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

In the wave of the digital economy, virtual money trading has become a global trend, turning into a new land of wealth for investors. In this digital gold rush, China's legal positioning on virtual money is ambiguous, and trading regulations are strict, making tax issues even more complex. Understanding related obligations is not only about legal compliance risks but may also directly impact investment decisions and returns. This article will focus on individual virtual money trading, exploring the possibilities and paths of Web3 compliance and taxation within the existing regulatory framework in China, providing references for building a healthy and sustainable Web3 ecosystem. What is Virtual Money? To clarify whether taxes need to be paid on Virtual Money, it is first necessary to understand what Virtual Money is and whether buying and selling it is permitted. Cryptocurrency is any form of money that exists in digital or virtual form and uses encryption techniques to secure transactions. Cryptocurrencies have no central issuing or regulatory authority, but instead use 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 (Yinfa [2013]289) (hereinafter referred to as "Document No. 289"), the "Announcement on Preventing Risks of Token Issuance Financing" issued by the People's Bank of China and seven other ministries on September 4, 2017 (hereinafter referred to as "Announcement No. 94"), and the "Notice on Further Preventing and Managing 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 No. 924"), virtual money is defined as not possessing the attributes of legal tender and coerciveness, nor having the same legal status as money, and it cannot and should not circulate as money in the market. However, the above notices do not deny the property attributes and commodity attributes that virtual money possesses. In addition, Circular No. 289 mentions that "Bitcoin trading is a commodity buying and selling behavior on the Internet, and ordinary people have the freedom to participate at their own risk", and Circular 924 mentions that "there are legal risks associated with participating in virtual currency investment and trading activities." If any legal person, unincorporated organization or natural person invests in virtual currency and related derivatives in violation of public order and good customs, the relevant civil juristic acts shall be invalid, and the losses arising therefrom shall be borne by them." It can be seen that under the current system in China, citizens have the right to buy and sell virtual currency. So, since virtual money can be bought and sold as personal property or goods, does this behavior require taxation? Is tax required? This article only discusses the most basic personal Virtual Money trading, without considering other situations such as airdrops, DeFi yields, and token staking. The question of whether taxes need to be paid can be considered from several aspects. From a national perspective, virtual money trading is not an industry that is encouraged for development, and therefore there are no corresponding tax incentives or reductions. Furthermore, under the current policy and economic environment, the state will also 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 categories of personal income are subject to individual income tax.

From a taxation perspective, the purpose of individuals trading virtual money is to obtain profits, so a more fitting category might be interest, dividends, or capital gains. However, holding virtual money does not have an entity in its economic structure that can generate profits, nor is there a predictable return on the occupied funds. Therefore, in terms of the purpose of holding and the nature of the asset, it more closely aligns with capital gains. From a legal perspective, as of now, China has not introduced specific tax laws or regulations targeting Virtual Money. China's Virtual Money tax policy 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 "National Taxation Administration's Reply on the Issue of Individual Income Tax Collection for Income Obtained by Individuals through Online Trading of Virtual Money" (Guo Shui Han [2008] No. 818) states that "income obtained by individuals through the online acquisition of players' virtual money and subsequently selling it at a markup is considered taxable income for individual income tax and should be calculated and paid according to the 'income from property transfer' item." Although this reply was issued before the birth of Bitcoin, there is no legal distinction between blockchain virtual money and game virtual money, so individual income tax should also be paid with reference to income from property transfer. How should the tax amount be calculated? Tax law stipulates: The income from property transfer is calculated as the income from the transfer of the property minus the original value of the property and reasonable expenses, resulting in 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 how to confirm the original value of the asset (purchase cost) becomes the key to calculating the taxable amount. When purchasing a certain Virtual Money with Renminbi and holding it before selling to exchange back to Renminbi, the selling price is considered as income and the buying price as cost. The taxable amount is = (income - cost) * 20% However, due to the characteristics of blockchain and the trading habits of investors, users may have conducted multiple purchases and coin-to-coin transactions during this period, and when converting some funds back to RMB, it may be difficult to accurately trace which purchase funds belong to. In this case, referring to the accounting methods commonly used for other assets, it may be considered to use the proportional allocation method for accounting:

Taxable amount = (Income - Current Cost) * 20% If the taxpayer is truly unable to provide the cost accounting basis, the tax bureau may conduct valuation or determine the collection through assessment agencies. To this end, investors should properly retain purchase receipts and asset snapshots at the time of sale in order to accurately calculate costs and declare taxes. How to plan taxes reasonably? The Web3 industry, as an emerging digital economy sector, offers vast opportunities for tax planning due to its unique operating model and cross-border characteristics. By engaging in reasonable planning, such as choosing 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 their tax burden while ensuring compliance. It is worth noting that under the current individual income tax system in China, the treatment of investment gains and losses depends on the specific type of investment and tax regulations. For most investments, including virtual money trading, tax authorities typically calculate taxes on each individual transaction rather than settling on an annual net profit or net loss (which is different from the annual reconciliation of comprehensive income for individual income tax). This means that losses from different transactions within the year usually cannot be used to offset gains from other transactions (which is different from the regulations for companies, funds, and the IRS in the United States). Under this framework, individual investors can also optimize their tax strategies by reasonably adjusting the nature of their assets and the reporting methods. For example: exchanging part of their stablecoins at the market peak and holding them, then converting stablecoins to fiat at the market bottom, which allows investors to reasonably defer the payment of part of their taxes. Situation 1: The cost of purchasing a certain Virtual Money A is 50 yuan. After rising to 100 yuan, it is immediately sold for 50 yuan in exchange for fiat currency. Afterwards, the market falls and the held A becomes 20 yuan. The amount to be taxed is:

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

The taxable amount is = (50-35.7)*20%=2.86 In both of the above situations, a total of 50 yuan of fiat currency was sold and exchanged, and 20 yuan of A was held. However, in a bull market, exchanging for 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 "one should cash out in a bull market." It should be noted that this assumption is based on the premise that the tax authority allows the use of the proportional allocation method for calculating the tax base. 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 modern tax collection management systems, big data technology, multi-department information sharing, electronic tax systems, and intelligent risk monitoring. 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 and are audited by the tax bureau, you will be ordered to make up the payment and will incur a daily late fee of 0.05%. Additionally, you may face a fine of 50% to 500% of the tax amount. In serious cases, you may also bear criminal responsibility. Mankun Lawyer Summary In the Web3 era, compliance declaration and tax payment are becoming increasingly important. Despite the new economic models and technological innovations brought by blockchain, cryptocurrencies, and decentralized finance (DeFi), compliance with tax obligations remains a legal duty that cannot be ignored. 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 payments 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. However, before that, staying vigilant and proactively adapting to changes will be key for investors to protect their interests in the Web3 space.

/ END. Author of this article: CryptoMiao