Crypto losses and the taxman

by | Feb 7, 2023 | Advisory Services | 0 comments

As the fallout of the FTX bankruptcy scandal rumbles on, many crypto investors in South Africa are likely to incur significant short-term losses. Sentinel’s Savannah Dawson, addresses concerns crypto asset holders may have about how crypto assets might be treated by SARS.

The world of crypto has taken a significant knock over the past year, with the recent cherry on top being the FTX bankruptcy scandal. This has the potential to cause significant crypto losses for many investors. With increased scepticism towards the asset class and the potential for assessed losses on a few investors’ balance sheets, this article aims to address any apprehensions crypto asset holders may have concerning assessed losses and how crypto assets may be treated by SARS.

General deduction formula

“Taxable income” is that which remains after deducting allowable deductions. Before assessing if an expense can be allowed as a deduction for tax purposes you should consider the general deduction formula, both in positive terms as well as negative terms. The first and most important requirement for an expense to qualify as a tax-deductible expense is to establish if the taxpayer was carrying out a trade. The law specifically prohibits any amounts not expended for the purpose of trade. As discussed below the definition of “trade” is quite broad and trading with crypto could be included in this definition.

An expense or a loss was further clarified in the Joffe case by Judge Watermeyer who said that : ‘in relation to trading operations the word [expense] is sometimes used to signify a deprivation suffered by the loser, usually an involuntary deprivation, whereas expenditure usually means a voluntary payment of money’. [i] The other very important requirements are for the expense to be actually incurred in the production of income during the year of assessment. The law prohibits a deduction of expenditure incurred in respect of amounts received that would not be included in ‘income’.

Is crypto trading stock?

Trading stock is defined as ‘anything produced, manufactured, constructed, assembled, purchased or in any other manner acquired by a taxpayer for the purpose of manufacture, sale or exchange by the taxpayer or on behalf of the taxpayer.’ The specific circumstances, purpose and details of each transaction would have to be considered to determine if an asset qualifies as trading stock. If the product does qualify as trading stock the opening and closing stock balances must be taken into account when calculating the total deduction from taxable income.

It is important to be aware that the mining, staking, buying or selling of crypto assets easily falls within the ambit of the definition of trading stock. Crypto assets are produced and purchased and often sold or traded for something else. The more frequently you trade Crypto Assets, the easier it is for SARS to qualify them as trading stock.

What is an Assessed Loss?

Notwithstanding the provisions of the Income Tax Act regarding exceptions and allowable deductions, Section 20 of the Act introduces ‘assessed losses’. Assessed Losses exist when deductions exceed the amount of income earned by a Taxpayer, meaning they have made an overall loss for the year. In practice, the Taxpayer would examine each trade to ascertain whether it constitutes “income” or “expenditure” before arriving at a total taxable income or total assessed loss for the year of assessment.

The benefit here is the ability to set off your assessed losses from your taxable income, ultimately reducing the amount of tax payable to SARS. There are two requirements for an assessed loss:

  1. The taxpayer must be carrying out any trade
  2. The set-off of an assessed loss is against income derived from carrying out such trade.

‘Trade’ is specifically defined under Section 1 of the act as follows:

“every profession, trade, business, employment, calling, occupation or venture, including the letting of any property…”

The definition is broad enough to include any activity where one may have the potential to earn income. Crypto trading should meet this requirement. The second requirement is that income is being derived from the trade with which assessed losses may be calculated.

Once the above has been established and it is clear you are engaging in a trade that derives income, the next hurdle is ensuring such trade does not qualify for ring-fencing. Ring-fencing means restricting the assessed losses to the specific trade from which they are derived. This means you are only able to set off assessed losses from this trade against profits resulting from the same trade. This ring-fence structure exists to protect SARS from individuals who hedge on risky assets to simulate a significant assessed loss, which can then be set off against their taxable income to decrease their tax liability.

To further assist SARS in assessing which trades should be ring-fenced, a list has been produced which identifies “suspect trades”. Crypto assets are currently listed as a suspect trade and depending on the circumstances (which shall be addressed below), assessed losses resulting from crypto trading may have to be ring-fenced.

How does SARS treat crypto asset Assessed Losses?

As explained above, suspect trades are at risk of being ring-fenced – to the ultimate detriment of the taxpayer. Importantly, assessed losses are not automatically ring-fenced, even if they come from a suspect trade. SARS uses a 4-step process to determine whether a trade should be ringfenced. These steps are clearly defined and can be broken down as follows:

  1. Individual taxpayer must be on the maximum marginal tax rate 
  2. ‘Three-out-of-five-years’ requirement OR ‘listed suspect trade’
  3. Facts and circumstances test
  4. ‘Six-out-of-ten-years’ test

Step one can be a lifesaver for some taxpayers. If you are not in the highest tax bracket (as of 2022 this means earning R1 656 600.00 or more), then your assessed losses cannot be ringfenced. This means that you would be able to set off all your assessed losses, regardless of trade, from your overall taxable income derived.

If you are at the maximum marginal tax rate, and you are buying and selling crypto assets, you would automatically satisfy the second step. This is for the sole reason that crypto assets are a listed suspect trade. Often, practitioners stop the test here and advise that if you are trading with crypto assets, all assessed losses shall be ringfenced. This may be true in some circumstances; however, it is not automatic and it may be possible to argue that the losses should not be ringfenced.

Step three often causes the most confusion as it relies on interpretation and the ability to argue your circumstances. As a taxpayer, the burden falls on you to argue why the trade should not be ring-fenced. This can be achieved by satisfying two requirements, commonly referred to as the “escape clause”. If you can argue that firstly, your crypto asset trade has a reasonable prospect of deriving taxable income (profit) and secondly, that you are able to make such profit within a reasonable period of time, then you are able to escape the consequence of your assessed losses being ring-fenced for your crypto asset trade.

The above step is significant as the Act does not define “reasonable”. Instead, numerous factors must be considered in order to determine whether the specific facts satisfy the escape clause. These factors include but are not limited to:

  • investigating the proportion of gross income earned from the trade compared to allowable deductions
  • whether you have a business plan to show the prospect of a profit
  • whether you operate the trade in a commercial manner
  • the extent to which the asset attributable to the trade may be used.

With crypto assets, considering whether you are mining/staking crypto in a commercial manner (equipment, location, use of space), would assist in determining whether your trade qualifies as a viable business capable of making a profit. The same observations can be made for a person who is trading with multiple crypto assets on crypto exchange platforms. If you are trading to make profits and have a clear business model which shows the propensity to make a profit, such circumstances would be favourable in arguing against ring-fencing your trade.

The final step is a catch-all provision, which states that should your trade incur an assessed loss for six-out-of-ten years, and you are engaging in a suspect trade, then you shall no longer be able to use the escape clause. The trade will automatically become ringfenced in that year and in all future years. Interestingly, this is not automatic if you are not engaging in a suspect trade or your trade involves farming.

Caution going forward

With the crypto sphere being as volatile as ever, all individuals who hold crypto assets should seek tax advice regarding how to best manage their assessed losses. Taking steps sooner rather than later could help you to avoid having your assessed losses ring-fenced. Sentinel International Advisory Services has skilled practitioners who can assist in navigating these circumstances.

[i] Joffe & Co (Pty) Ltd v CIR (1946 AD)