Cryptocurrencies: Do We Know Enough?

By Ruan Botha, Legal Adviser, Western Cape

Table of Contents

About Cryptocurrencies

The Road to Crypto Regulation

Cryptocurrencies and Your Financial Affairs

In Closing

About Cryptocurrencies

What is Meant by the Term ‘Cryptocurrencies’?

A cryptocurrency (crypto) is a digital or virtual currency that is secured by cryptography (to secure transaction records) which makes it nearly impossible to counterfeit. It is intended to work as a medium of exchange – it can be used to buy goods and services or one can trade them for profit. It does not exist in physical form – so it is not like paper money, and it is generally not issued by a central authority. There are many different cryptocurrencies around – Bitcoin was the first to be issued in 2009.

A cryptocurrency, crypto-currency, or crypto is a digital asset designed to work as a medium of exchange.

What is Blockchain and What Role Does it Play in Cryptos?

When cryptos are released into the market, they typically use decentralised controls as opposed to centralised controls, like central banks. When a crypto is released by an issuer, it is considered to be centralised; however, as soon as it is available in the market, it is decentralised and distributed via ledger technology that is referred to as blockchain. It serves as a database of all the financial transactions.

Blockchains store data in blocks that are then chained together, and as new data comes in, it is entered into a fresh block. This block with fresh data is then chained onto the previous block.

Who Developed Cryptos?

The most common cryptocurrency known is Bitcoin which was launched in 2009 by an individual or group known by the pseudonym “Satoshi Nakamoto.” Although the name “Satoshi Nakamoto” is often synonymous with Bitcoin, the actual person that the name represents has never been found, leading many people to believe that it is a pseudonym for a person with a different identity or a group of people.

Subsequent to Bitcoin, many other cryptos have been launched where the founders or creators are known, some of the most common examples include:

  • Dodgecoin, introduced in 2013 by Jackson Palmer and Billy Markus,
  • Ripple, also introduced in 2013 by Chris Larsen and Jed McCaleb,
  • Ethereum, introduced in 2015 by Vitalik Buterin.

In total, there are between 4 000 and 5 500 (depending on which search engine you believe).

Who is the Owner of Cryptocurrency?

Generally speaking, the investor is the owner of the cryptocurrency.

When considering who ‘owns’ the crypto, one would rather look to the person that controls the system on which the blockchain or similar system operates, so they would rather be found at the helm of a technology company which will develop the payment protocol and exchange networks linked to that specific cryptocurrency.

How Is the Value of Cryptocurrencies Determined?

Bitcoin and other digital currencies are valued according to the supply and demand thereof and the speculative interest. Other factors include the regulations governing its sales, its internal governance, the number of competing cryptocurrencies and also the cost of producing crypto or bitcoin through the mining process and rewards issued to miners for verifying transactions to the blockchain.

According to Investopedia, there were over 18.6 million bitcoins in circulation as of March 2021, with a total market cap of around $927 billion.

What Does Mining of Cryptos Mean?

Mining is the process in which transactions between users are verified and added to the blockchain ledger. The process is also responsible for introducing new coins into the existing circulation supply. It is important to note that not all cryptos are mineable.

These digital currencies are not backed by any physical commodity or precious metal.

The Road to Crypto Regulation

Cryptocurrencies are very difficult to regulate, and a lot of emphasis is made on the fact that it needs to be regulated. As there is no central bank and nothing about crypto being centralised, it is very easy to use crypto for illicit transactions, as proceeds and cost basis are exceptionally difficult to track.

A recent anti-money laundering rule proposed by the U.S. government would require people who hold their crypto in a private digital wallet to undergo identity checks if they make transactions of $3,000 or more. The U.S. isn’t the only country considering strict new rules on crypto.

In India, for example, the government is considering a law that would ban cryptocurrencies and penalize anyone holding or trading them. According to the recent news published by Business Insider, the Turkish central bank said it would ban the use of cryptocurrencies as a form of payment, effective from 30 April 2021. The new regulations do not stop Turkish citizens from holding crypto assets.

So, How Will This Be Regulated in South Africa?

Will we follow in the footsteps of the first world countries?

Numerous crypto investors would argue that the main reason for cryptos being popular, is because it is free from any regulations. They fail to realise that regulations are in fact imposed to protect consumers, economic stability and the interest of stakeholders.
The FSCA is constantly publishing warnings to investors to be very cautious and vigilant when either dealing or investing in these virtual currencies. In November 2020 they published a position paper on cryptocurrencies which was open for comment until the end of January. They also released the following statement:

“The FSCA would like to emphasise, crypto-related investments are not regulated by the authority or any other body in South Africa. As a result, if something goes wrong, you are not likely to get your money back and will have no recourse against anyone.”

