Cryptocurrency has moved firmly into the financial mainstream. The price of bitcoin is now reported alongside exchange rates and share market indices. While some see cryptoassets as a legitimate medium of exchange, others view them as financial products operating with limited transparency and regulation. As crypto markets continue to evolve, the question increasingly arises: how should the tax rules apply?

As discussed in earlier articles, the Income Tax Act generally treats cryptocurrency in the same way as other forms of personal property. This means that income derived from disposing of cryptoassets will be taxable unless the holder can establish that the asset is held on capital account. In practice, that position can be difficult to sustain, particularly given the way many cryptoassets are acquired and used.

The analysis becomes more complicated when cryptoassets are used in decentralised finance (DeFi) transactions. These arrangements allow cryptoassets to be used in financial activities such as lending, staking, wrapping and bridging. Inland Revenue’s Tax Counsel Office has recently released an Issues Paper examining how the tax rules may apply when cryptoassets are used in these more sophisticated financial arrangements. It also explains what these arrangements are and how they operate from a technology perspective. 

The Issues Paper is a technical document, but its purpose is to explore possible interpretations rather than to reach definitive conclusions.  Once officials have considered the feedback they will decide whether to offer further guidance.  However, in the meantime, the Issues Paper is a useful guide to navigate the complexity of these products, both in terms of the technology involved and the tax analysis.

A key feature of many DeFi transactions is that a cryptoasset may be transferred to another party with the expectation that it will be returned later. However, the exact asset is rarely returned. Instead, the holder typically receives an identical asset or one of equivalent value.

In some respects, this resembles a bailment-type arrangement. For example, livestock may be transferred to another party with the expectation that equivalent animals of the same type and age will later be returned. However, in the case of cryptoassets, the transfer and later return of equivalent tokens may still constitute a disposal and reacquisition for tax purposes. If that is the case, the transaction may trigger taxable income rather than being treated as a capital transaction.

The Issues Paper also considers whether there should be a policy response. One option would be to extend the share-lending rules in the Income Tax Act to cryptoassets. This could address concerns that some DeFi transactions are taxed in circumstances where participants may expect a capital outcome. Another option would be to deem cryptoassets with equity-like characteristics to be shares, in a similar way to what has been done for financial arrangements.

Overall, this Issues Paper provides a useful explanation of how the tax rules should apply to what are technically complex and rapidly evolving transactions. At the same time, it highlights the broader challenge of applying traditional tax concepts to new financial technologies. As crypto markets continue to develop, ensuring that the tax system can respond coherently to these innovations will become increasingly important.