1 The Senate Inquiry
Digital currencies, and what they mean for Australia and Australian business, are high on the agenda after the Economics References Committee of the Australian Senate (the upper house of Australia’s federal Parliament) conducted the first hearing of its Digital Currency Inquiry on 26 November 2014.
The Senate Inquiry’s terms of reference include:
- how to develop an effective regulatory system for digital currency;
- the potential impact of digital currency technology on Australia’s economy including the payments sector, retail sector and banking sector; and
- how Australia can take advantage of digital currency technology in order to establish itself as a market leader in this field.1
2 What is Bitcoin and why is the Senate looking at it?
Bitcoin is the most well-known digital currency or crypto-currency: a virtual currency which can operate as an anonymous and decentralised peer-to-peer medium of exchange. Crypto-currencies work by using encryption techniques to regulate the production of units of currency and verify the transfer of funds, independently of a central bank or authority.
Global uptake of crypto-currencies is increasing, with more than 60,000 online retailers now accepting crypto-currencies worldwide.2 The global regulatory picture for Bitcoin is, however, mixed.
- In June 2014, the European Banking Authority identified approximately seventy risks associated with digital currencies, acknowledged that regulation to address all elements would be substantial and recommended that regulators discourage credit institutions, payment institutions and e-money institutions from buying, holding and selling digital currencies.3
- The US’s Internal Revenue Service guidelines provide that crypto-currency is treated as property for US federal tax purposes.4 In 2013, the US Department of Treasury’s Financial Crimes Enforcement Network released a guidance paper providing that digital currency exchangers and administrators are money services businesses requiring registration, reporting and recordkeeping, including establishing an anti-money laundering program and filing suspicious activity reports.5
- Russia has deemed digital currencies as an unlawful substitute for money and plans to pass a law to ban digital currencies in 2015.6
- Bitcoin has effectively been banned by The National Assembly of Ecuador in light of the establishment of guidelines for the creation of a new state-run crypto-currency.7
- The People’s Bank of China has also banned all third-party payment service providers from dealing with Bitcoin, leaving private individuals to do so at their own risk.8
While Bitcoin offers scope for significant innovation and growth opportunities for Australian businesses,9 it challenges the existing legal framework in respect of taxation, financial services, payment systems, banking, personal property and securities, insolvency, anti-money laundering, counter-terrorist financing and consumer protection. Australian regulatory authorities have now begun reviewing how Bitcoin may be used by businesses and, in some cases, providing comments and/or developing guidelines and procedures for businesses to consider.
3 How Bitcoin transactions work
Bitcoin transactions are transfers of value between ‘Bitcoin wallets’ which are software programs that emulate bank accounts. Each wallet contains a ‘public key’ and a ‘private key’. The public key is the wallet address (similar to a payment account or card number) which can be shared with others and the private key is the signature (or security code) that authorises a transaction.
If, for example, one wishes to make an online payment to a company using Bitcoin:
- The company creates a new Bitcoin address, and directs the payer to send their payment to it;
- The payer directs the payment to the company’s new Bitcoin address by instructing their Bitcoin client (the end-user software that facilitates private key generation and security) to transfer the requisite number of Bitcoins from their wallet to the company’s new Bitcoin address;
- The payer’s Bitcoin client electronically ‘signs’ the transaction request with the private key of the address from which they are transferring the Bitcoins;
- The transaction is broadcast to the Bitcoin network and can take up to 10 minutes to be confirmed.10
All confirmed transactions are recorded permanently on a shared public ledger called a ‘block chain’ which updates globally approximately every ten minutes.
Although Bitcoins are virtual, Bitcoin ATMs, derivatives and prepaid cards are beginning to emerge. Australia’s first crypto-enabled Automated Teller Machine (ATM) which permits cash deposits and withdrawals in exchange for Bitcoin was launched in Sydney in April 2014.11
4 Australia’s first official regulatory response to Bitcoin – did the ATO get it wrong?
On 20 August 2014, the Australian Taxation Office (ATO) released a guidance paper providing an overview of the proposed tax treatment for transactions associated with crypto-currencies, specifically Bitcoin, in Australia.
The ATO’s guidance proposed that Bitcoin and other crypto-currencies should not be treated as currency for Australian tax purposes. Rather, transacting with Bitcoin should be considered as akin to a barter transaction where non-cash consideration is received and Bitcoin should be treated as a commodity for tax purposes in business transactions.13
The ATO also suggested that Bitcoin should be treated as an asset for Capital Gains Tax (CGT) purposes. The disposal of Bitcoin in the course of carrying on a business or when acquiring an investment could therefore also have CGT implications.
Critics of the ATO’s approach argue that the implications of this are that GST could be payable twice in respect of a business transaction involving Bitcoin – GST could be levied on both the acquisition of a Bitcoin and also when the Bitcoin is used to pay for goods and services.
