Mankiw Research | Do you need to pay taxes when trading Virtual Money?

In the wave of the digital economy, virtual money trading has swept the globe, becoming a new hotbed for investors chasing wealth. In this digital gold rush, China's legal positioning on virtual money is vague, and trading regulation is strict, making tax issues even more complex. Understanding relevant obligations not only relates to legal compliance risks but may also directly impact investment decisions and returns. This article will focus on personal virtual money trading, exploring the possibilities and pathways for compliance and taxation under the existing regulatory framework in China, providing a reference for building a healthy and sustainable Web3 ecosystem. What is Virtual Money? To clarify whether Virtual Money is subject to taxation, one must first understand what Virtual Money is and whether buying and selling is permitted. Cryptocurrency is any form of currency that exists and is used in a digital or virtual way, utilizing encryption technology to secure transactions. Cryptocurrencies have no central issuing or regulatory authority, instead using a decentralized system to record transactions and issue new units. Currently, according to the "Notice on Preventing Bitcoin Risks" issued by the People's Bank of China and five other ministries (Yin Fa [2013]289) (hereinafter referred to as "Document 289"), the "Announcement on Preventing Token Issuance and Financing Risks" issued by the People's Bank of China and seven other ministries on September 4, 2017 (hereinafter referred to as "Announcement 94"), and the "Notice on Further Preventing and Handling Risks of Virtual Money Trading Speculation" issued by the People's Bank of China and ten other ministries on September 24, 2021 (hereinafter referred to as "Notice 924"), virtual money is defined as lacking legal compensatory and mandatory characteristics of currency, not having the same legal status as currency, and should not be used as currency in market circulation. However, none of the above notices deny the property and commodity attributes enjoyed by virtual money. Furthermore, Document No. 289 mentions that "Bitcoin trading, as a form of buying and selling goods on the Internet, allows the general public the freedom to participate at their own risk," and Notification No. 924 states that "participating in virtual money investment trading activities carries legal risks. Any legal entity, non-legal entity, and natural person investing in virtual money and related derivatives, which violates public order and good customs, will have their relevant civil legal actions deemed invalid, and any losses incurred will be borne by themselves." It can be seen that under the current system in China, citizens have the right to buy and sell virtual money. So, since virtual money can be bought and sold as personal property or goods, does this activity need to be taxed? Do I need to pay taxes? This article only discusses the most basic personal Virtual Money trading, without considering airdrops, DeFi yields, token staking, and other situations. The question of whether taxation is required can be considered from several aspects. From a national perspective, virtual money trading is not an industry that is encouraged to develop, and therefore there are no corresponding tax incentives or exemptions. In addition, under the current policy and economic environment, the country will not give up on collecting this potential tax source. From a regulatory perspective, taxing individuals first falls under the category of individual income tax. According to the "Individual Income Tax Law of the People's Republic of China," the following items of personal income are subject to individual income tax.

From a tax point of view, if an individual trades virtual currency for the purpose of obtaining income, then a more appropriate category may be interest, dividends, bonus income, or income from the transfer of property. However, if you hold virtual currency, there is no entity in its economic structure that can generate income or have a predictable return of interest to the occupied funds. Therefore, in terms of the purpose of holding and the nature of the assets, it is more in line with the income from the transfer of property. From a legal perspective, China has not yet introduced specific tax laws or regulations targeting virtual money as of now. The tax policy for virtual money in China mainly relies on the interpretation of existing tax laws and the practices of local tax authorities. In addition to the "Individual Income Tax Law of the People's Republic of China" mentioned above, the current "Reply of the State Administration of Taxation on the Issue of Individual Income Tax Collection for Income Obtained from Buying and Selling Virtual Money through the Internet" (Guo Shui Han [2008] No. 818) states that "individuals who purchase virtual money from players online and sell it to others at a markup should consider the income as taxable income for individual income tax, which should be calculated and paid according to the 'income from property transfer' item." Although this reply was issued before the birth of Bitcoin, the legal principles of blockchain virtual money and game virtual money are essentially the same, so individual income tax should also be paid in accordance with income from property transfer. How should the tax amount be calculated? Tax law stipulates: The income from property transfers is the balance after deducting the original value of the property and reasonable expenses from the income amount of the transferred property, which is the taxable income. A proportional tax rate applies, with a tax rate of 20%. In practical cases, transfer income is generally easier to confirm, while determining the original value of the property (purchase cost) becomes the key to calculating the taxable amount. In the case of purchasing a certain virtual money with RMB, holding it, and then selling it back to RMB, the selling price is considered income, while the buying price is considered the cost. Taxable amount = (Income - Cost) * 20% However, due to the characteristics of blockchain and the trading habits of investors, users are likely to have made multiple purchases and coin-to-coin transactions during this period, and when converting part of the funds back to RMB, it may not be possible to accurately trace which purchase funds belong to. In this case, referring to the accounting methods typically used for other assets, the proportional allocation method can be considered for accounting:

