This is part 2 of our series of articles ‘how a trade can go from bad to worse’. We recommend reading part 1 which outlines this core concept, and this latest article builds on the foundational principle.
All tokens of the same cryptocurrency are combined for inventory purposes.
This article will be complex, however for a trader, especially in a bull market it is important to understand how profit is calculated.
Having a separate legal entity (such as a company) for owning cryptocurrency that will not be traded, may be appropriate for holding some tokens.
Example:
John buys 200 ETH for $200 NZD each ($40,000 total) – buying is not a taxable event.
190 ETH are transferred to cold storage and not used for trading – transfers from exchange to wallet is not a taxable event. Although these tokens appear to be separate from the trading activity, the trading activity will affect their tax value (as seen in the examples below). There is no ability to isolate these tokens from the trading activity and weighted average cost (WAC) increases with each trade (buying back ETH at market value). It is important to understand despite 95% of ETH not being used for trading, the WAC of his combined ETH is increasing on each repurchase which increases in value and is responsible for an increase in profit.
Only 10 ETH are used for trading. In this example, we have used trading with an NZD pair (and removed network and exchange fees) for simplicity, however it does not matter what trading pair, or if multiple trading pairs are used.
The table below shows that over the month of January 2021 John has traded back and forward 10 ETH 16 times (160 ETH brought and sold) at the market value for each transaction. Each time he buys the ETH back, he is purchasing it at the market value which is increasing the WAC of his closing ETH.
Isolating the trading activity (excluding original purchase of ETH in 2017), can be summarised as follows:
Sales 160 ETH for $264,554 NZD
Purchases 160 ETH for $263,386 NZD
Profit $1,168 $NZD and no change in ETH quantity (160 ETH brought and sold)
Despite trading more than a $250k of ETH (10 ETH back and forward 16 times), it appears John has a small profit of $1,168, however, this is not what happens for tax purposes.
When we look at John’s overall activity, it can be summarised as follows:
Sales 160 ETH for $264,554 NZD (same as trading activity)
Purchases 360 ETH for $303,386 NZD (trading activity plus the original 200 ETH for $40k)
Closing stock 200 ETH for $206,173 (see below for calculation method)
As highlighted in all other examples, here, here, and here, buying cryptocurrency is not a taxable activity. John will only receive a deduction for his closing stock only when he sells the ETH.
Therefore, the closing stock, must be added back, because it has not yet been sold.
Profit = sales less purchases plus closing stock
Profit = $264,554 less $303,386 plus $206,173
Profit = $167,341
Closing Stock Value:
The value of the closing 200 ETH, using a weighted average cost (WAC) method is $206,173 (or $1,031 per ETH). This is significantly higher than the original cost of $40,000 (or $200 per ETH).
There is no ability to isolate the 195 ETH and record it at its original cost value of $200 per ETH. The entire activity of the trader needs to be considered. John could have sold the ‘holding’ token to a separate investment company (separate legal entity and different IRD number), so the increase in WAC is ring fenced to the trading activity. The 190 ETH in the holding company would still be taxable on disposal in the future.
Each time ETH is repurchased (with each trade), the weighted average cost of the original 200 ETH increases. This is because the value of ETH has now increased from the original purchase value of $200. As seen in the calculations below (WAC is the column on the far right)
Diving into the detail further, the WAC is calculated by taking the purchase cost of ETH, adding it to the previous purchases of ETH, and divided by the quantity (plus adjustments for sales).
Summary
Each purchase of ETH (from a trade) will increase the WAC (of the closing stock). A deduction is not allowed for the closing stock, until the token is sold.
Although the trades (between ETH/NZD) appear to be making very small adjustments between each trade (and the overall loss of $1,168), from a tax perspective, each trade is realizing profit on the overall holding of 200 ETH, due to the original low purchase value. The mechanism this profit is realised, is through increasing the weighted average cost of ETH.
Contact Us
Contact Tim Doyle for a no obligation call or meeting to discuss any cryptocurrency tax or accounting questions. Our office is in Cambridge, Waikato, or we can arrange a video conference call.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.