FSCA, November 2020

The intention of the FSCA is not to regulate cryptos per se, but rather the services related to it. One way would be to include it under the definition of a financial product in the FAIS Act – which it is not at this stage.

Regulation is essential for cryptocurrencies as it will help build the trust that reputable crypto operators are seeking, and it will definitely help prevent the possible next scam.

To support this notion, let’s look deeper into the MTI fraud case and whether regulation could have been the hero. The infamous case of South Africa’s Mirror Trading International (MTI) has been crowned as the world’s largest cryptocurrency Ponzi scam. MTI was an online bitcoin trading platform with their headquarters in Stellenbosch that promised lavish returns to investors looking for passive income. It was started in April 2019 by Johann Steynberg from Polokwane who was the group’s founder, CEO, and according to company records, sole director. After accepting hundreds of millions of rands in investments, it was provisionally liquidated in December 2020 after it abruptly stopped paying out funds. A total of around $589 million was lost.

There are various ways that MTI’s fraud could have been prevented and/or limited. The Companies Act required MTI to be audited as a result of it holding customers’ bitcoin and currency in a fiduciary capacity where that value was in excess of R5 million.

Based on the application of relevant accounting frameworks, each rand or bitcoin invested into MTI would have resulted in a corresponding customer liability on the balance sheet. This massive liability would have resulted in a significant public interest score (as calculated by the Companies Act) that would have also required the company to be audited and to have a social and ethics committee.

Properly constituted, this would have further reduced the possibility of fraud as a result of a single director denominated company. MTI had a February year-end, and in terms of the Companies Act, was required to have audited financial statements by no later than August 31, 2020, which is six months after its financial year-end. Had MTI been regulated by the FSCA, this period may have decreased to three months – shedding light sooner on the misappropriation of funds.

At the rate at which funds were flowing into MTI (but also out the back door), these losses could have been limited to August or even May of 2020. The sole director had failed to appoint an auditor and there was no regulating body overseeing or requesting MTI to provide audited financial statements.

Several red flags on its extremely complex marketing business plan would have been raised by both regulators and auditors. If a company such as MTI made it past the acceptance procedures of an audit firm, the challenge would be to identify the fictitious assets that a Ponzi scheme relies on in addition to a certain level of pseudo-anonymity that bitcoin provides.

Although the MTI case has shown that crypto assets present a variety of novel legal complexities, we are interested to see what arguments are going to be presented in favour of converting MTI’s liquidation into business rescue should the group of investors pursue this route. We hope to see the court develop a clearer precedent for navigating these unchartered waters.

What Worldwide Developments Are Currently Taking Place to Support Governance and the Road Ahead?

The good news is that the world is moving towards regulating cryptos, with various initiatives on the go at the moment.

There is a new initiative called The Regulatory Sandbox. According to MyBroadband’s webpage, there is a collaboration between currency specialists, Mercury Foreign Exchange and Rexchange platforms Ripple and VALR, who have announced that their initiative to test the regulatory treatment of cross-border payments using the Ripple cryptocurrency, XRP.

There is another Regulatory Sandbox being created that is an initiative of the Intergovernmental Fintech Working Group (IFWG), an organisation that includes South Africa’s major financial regulators and government agencies. National Treasury, the South African Reserve Bank, the South African Revenue Service, the National Credit Regulator, the Financial Sector Conduct Authority, the Financial Intelligence Centre and the Competition Commission are all part of the IFWG.

The IFWG has stated that the purpose of its regulatory sandbox is to provide a space for safe experimentation.

Standard Bank is currently experimenting with the reporting of cross-border foreign exchange transactions submitted to the Financial Surveillance Department of the South African Reserve Bank using a blockchain platform, and verifying that the reporting is timely and in compliance with all relevant reporting rules as prescribed in the Business and Technical Specifications. The reporting tested will happen in parallel to the existing reporting process, and clients would not be impacted.

Investec is testing a safe custody service for crypto assets through a Digital Asset Vault. This is a secure mechanism for Investec clients to store and transfer crypto assets, reducing reliance on crypto asset exchanges or complex cold storage, i.e. hardware wallets. The objective is to test Investec’s regulatory compliance, regulatory reporting processes, and related risk management frameworks in collaboration with the IFWG.

Taking Everything Into Consideration, One Can Ask: “Are There Any Plans for Regulating Cryptocurrencies in South Africa in the Future?”

The short answer is, yes! The IFWG has recently published a position paper on crypto assets in SA and their plan on how to regulate it. They have stated that they are not necessary for or against cryptos and the purpose of the proposed regulation would be to level the playing field for existing and new entrants to the market. They do not intend to regulate the actual cryptos, but rather the entities that provide the services relating to cryptos – regulating crypto asset service providers (CASPs). One of the first steps will be to bring CASPs under the auspices of FICA and then to place certain obligations on these entities regarding reporting duties in respect of suspicious transactions and also transactions above a certain amount. Similar to banks, they will also have to do risk assessments on clients. It is made clear though, that cryptocurrencies will not be recognized as electronic money – and whether it will be included in the definition of financial assets under the FAIS Act is not clear at this time.