The ATO’s approach was criticised in some submissions made to the Senate Inquiry, and is at odds with the approach taken by some foreign revenue authorities, although it is consistent with others.14
For example, HM Revenue and Customs (the UK customs and tax authority) has discarded its plans to charge Value Added Tax (VAT) on income received from Bitcoin mining and related activities.15 VAT will simply be due in the normal way from suppliers of goods and services sold in exchange for Bitcoin.16
Advocates of Bitcoin claim that the ATO’s approach has caused confusion in the industry, gives rise to difficulties in structuring transactions, makes Bitcoin impractical to purchase locally and fails to reflect the true functional characteristics of Bitcoin and the way that it operates.17
MasterCard, in a written submission, argued that any regulations should be technology neutral and that all participants in the payments system that provide similar services to consumers should be regulated in the same way to achieve a level playing field for all.18
5 Commercial risks and opportunities associated with Bitcoin
Low fees. Bitcoin is subject to minimal transaction fees, particularly because transactions are peer-to-peer. In this way, Bitcoin has the potential to reduce transaction costs for payments and fund transfers and users can theoretically avoid fees and other constraints that are imposed typically on transactions by traditional financial institutions.
Convenience. Another major benefit of Bitcoin is that it is very convenient and versatile and may potentially improve payment efficiency. Cross-border transactions, in particular, are facilitated by the fact that Bitcoin is digital and is able to operate independently of geographical borders. One sector which has seized on the convenience offered through the use of Bitcoin is online gambling. This benefit is also particularly relevant for global e-commerce transactions, for example in connection with online shopping.
Resistance to regulation. There is a clear tension between Bitcoin’s intrinsic resistance to regulation and the need to develop an effective regulatory system for crypto-currencies. Bitcoin is especially difficult, if not impossible, to regulate at a transactional level, because it is intangible and involves largely anonymous, peer-to-peer transfers. This makes it difficult for authorities to trace accountability and monitor the use of Bitcoin where there may be a suspicion of criminal activity. This has bolstered concerns that the characteristics of Bitcoin facilitate transactions involving money laundering, tax evasion, fraud and the purchase of illegal goods such as drugs.19 ASIC has also commented that, if the Bitcoin network fails or is hacked, individuals will not be protected and will have no statutory recourse or consumer protection.20 For example, in October 2013 an Australian Bitcoin bank was hacked, resulting in losses equivalent to US$1 million.21
Volatility. The value of Bitcoin is extremely volatile and vulnerable to the effect of extraneous factors, including its popularity at any given time. This can be influenced by factors such as the number of merchants accepting Bitcoin and the ease with which it can be used and traded internationally, particularly in light of the effects of external regulation measures operating in different jurisdictions.22
Technical limitations. Bitcoin has various technical limitations that may also inhibit its utility. The most significant of these include:
- Fragmentation: fractions of Bitcoin may accumulate where small purchases involve only a fraction of a Bitcoin. In the future, especially as individual Bitcoins increase in value, the system may potentially become clogged with fragments of Bitcoin because it is impossible to arbitrarily join the fragments; and
- Response time: the completion of Bitcoin transactions is not necessarily automatic. This may make Bitcoin impractical for point of sale and limit immediate sales to small value items.23
6 The future
The Senate Inquiry’s objectives are admirable, and seek to identify a regulatory regime that:
- Determines the most appropriate definition of digital currencies under Australian law;
- Promotes competition and the growth of the digital currency industry;
- Ensures ongoing stability in the financial services industry;
- Secures the protection of consumers and businesses against illegal activities;
- Incorporates digital currencies into Australia’s national security framework; and
- Ensures the financial stability of the digital currency industry.24
Given the distinguishing characteristics of Bitcoin and other crypto-currencies, and the pace at which the industry is moving on a global level, designing practical solutions to address these concerns is an important and complex task.The future of Bitcoin and its regulation in Australia is difficult to predict. Submissions to the Senate Inquiry, however, highlight the fact that the maintenance of the ATO’s current approach is a major cause for concern for Australian businesses, especially startups: it seems clear that a regulatory approach that imposes double taxation will make transactions uneconomic and discourage the uptake of the new technology by Australian businesses.
It is clear that regulators need to develop thoughtful, innovative and sensible policies that protect the public without stifling crypto-currency innovation and the resulting potential for economic growth.25 An overly cautious and ill-considered legislative response is likely to have significant implications for Bitcoin’s utility in Australia in the short term, and ultimately the question as to whether Australia can take a leading role in promoting FinTech and e-commerce or whether we will be playing catch-up with other jurisdictions who more nimbly seize these opportunities.
The Senate Inquiry’s Report is due to be published by the first sitting day of Australia’s federal Parliament in March 2015.
We will keep you informed of further developments.