax is payable.
These many different positions being taken by governments around the world makes this a difficult chapter to write, and one which will likely require some adjustment in future editions. Thus, the insights provided are general and may not apply to all countries. For the most part they are likely to comply with the existing regulations of many countries, however this article is not legal or tax advice and appropriate professionals should be consulted for specific blockchain loyalty program legal and tax guidance relevant to the country in which the blockchain loyalty program is operating.
Capital Gains Tax
If a trader buys shares and those shares increase in value, when they sell the shares and realise a profit they will be required to pay capital gains tax.
The same generally applies for cryptocurrencies and cryptotokens; a trader buys Bitcoin, the value increases and they sell, and the profit needs to be declared as a capital gain which attracts applicable taxes.
How does this affect a blockchain loyalty program? If a member of the program shops with a retailer and earns $10 of cryptotokens and those tokens increase in value to $20, when they redeem the tokens for a $20 discount on a future transaction are they required to pay capital gains on the $10 of additional value they have earned?
Technically this is a taxable event, however many tax offices around the world recognise the concept of a ‘personal use asset’ which allows members to avoid any tax obligation. This is an asset which is used or kept mainly for the member’s personal use or enjoyment for capital gains purposes. Therefore, if the cryptotokens are held by the member mainly for personal use or enjoyment, any gain or loss on the disposal will be disregarded for capital gains purposes on the basis that the cryptotokens are personal use assets for that member. Thus, members of a blockchain loyalty program are provided with the opportunity to earn a capital gain without paying capital gains tax.
This all changes if the member starts accumulating and trading their cryptotokens on an exchange. Under those circumstances the tax office could argue the cryptotokens are no longer being held mainly for personal use or enjoyment but to generate a profit, and capital gains tax is likely to apply.
Not all countries will take this stance, so it is important to seek local tax advice.
Anti-Money Laundering (AML) & Counter Terrorism Funding (CTF)
Companies trading in shares, such as stockbroking houses, are required to collect personal information about their clients and conduct AML/CTF checks. Most countries have an AML act (such as Australia’s Anti Money Laundering and Counter Terrorism Financing Act 2006) which requires the background check to reveal any record of money laundering or terrorism financing, both nationally and internationally. In addition, once the customer has commenced trading, the company is subject to AML/CTF compliance and reporting obligations. This means collecting and storing information on their customers’ identities and transactions, having a system to monitor suspicious activity and reporting any suspicious transactions over a certain amount.
Not surprisingly, countries around the world are rushing out new regulation of cryptocurrency exchanges under new AML/CTF laws made through amendments to the existing acts. This means, just like shares, any exchanges trading in cryptocurrencies or cryptotokens must comply with the regulations of that country, including conducting the appropriate AML/CTF checks and adhering to the ongoing obligations.
What does this mean for a blockchain loyalty program? As discussed earlier, making a loyalty program simple to join is essential for success and if a member needs to pass an AML/CTF process to register this is likely to be a significant detractor. Fortunately, in most countries this appears to be only required if the member wishes to transfer the cryptotoken out of the program such that they can trade on an exchange, which means the program join process can remain simple.
To explore this in more detail, consider the actions a member can take after joining a blockchain loyalty program. They can earn cryptokens, they can redeem cryptotokens with a participating retailer, they can transfer to other members, and they can transfer to their own crypto wallet or an exchange to trade. For the first three actions (earn, redeem and transfer to other members), the position of most countries is likely to be that AML/CTF checks are not required. This is because regulations tend to have specific clauses related to what they deem to be a digital currency. This is generally along the lines of a currency which functions as a medium of exchange, is not issued by a government body, is interchangeable with money, and is generally available to members of the public. Thus, if a loyalty currency is not interchangeable with money, regulators will generally rule it is not technically a digital currency and therefore AML/CTF checks are not required. One again, local legal advice is recommended to understand country-specific positions.
