Thinking of investing in crypto? Here’s what you need to know

by | Nov 30, 2022 | Advisory Services | 0 comments

By Savannah Dawson, Sentinel International

In light of recent events concerning the FTX bankruptcy scandal, have a look at our approach to the taxation of crypto assets in South Africa. Stay tuned for a follow-up article specifically relating to how to manage your assessed losses from crypto assets. Sentinel International Advisory Services can assist you in this regard.

In the ever-changing world of finance, the biggest player to come out on top in recent years is cryptocurrency and its use of blockchain technology. Unfortunately, as technology has progressed, so too have the tax laws. To prevent being caught unprepared, here’s a guide to understanding how cryptocurrencies and decentralised systems work and any relevant tax consequences should you decide to invest.

What is cryptocurrency?

Let’s start at the beginning. Simply put, it’s a digital currency designed to work on a decentralised ‘blockchain’ system, which does not rely on any single authority such as a bank or government. The most popular cryptocurrency, and the one that made crypto famous, is Bitcoin. In South Africa, the South African Revenue Service (SARS) has amended its definition of cryptocurrency to include ‘crypto assets. Consequently, in this article, any reference to cryptocurrency equates to crypto assets, or just ‘crypto’ for short.

The main stumbling block in crypto is people’s inherent mistrust. When the average investor hears ‘Bitcoin’ or ‘blockchain’, they immediately think there’s something suspicious going on. But as with anything in finance, it pays to get to grips with the jargon and to understand how the system works.

When we refer to ‘blockchain’, we’re talking about a decentralised ledger of transactions – this is the technology at the heart of almost all cryptocurrencies. To understand the concept of a decentralised system, you first need to understand how a centralised system works. A centralised system is when there’s a single owner who stores all the data and user information that other users can access. It’s a comparatively easy system to operate and set up, as everything leads back to a single entity. But there are some negatives: Because of the single-entity control, a centralised system is exposed to greater security risk; and the system is more susceptible to mistakes and failures. A bank is a good example of a centralised system.

A decentralised system, on the other hand, does not have a single owner but instead operates on a network with multiple users who work independently to verify the transactions that occur on that system. The benefit of this multi-user structure is that if one user crashes, there are others who will still be able to provide access to the information and store the data, meaning that the system is less likely to fault compared to a centralised system. A negative is that maintaining a decentralised system costs substantially more. As mentioned above, the blockchain is the platform that connects users on a decentralised cryptocurrency system.

More jargon busting

Those aren’t the only terms people bandy about when discussing crypto. Throw in ‘mining’, ‘staking’, ‘ICOs’ and ‘NFTs’, and the average investor might think you’re speaking a different language! It’s easy to feel confused and overwhelmed.

Let’s start with the most frequently used term: mining. This is the process of creating more of a certain cryptocurrency. For example, to create more Bitcoin – to ‘mine’ it – complex maths problems need to be solved that verify Bitcoin transactions, usually achieved using tremendous computing power. Depending on how many of these are solved, the miner will receive a specific amount of Bitcoin in return.

Staking is essentially the same thing – it also refers to creating more of a certain cryptocurrency. (Depending on the type of crypto you hope to make more of, you might use one of these terms.) With staking, crypto is created by ‘locking’ the cryptocurrency in question for a specific period of time. During this lock period, the user participates in a process of verifying transactions. The more the user participates, the more cryptocurrency is spawned (or minted to use a traditional term). Ethereum is an example of a cryptocurrency that uses staking.

ICO? This is an acronym for Initial Coin Offering, which is basically the crypto version of an Initial Public Offering (IPO). A platform or company will develop a cryptocurrency and offer it to the public to be purchased. Depending on the purpose of that specific cryptocurrency, it can either be used as a shareholding in the company or even as airtime to access the company’s platform. The crypto universe is vast and expanding rapidly, and new currencies appear regularly. Some of them are not as legitimate as others, and it pays to do your research before you decide to participate in any ICO scheme.

