Cryptocurrency Tax – Collateral Finance Loans

We have recently updated this article in November 2022. Please view the most up to date article here.

Cryptocurrency collateral finance loans are becoming increasingly popular. They allow an individual to maintain price exposure to token price fluctuations while providing additional capital (the loan) to utilize (how they choose).

An individual deposits cryptocurrency into a contract or an online platform. In return, they receive a loan. Interest is charged on the loan, and the loan must be repaid. The cryptocurrency is held as collateral (security) over the loan agreement.

These agreements create an interesting tax position.

For example, I have 2,000 ETH on a de-fi platform. I use it as collateral and borrow $500k in USDT. I cash the $500k USDT into NZD. Therefore, I essentially still own the 2,000 ETH, and I now have a debt of 500k USDT incurring 4% interest. I spend the NZD on whiskey. What are the tax implications?

In the below article, we present three different answers to the above question.

Inland Revenue (IRD) is yet to publish any comments or rulings on collateral finance loan arrangements.  IRD considers cryptocurrency as property, which is a fundamental classification, as we will explore further in answer one below.

IRD has recently amended tax legislation to make cryptocurrency an excepted financial arrangement. The outcome is that most cryptocurrency staking and defi arrangements will not be subject to financial arrangement legislation. We will explore in answer two what the taxable outcome would be if IRD did consider cryptocurrency a financial arrangement.

The third answer considers whether putting the ETH up as collateral is treated as a disposal.

In summary, if you are involved in cryptocurrency collateral financial loans, we recommend caution because there is current uncertainty of the tax position.

Breakdown of the Different Components in a Collateral Finance Loan Agreement

  1. Depositing 2,000 ETH (see our earlier article about tax implications of staking cryptocurrency)
  2. Receiving 500k USDT in exchange for providing 2,000 ETH as collateral
  3. Exchanging 500k USDT for $NZD (assume happens immediately)
  4. Paying interest on the loan at 4% pa
  5. Repaying 500k USDT loan in $NZD

We’ve added dollar values to make the answers easier to follow (and assumptions about dates and repayments). The question was first asked in December 2020 when ETH was NZD 840 ($1.68m value for 2,000 ETH). They received 500k USDT in December 2020, which was NZD 690k. Today, ETH is valued at $6,600 ($13.2m value for 2,000 ETH November 2021). For simplicity, at today’s value, 500k USDT is worth NZD 690k (no foreign currency movement), and the loan is repaid today.

Answer One: Treated as a Loan

In Cryptocurrency Tax Basics, we outlined:

  1. Buying crypto is not a taxable event.
  2. Selling crypto for fiat (e.g., NZD) is a taxable event
  3. Trading one coin for another is a taxable event
  4. Using crypto to purchase goods or services is a taxable event (disposing of cryptocurrency)

In application to the collateral finance loan, the ETH is not sold, exchanged, or traded to another token. Therefore, it appears to be a non-taxable event.

When comparing cryptocurrency collateral finance loans to non-cryptocurrency situations, it’s like a homeowner providing their house as security for the bank. The bank takes security over the house (the ETH is locked up). Just because the bank has security over the home (or ETH) does not mean that the bank has legal ownership of the house. The owner of the house (or ETH) remains the same. The house (ETH) is not sold.

The house owner receives $690k from the bank (similar to the ETH owner receiving a 500k USDT loan). The loan could be for a house renovation, purchasing another property, buying a boat, or something else. If a defi collateral finance loan was taxed as a loan, obtaining the $690k loan is not income. It is an advance of capital (a loan).

The house owner pays interest on the loan to the bank at 4% pa (mortgage interest rates). The loan’s interest is tax-deductible if the house owner used the $690k to earn taxable income (e.g., purchased a rental property and now receives rental income). The interest is not tax-deductible if the loan is to buy whisky for private use and enjoyment.

The house owner repays the $690k loan to the bank (non-taxable event). The security is released from the property after the loan is repaid. After the 500k USDT loan is repaid, the 2,000 ETH is released from the defi contract. Receiving the ETH back is not a taxable event.

From the beginning to end, the house (or ETH) is owned by the same person. The house (or ETH) is not involved in a taxable event or transaction.

There is a second taxable event to consider; the repayment of the 500k USDT loan. In this example, the loan of 690k NZD was received, and 690k NZD was repaid. Therefore, there is no movement in the amount of the loan received and paid and no taxable profit or loss. If the loan was in a cryptocurrency token, or the USDT value had fluctuated against NZD, there is likely to be a taxable activity calculated as the sale price less the purchase price (i.e., if 650k NZD was repaid to settle the 500k USDT loan in full, the taxpayer is 40k NZD better off, and this would be taxable income).