Cryptocurrencies and Your Financial Affairs

Can a Licensed FSP Give Advice on Cryptocurrencies?

As quoted above, the FSCA has stated that crypto-related investments are not regulated by them or any other body in South Africa. As a result, if something goes wrong, you’re unlikely to get your money back and will have no recourse against anyone.

Over the last couple of years, many financial advisers in South Africa have been held accountable by the FAIS Ombud, the Appeal Board and our Courts after advising clients on high risk investments that failed. The question is whether history will repeat itself as more and more financial advisers buy into and express “opinions” to their clients about virtual currencies.

The Financial Intermediaries Association of South Africa (FIA) is concerned about financial advisers expressing opinions about virtual currencies to clients or potential clients, without understanding the potential implications.

Virtual currencies are not defined as securities in terms of the Financial Markets Act, 2012 (Act No. 19 of 2012. According to the FSCA, a virtual currency is not a financial product as defined in section 1(1) of the FAIS Act, and the definition of “advice” has no relevance when it relates to a product that is not a financial product. But this does not mean that a person (who is also an FSP) advising a client to invest in a virtual currency cannot be held liable based on the law of delict.

Expressing an opinion can be perceived by a client as an endorsement or encouragement to “buy” into a digital currency and may attract liability for advisers. It is well published that the High Court in the Eastern Cape has previously held an adviser accountable for giving “advice” at a “braai” and advisers should therefore not be surprised if this happens again. It is fashionable these days for advisers to engage in conversations and some even encourage their clients to invest in cryptocurrencies.

The High Court in Bloemfontein has recently stated that the principles in DURR v ABSA, (a matter that went all the way to the Supreme Court of Appeal and which preceded the FAIS Act by several years) are still relevant today. What is important to remember is that DURR v ABSA dealt with the duties of a financial adviser, which includes the duty to act with care, skill, and diligence. The principles in this matter have been used by the FAIS Ombud and the High Court on many occasions as the legal basis on which advisers have been held liable in the past, and advisers will do well to consider it carefully.

One of the main arguments that the FAIS Ombud, the Appeal Board and our Courts have used in their findings against advisers is the issue of due diligence. Currently, it is simply impossible to do a proper due diligence on virtual currencies.

The National Treasury, on behalf of the South African Reserve Bank, the FSCA, the South African Revenue Service and the Financial Intelligence Centre, have warned members of the public to be aware of the risks associated with the use of virtual currencies for either transactions or investments. Treasury made it clear that there is no investor protection and no recourse, and because virtual currencies are not regulated, users are not protected and are at the risk of losing money.

However, this does not guarantee that financial advisers may not be held accountable if it is perceived that they have expressed an opinion, which investors could allege may have been instrumental to buy into a virtual currency. It is also important to remember that advisers do not have to be paid for their guidance for it to qualify as “advice”. Being paid a fee or commission is not a prerequisite for potential liability to exist.

Are the Proceeds From Crypto Transactions Taxable?

SARS considers digital currencies or cryptocurrencies to be assets of an intangible nature as opposed to currency or property. Is it then subject to income tax or capital gains tax?

When making a profit from a crypto transaction, one has to ask whether the intention is to trade in cryptocurrencies or to hold it as a long-term investment (similar to when investing in listed shares). If the investor’s intention is to trade, then any profits realised when selling cryptocurrency will be seen as gross income, and as a result, it will be subject to income tax at the investor’s marginal income tax rate. Any expenses incurred to realise the gross income may qualify as a deduction when determining the taxable income (as per normal) and the investor will have the burden of proof to convince SARS that the expense is in fact tax deductible.

If the investor’s intention is to hold the cryptocurrency as a long-term investment, then any gains realised will be of a capital nature and as a result subject to capital gains tax. In this case, the purchase price of the cryptocurrency will be the base cost and depending on the nature of the expenses incurred to acquire the crypto, it may also be allowed as part of the base cost.

The question on all taxpayers’ minds is obviously, if cryptocurrencies are not yet regulated, how will SARS know about the transactions if the taxpayer does not declare it? SARS was quoted by South African media sources in early 2020 that they are busy expanding their cryptocurrency audit and detection services, and as a consequence, they have also listed employment opportunities geared towards crypto tracking. But the short answer to this question is, that similar to any other income that is not reported to SARS, the duty is on the taxpayer to declare the income or capital gains realised and if it is not done, the Tax Administration Act and the Income Tax Act provide SARS with the tools to take necessary action and to charge penalties and interest on taxes that were due but not declared and paid.