Taxable amount = (Income - Cost this time) * 20% If the taxpayer is truly unable to provide cost accounting basis, the tax bureau may conduct valuation or determine tax collection through an assessment agency. To this end, investors should properly retain purchase receipts and asset snapshots at the time of sale to accurately calculate costs and report taxes. How to plan taxes reasonably? As an emerging digital economy sector, the Web3 industry offers vast opportunities for tax planning due to its unique operational model and cross-border characteristics. By engaging in reasonable planning, such as selecting jurisdictions with low tax rates or tax incentives, differentiating income types to optimize tax treatment, optimizing asset structure design, and seeking tax reductions and deferral tools, industry participants can effectively reduce tax burdens while ensuring compliance. It is important to note that under the current PRC individual income tax system, the treatment of investment gains and losses depends on the specific type of investment and tax regulations. For most investments, including virtual currency transactions, the tax authorities usually calculate the tax on a separate basis, rather than on the basis of annual net income or net loss (unlike the annual reconciliation of comprehensive income tax). This means that losses from different trades during the year generally cannot be used to offset gains from other trades (unlike corporations, funds, and IRS rules). Within this framework, individual investors can also optimize their tax plans by reasonably adjusting the nature of their assets and reporting methods. For example: exchanging part of their stablecoins at the market peak and holding them, then converting the stablecoins into fiat currency at the market bottom, which allows investors to reasonably defer the payment of certain taxes. Situation 1: The cost of buying a virtual currency A is 50 yuan, and after it rises to 100 yuan, it is immediately sold for 50 yuan and exchanged for fiat currency, and then the market falls and the A held becomes 20 yuan. The amount to be taxed is:

The taxable amount is = (50-25)*20%=5 Scenario 2: The cost of purchasing a certain virtual money A is 50 yuan. After rising to 100 yuan, 50 yuan is exchanged for a stablecoin. After the market drops, the value of A held becomes 20 yuan, and the total assets become 70 yuan. At this point, selling the 50 yuan stablecoin for fiat currency requires paying taxes on the amount:

The taxable amount is = (50-35.7)*20%=2.86 In both of the above situations, a total of 50 yuan in fiat currency was ultimately sold and 20 yuan in A was held. However, in a bull market, converting to fiat currency requires paying 5 yuan in individual income tax, while in a bear market, only 2.86 yuan in individual income tax is required. From a legal tax perspective, this contradicts the common intuition that 'you should cash out in a bull market.' It should be noted that this assumption is based on the premise that the tax bureau allows the use of the proportional allocation method for tax base accounting. What are the risks of not declaring? There is a popular saying that goes, "The tax authority knows you better than you know yourself." Although this statement contains a certain degree of exaggeration, it also reflects the comprehensive application of big data technology, inter-departmental information sharing, electronic tax systems, and intelligent risk monitoring in the modern tax collection and management system. Especially after the launch of China's "Golden Tax Phase III" system, its powerful data collection and analysis capabilities can restore your economic activities from multiple dimensions. If you evade tax payment, you will be ordered to make up for it after being inspected by the tax bureau, and a late fee of 0.05% will be charged daily. Additionally, you may face a fine of not less than 50% and not more than five times the tax amount. In serious cases, you will also bear criminal responsibility. Summary by Lawyer Mankun In the Web3 era, compliance in tax declaration is becoming increasingly important. Although blockchain, virtual money, and decentralized finance (DeFi) have brought about new economic models and technological innovations, compliance in tax payment remains an unavoidable legal obligation. Web3 practitioners and users must pay attention to tax policies, actively record transactions and retain transaction proofs, take snapshots of assets at key points, and reasonably plan for tax payment within the legal framework to avoid legal risks arising from non-compliance. The complexity of tax obligations arises not only from the uncertainty of policies but is also closely related to investors' understanding of Compliance. In the future, as the regulatory framework gradually improves, the rules in this area may become clearer, but before that, staying vigilant and actively adapting to changes will be key for investors to protect their interests in the Web3 space.

/ END. Author of this article: CryptoMiao