The interest cost of 4% pa is not tax-deductible because the capital (the loan) is not used to earn taxable income (they are used for private use and enjoyment).

In summary, there is no taxable activity that applies to ETH. However, it is important to consider what happens with the borrowed funds, the interest cost, and the loan repayment.

Answer Two: Treated as a Financial Arrangement

Note: IRD published an issues paper about cryptocurrency and financial arrangements on 24 February 2020. They have since taken a u-turn. Inland Revenue has recently amended tax legislation to make cryptocurrency an excepted financial arrangement. The outcome is that most cryptocurrency staking and loan arrangements will not be subject to financial arrangement legislation.

Therefore, it is unlikely the tax position below will apply; however, we have included commentary to help the reader understand the complexity of these transactions and the uncertainty of cryptocurrency tax situations.

A financial arrangement is an arrangement that involves the deferral of the payment or consideration. There must be: an agreement or understanding between the depositer and lender; the depositer provides value (cryptocurrency) to the lender; the lender provides money, or money’s worth in the future to the depositer (the 500k USDT loan), and, the repayment of the loan is in the future.

Financial arrangement tax legislation requires taxpayers to account for unrealized gains or losses over the term of the arrangement. Financial arrangements disregard any distinction between capital and revenue, and there is a wash-up calculation (base price adjustment) when the rights and the obligations cease or when the tokens are disposed of.

In application to the original example

  1. The deposit of the ETH creates a financial arrangement. The value at the time was $1.68m.
  2. They received value back of $13.2m
  3. The $690k was received and paid back (contra to $0)
  4. There is an $11.2m gain from the financial arrangement, which would be taxable income.

Financial arrangements legislation makes no distinction between realized and unrealized taxable income. Therefore, the gain on the increase in value of ETH is taxable income.

We can compare this option to other non-cryptocurrency situations, such as an NZ tax resident who owns a rental property in Australia subject to financial arrangement tax rules on their overseas loan (which is a financial arrangement).

For example, an NZ taxpayer borrows NZD 500k to purchase an Australian rental property. At the time of the purchase, the AUD to NZD was 1:1 (I,e. AUD 500k). On 31 March 2021, the AUD currency tumbles to 0.50 AUD to 1 NZD. On 31 March 2021, the loan amount is now AUD 500k or NZD 250k. The taxpayer has a taxable income of NZ 250k; the gain made on the financial arrangement (the loan). For simplicity, interest payments are removed.

In summary, the movement of the ETH price would be taxable under financial arrangement tax legislation, although the gain is unrealized.

Answer Three: Treated as disposal of ETH when put up as collateral?

Disposal of ETH on entry to the contract is an untested view, and although I think this position is unlikely, it can’t be ruled out. As outlined above in the ‘loan’ situation, it appears that the cryptocurrency (ETH) does not change ownership during the entire activity.

When the ETH is transferred to a new wallet (as part of proving collateral), who is the legal owner? On centralized platforms such as Celsius or BlockFi, the terms and conditions of these platforms outline that by depositing cryptocurrency with them, you give up the ownership rights.

The cryptocurrency is unlikely to be in the owner’s wallet. Otherwise, the collateral loan would not be possible; therefore, is the ETH disposed of on entry to the loan agreeemnt? Arguable, due to the nature of cryptocurrency, the ETH has also changed formed – it is not the same ETH that was initially held.

As outlined in our cryptocurrency tax staking article, the arrangement creates an interesting tax perspective. By giving up ownership (on entry), is the taxpayer disposing of their cryptocurrency? And therefore, is this a taxable event?

My (current) view is that it is not a disposal; however, IRD may disagree and are currently unsure of their tax position. I believe these arrangements are not a disposal because the taxpayer isn’t receiving any consideration (nothing in return) for disposing of their cryptocurrency.

However, we have seen some agreements (in staking too), where a depositer will receive a token as proof of their deposit (similar to a liquidity pool token received). In this situations, it appears the taxpayer has exchanged their cryptocurrency for a new token which would be a taxable event, based on the market value on the time of disposal.

Finally, there are other factors to consider and other possible situations that may occur that haven’t been considered in the original question.

Something else to consider: Non-repayment of loan

If cryptocurrency (ETH) prices decrease to less than $690k, the amount that they borrow, what would happen if the borrower decided to forfeit the loan and not repay it? This creates uncertainty about debt remission income (when the borrower is released from paying a debt, it may be considered income).

Contact Us

Contact us for a 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.

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