Cryptocurrencies – a digital minefield for trustees

Why do cryptocurrencies matter?

It is now ten years since the introduction of Bitcoin. In 2009 the value of one Bitcoin was US$1 but at the time of this article the value of one Bitcoin has risen to US$4012.81 – a significant investment return. There are also now hundreds of other 'altcoins' (alternative digital currencies) in the market with varying degrees of value and investment potential.

The sceptics may still query whether cryptocurrencies are an asset to stay or a passing fad but for trustees the reality is that cryptocurrencies are now forming part of the asset class which they are responsible for and cryptocurrencies are an investment class which the higher risk investment managers are considering. It is therefore vital that trustees educate themselves in relation to the cryptocurrency market and, more importantly, the risks of this market.

What is it?

The Government's Cryptoasset Taskforce produced a report on cryptoassets in October 2018 which provides a helpful overview of cryptoassets and the underlying technology. The report also assesses the associated risks and potential benefits of these assets and sets out the prospective regulatory pathway for these assets within the UK.

This report acknowledges that there is not a single widely agreed definition of a cryptoasset but it broadly states a cryptoasset is a "cryptographically secured digital representation of value or contractual rights that uses some form of distributed ledger technology (DLT) and can be transferred, stored or traded electronically". The report goes on to conclude that cryptoasset broadly fall into 3 categories:

• Exchange tokens – these are often referred to as cryptocurrencies. They utilise a DLT platform and are not issued or backed by a central bank or other central body.
• Security tokens – these amount to a 'specified investment' as set out in the Financial Services and Markets Act (2000) (Regulated Activities) Order. They may provide rights such as ownership, repayment of a specific sum of money or entitlement to a share in future profits.
• Utility Tokens – these can be redeemed for access to a specific product or service which is using a DLT platform.

It is important for Trustees to be aware of the different types of cryptoassets on the market but in this article we will focus on 'Exchange Tokens' or 'Cryptocurrencies' which have the following key features:

• The Exchange tokens or cyptocurrencies are not physical coins but simply a digital record of a transaction.
• This digital record is known as the blockchain and provides a historical record of each transaction.
• There is no centralised system so each transaction is verified by a number of computers in the network working at the same time to try to verify the transactions following which it is placed on the ledger.
• The ledger is public and once on the ledger, it cannot be changed by just one individual.

What do Trustees need to be aware of?

Ownership

Firstly it is important for a trustee to determine the nature of the asset. Cryptoassets and cryptocurrencies are terms which are banded around but which may not actually properly describe the asset held by the Trustee. A trustee needs to establish whether the asset in question is an 'Exchange Token' or whether it is some other form of cryptoasset as set out above or whether it is in fact a form of investment in another entity which holds cryptoassets.

If the asset is a cryptocurrency, the ownership of that asset and the ability to track ownership is created through the use of the cryptocurrency wallet. There are different types of wallets and these include paper wallets, software wallets, online wallets or an online exchange. They store the public and private cryptographic keys. The private key enables the holder to spend the cryptocurrency from that address, whereas the public key allows other wallets to make payments to that wallet's address.

Dealing with a cryptocurrency as an asset

Transfer of ownership is important for trustees where a settlor is settling cryptocurrency on trust. The trustee needs to ensure that both the legal and beneficial title to the cryptocurrency is being settled by effective transfer of both to them.

Similarly, a trustee looking to invest in cryptocurrency for the first time must be clear to receive and store both the private and public keys and be satisfied as to the ownership of the private key of the transferor and thus the funds. The concern that arises in practice is that how can it be proved that the private key has not been shared (or stolen) by a third party.

Given the value of cryptocurrency, it is now necessary to consider them as part of an individual's estate and the necessary planning around that. The result is likely to be that some trustees (and certainly executors) find themselves receiving these digital assets into their hands whether or not they wanted to. Unlike the professional trustee, the executor or administrator has little choice whether to accept these assets.

Risks

There is no doubt that cryptocurrencies can be seen as high risk assets when assessing potential trust investments. The value can be volatile, the market is unregulated and susceptible to significant risk from fraudulent cryptocurrencies, the asset is intangible, illiquid and either under-insured or uninsurable.

Tax

The tax treatment of cryptocurrencies depends on a variety of factors and differs between the jurisdictions. The laws of the jurisdiction applicable to the cryptocurrency in question also depends on the residence of the trustee, settlor and beneficiaries, as well as the situs of the assets themselves. Such analysis requires careful and specialist advice but it is important for trustees to be aware of those triggers in order that they know when to seek such advice. In the US and UK for example, a transaction (the transfer of cryptocurrency) can trigger a taxable disposal even where no compensation has been received in exchange.

In all likelihood, whatever our specific roles within the private client industry and regardless of whether we are dealing with trusts or estates, cryptocurrencies are very valuable assets peppered with complexities which we will all come across and it will be essential to ensure that specialist advice is sought when dealing with these issues.

If you have any queries regarding cryptoassets please contact a member of our team.