For the fourth action, transferring the cryptocurrency to their own crypto wallet or an exchange to trade, an AML/CTF check is required because the loyalty currency is now interchangeable with money and is therefore technically a digital currency. In most countries this will not be as onerous as it might seem, for two reasons. Firstly, the loyalty program can segment the process for members depending on what they wish to do. As most members will be content with earning and redeeming within the retail partner network, they will never need to complete the AML/CTF process. Only those minority of members wishing to transfer their cryptotoken holding to an exchange or personal crypto wallet will need to conduct the check. Secondly, with the massive rise in the need to conduct AML/CTF checks around the world due to the growth in cryptocurrency trading, a number of companies have developed software which enables automated AML/CTF checks to reduce administrative overheads.
It is also important to note if a loyalty program was structured such that members could convert points into cash they would technically also have to conduct AML/CTF checks. Not surprisingly, most loyalty programs specifically avoid providing members with this option to ensure they avoid this need.
Financial Services Licensing
In most countries a company requires a FSL to provide financial services. Thus, if a blockchain loyalty company is providing a financial service, it will require a FSL. Whether the blockchain loyalty company is providing a financial service will depend on whether the cryptotoken is characterised as a financial product. This is important because obtaining a FSL can be a lengthy and expensive process.
To better understand this, it is interesting to consider whether Bitcoin (and other major cryptocurrencies) constitutes a financial product. Interestingly, many countries take the position that they don’t, which is why so many cryptocurrency exchanges can operate around the world without FSL’s. Bitcoin doesn’t constitute a financial product because it is not a facility through which a person makes a non-cash payment, which is a scheme through which a person makes payments other than through the delivery of notes or coins. Bitcoin ownership does not afford the holder any rights to make payments using Bitcoin or to redeem it for cash. The ability of a person to use Bitcoin for making a payment depends on other arrangements under which another party agrees to accept payment in that form. Accordingly, most regulators consider that it is unlikely that Bitcoin is a facility through which a person makes non-cash payments. It follows that Bitcoin is not a financial product.
For a blockchain loyalty program the position differs. Loyalty cryptotokens can be defined by regulators as a non-cash payment facility, because unlike Bitcoin and other cryptocurrencies, ownership does afford the holder the right to make payments using the cryptotoken, specifically with participating retailers.
To illustrate this further, if a member of a blockchain loyalty program holds both Bitcoin and the loyalty cryptotoken and they wish to spend them with a participating retailer, the retailer has no obligation to accept the Bitcoin, but under the terms and conditions of the loyalty program, they are required to accept the loyalty cryptotoken. This makes the cryptotoken a financial product, which generally means a FSL will be required to operate a blockchain loyalty program. Many countries have specific exemptions for loyalty programs however, which is important because if they didn’t there wouldn’t be very many loyalty programs operating at all. Any loyalty program wishing to operate without a FSL needs to ensure they comply with the relevant definition of a loyalty program by the relevant regulators to access the exemption. This may include characteristics along the lines of:
- The dominant purpose is to promote spending on goods and/or services from the issuer or third parties participating in the scheme.
- Clients are allocated a measure of value as a result of acquiring or using goods and/or services of the issuer or third parties participating in the scheme, whether or not a monetary value is expressly attributed to the credits.
- The credits allocated can be used to make a payment or part payment for goods or services or to obtain some other benefit.
Thus if a member is earning, redeeming or transferring cryptotokens to other members a FSL shouldn’t be required. The loyalty exemption may no longer apply however once the blockchain loyalty program allows members to transfer the cryptotoken to an exchange to trade for other cryptocurrencies or fiat currencies. This is very much a grey area and one for which local legal advice is required. Some countries may support the program allowing members to transfer to an exchange to trade as long as the dominant purpose of the program remains to promote spending on goods and/or services from the issuer or third parties participating in the scheme. Other countries will insist a FSL is required if it is allowed at all. This area is so new and unexplored most regulators and legal specialists around the world haven’t even considered their position.
This is an excerpt from Blockchain Loyalty: Disrupting loyalty and reinventing marketing using cryptocurrencies (1st Edition) by Philip Shelper.
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