So How Should the Taxpayer Make the Declaration?

According to the SARS crypto guidelines, it is specified that investors can exchange local currency for a cryptocurrency or vice versa via exchanges or through private transactions. These transactions will be categorised as “normal cash transactions” to be reported on the Provisional Tax Return (IRP6).

To either prove or document your transactions, SARS guidance states that conventional invoices and or receipts will be sufficient.

SARS has already begun asking for information on crypto transactions on audit letters issued to taxpayers, and this means that non-compliant taxpayers will either have to lie (and risk incurring further penalties and back tax later) or reveal their trading history. Remember that the provision of incorrect information will constitute a criminal offence.

In addition, SARS is investing heavily in its IT capabilities which will enable it to analyse financial and transactional data more effectively and identify transactions in and out of crypto platforms. Using foreign bank accounts is not a solution either because South Africa is party to numerous agreements which enable automatic reporting between jurisdictions.

And in closing, it is important to remind ourselves that the Financial Intelligence Centre Act places an obligation on the financial adviser to report tax evasion – as a result, if a client is invested in cryptocurrencies and the financial adviser is aware that the client is not declaring gains/income for tax purposes, there is a duty to report.

Practically, What Happens if the Investor Dies?

Calls have been made for a more responsible approach to ensure an enduring financial and family legacy for future generations. Despite all the buzz around legislation or tax consequences, there are a lot of crypto investors currently in South Africa, and these investors generally fail to give their beneficiaries a full picture of their crypto portfolio. In addition, there is an absence of legislation governing how digital assets should be dealt with on death.

An executor is generally appointed to administer the deceased estate, to finalise all matters that the estate was involved in and to give effect to the wishes of the deceased as contained in the Will or the Intestate Succession Act, where no Will exists. For an executor to do this successfully, information is key – the executor can only work with what is known. So as a first step, it is important to ensure that the executor knows that the investment in cryptocurrency actually exists. And on this point, it is important to note that with every account a crypto investor holds, another layer of complexity at death is created. This varies from authenticator keys, hardware wallets, usernames, passwords, security questions to simple smartphone login details. This means that it could be very difficult for an investor’s beneficiaries or heirs to know how and where to access this digital wealth.

Investors should consider a storage execution strategy for account information. It is advisable that where a digital currency portfolio exists, an inventory should be made of all digital assets and accounts. Very important is to indicate how they all can be accessed by providing the usernames and passwords. An investor should then store the information in a secure place and then provide access to a trusted friend, family member or loved one (or executor).

Are Cryptocurrencies Part of the Deceased Estate for Estate Duty Purposes?

In addition to the practical aspect (even if the financial adviser does not provide advice on the actual investment into cryptocurrencies), it is necessary that cryptocurrencies are considered when doing an estate plan and when implementing that plan.

When doing the estate liquidity calculation, one can consider the crypto as liquid – as it is generally easily traded – however, volatility does pose a threat to the success of a liquidity plan purely based on cryptos.

Cryptocurrencies will be part of property in the estate of the deceased, and they will be subject to estate duty, as with any other asset. Therefore it can have detrimental consequences to the plan if it is ignored – some portfolios are so valuable that it can result in millions in estate duty, especially if it is not dealt with in the Will and no mention is made of a residue – if an asset is not bequeathed in terms of the Will of a deceased person, the Intestate Succession Act will apply in respect of that asset, which can have consequences much different to what the deceased intended.

Consider this example:
Peter invested the equivalent of $10 000 in bitcoin on 31 October 2015 (exchange rate on the day was R13.82/$ = R138 200). The price was $333 – therefore, acquiring 30 bitcoins.

If Peter died on 1 May 2021, the price of bitcoin was at $57 206 – therefore leaving Peter’s estate with $1,717 897 in bitcoin – converted to Rand at the exchange rate of R14.49/$ it is R24 892 327. If this asset was ignored in his estate plan, what impact could that have?

In Closing

One thing is sure, change is inevitable, and in the financial services industry, there is something new to learn every day. Cryptocurrencies results in a bit of a contradiction as financial advisers are not authorised to give advice on the actual investment made; however, when doing a client’s tax planning and estate plan, the topic has to be breached with the client – which can open the door for unintentional advice being given. Therefore, until such time as cryptos are included as financial products under the FAIS Act, it is important to inform the client that advice cannot be provided on the investment into cryptos, BUT, for the estate plan and tax planning to be done accurately, the information relating to the investments must be made available.

The sources listed below were used to research this topic:

  • Investopedia
  • Wikipedia
  • BusinessInsider
  • FSCA website
  • SARS website
  • News24
  • Moneyweb
Share This
0
    0
    Your Cart
    Your cart is emptyReturn to Shop