Another prominent asset that has started stealing headlines in the crypto sphere is the NFT, or ‘non-fungible token’. An NFT is usually a digital file – a video, an audio clip, a photo or any other image or artwork – that is tradable on a blockchain. NFTs differ from cryptocurrency in that each one is unique and will not be replicated. The idea is that they will be valuable in a fully digital realm like the fabled Metaverse (a series of connected virtual 3D worlds).

Tax considerations when investing in crypto

As mentioned, cryptocurrencies are referred to by SARS as ‘crypto assets. This is an important distinction because ‘currency’ is a defined term for taxation purposes, and cryptocurrency is not considered a currency when it comes to South African taxation principles.

Purchasing an asset does not generally result in tax consequences, but the disposal of that asset does. Selling it, in other words. Thus, when selling crypto assets, the main aspect to consider from a tax perspective is intention. This is the determining factor in establishing whether you might have to pay capital gains tax or income tax. If the intention was to make a profit, it’s likely that income tax rules will be applied, and you’ll be taxed according to your tax bracket. The difference can be massive: income tax might be as much as 45% if you’re in the highest bracket, whereas capital gains tax will max out at 18%. The intention, therefore, plays a massive role, and the onus is on the taxpayer to prove whether income gained from crypto is revenue or capital in nature. It’s a tricky tightrope to walk, and it might be worth consulting with a tax expert if you plan to take your crypto investing seriously.

Another thing to note is that South African retirement funds that operate under the Pensions Fund Act are (currently) not permitted to invest in crypto assets. This is due to the high risk and volatility of crypto trading. So, if you decide to invest, you must do it outside of regulated fund structures.

What about exchange control and arbitrage?

When purchasing crypto assets, it’s important to clarify where they are coming from. This is because South Africans are subject to exchange control regulations and cannot freely remit South African funds overseas unless they have the necessary clearance from the South African Reserve Bank (SARB), which is in the process of creating its own set of rules to regulate the trade of crypto assets.

Many investors use a process called arbitrage to maximise their crypto returns. Arbitrage is the simultaneous buying and selling of cryptocurrency in different markets to take advantage of differing prices for the same asset. At the moment, it remains legal to arbitrage crypto assets, provided individuals use their own discretionary allowance, or they have the necessary tax clearance, to buy dollars and purchase crypto overseas then transfer those assets to a local platform and sell them for rands. However, it’s illegal to sell offshore assets and accept crypto assets as payment, which you then transfer to South Africa in exchange for fiat currency.

The difficulty with having a decentralised system is that there is a multitude of users located all over the world. Therefore, Crypto does not have a country of origin, but the platform on which it’s traded does, and that determines where your assets are held. Take Luno, for example. It’s probably the most popular crypto trading platform in South Africa and although it was founded by two South Africans, the business itself originated in Singapore. However, Luno has set up a local company to allow South Africans to trade on a South African exchange.

Three takeaway messages

With all of the above in mind, you can feel more confident when engaging with cryptocurrencies and other crypto-based assets. To summarise, here are three key aspects you should consider if you’re considering investing in crypto:

1 Make sure you know where you stand with SARS

SARS is on a crypto mission and they’re holding a magnifying glass to people who have invested in crypto assets. Make sure you’re prepared for the scrutiny. Consult with a tax expert and ensure your crypto investments are structured in the most tax-efficient way possible.

2 Crypto remains a high-risk asset

Don’t cash in all your traditional investments and load up on Bitcoin. Despite crypto becoming more mainstream, it still pays to trade with caution.

3 Do your research

The crypto landscape is constantly changing. Before you decide to buy a newly minted currency, invest in an NFT, or decide on an arbitrage strategy or a platform to trade on, do your research. Read what is being said online, speak to people who have made similar investments and proceed with discretion.

This article is based on a podcast that Savannah did with KPMG. Listen to the interview here (scroll down to the “Intro to Crypto Assets Podcast“).