In the advent of globalization, new emerging business models have developed in the last 10 years with the recent developments heavily experienced in the financial products and intermediaries such as Decentralized Finance (DeFi). At the same time jurisdictions globally are concerned about the potential growth of digital economy and the risks associated with reduced transparency and base erosion for taxation purposes.
As Kenya is grappling with how to transition the informal to formal sector for taxation purposes, the digital economy also poses a potential threat to tax base erosion with the recent developments being implementation of digital service tax in the income tax law to tap into the sector. In addition, the international taxation is racing towards developing model rules to guide member jurisdiction in taxing the digital economy through an introduction of pillar one and two.
As the digital economy is rising, individuals and businesses are adopting the use of crypto assets for a range of investment and financial activities. According to Bloomberg tax report on digital assets, unlike traditional financial products, crypto assets can be transferred and held without the intervention of established financial intermediaries and without any central administrator having full visibility on either the transactions carried out. Therefore, crypto assets can be exploited to undermine existing international tax transparency initiatives, such as the common reporting standard (CRS).
In response to the crypto assets development, the Central Bank of Kenya issued a discussion on Central Bank Digital Currency (CBDC) in February 2022 to ensure Kenya’s Payment System remain relevant and fit for purpose. The CBDC would therefore be considered as a legal tender because Central Banks are faced with dwindling usage of paper currency, seeking to popularize a more acceptable electronic form of currency like Sweden among many other reasons put forth in the paper.
According to EU Regulation on Markets in Crypto assets (MiCA) defines crypto assets as a digital representation of value or rights which may be transferred and stored electronically using a distributed ledger technology or similar technology. In addition, experts point that Crypto technologies are much more than secure payment and investment mechanism enablers. They are seen as vital to a much broader Web3 based digital future.
Crypto assets act as an umbrella, it describes digital assets that are transferred and stored on a distributed ledger (Blockchain) and secured by cryptography. It is divided into three broad categories based on their purpose;
- Payment tokens (also known as virtual currencies): act like money and are designed to be used as a means of exchange for goods and services.
- Security tokens: are similar to equity shares or short-term loans, as they permit the investors to earn dividends or embody the right to variable or fixed interest during a specified time period.
- Utility tokens: facilitate access to specific goods or services and operate in a similar way to vouchers or prepayments, giving their owners the right to use a particular service or purchase a particular product in the future.
Therefore, in order for Kenya as a jurisdiction to tap into the rapid growing crypto economy through taxation, the tax administrators should understand the stages involved in the life cycle of crypto currencies as put forth by Bloomberg digital taxation report on India Income tax law on Virtual Digital Asset (VDA);
Once a new cryptocurrency is created, one of the first steps is to ensure that it is available in the hands of potential users. The distribution of cryptocurrencies can be undertaken in several ways, including through;
- Airdrops—free distribution among influencers to increase awareness of a particular cryptocurrency
- Initial coin offering—issued in exchange for a cryptocurrency, or, in some cases, fiat currency
- Mining (proof of work): refers to the process of validation of transactions through solving complex mathematical algorithms. As a reward for such solving, a digital coin is awarded to the miner by the blockchain network.
- Forging (proof of stake)—refers to the process through which transactions are verified when a distributed ledger technology uses a “proof of stake” mechanism where shares of validation rights are assigned to users according to the stake that they have in the blockchain.
To store the cryptocurrency, the user requires a wallet, which consists of one or more digital wallet addresses.
Exchange of Cryptocurrencies Stage
The next stage in the life cycle of cryptocurrencies would be to find potential purchasers or sellers. This is done through virtual currency exchanges (VCEs) who are the most well-known mode of exchange where an online service facilitates customers to trade virtual currencies in exchange for either fiat currency or for other crypto-assets.
Disposal of Cryptocurrencies Stage
Disposal of cryptocurrencies may occur in any of the following ways:
- in exchange for fiat consideration
- in exchange for another cryptocurrency or digital asset e.g., NFT (Non-Fungible Token)
- to procure goods or services; or
- without any consideration (e.g., as a gift)
In addition to digital assets like Crypto, there is another set of digital assets NFT which has taken the world by storm and it is also build on blockchain technology. It derives their value from uniqueness in that their rise in popularity can be explained by the fact that people have always been willing to pay large amounts of money for rare assets that are difficult to obtain due to their scarcity.
Just like other crypto assets, NFTs may be purchased for investment reasons. However, their common use case is to create a verifiable digital record of ownership title to a unique underlying digital asset. When someone “mints” an NFT, they create a unique digital token on an existing blockchain (e.g., Ethereum). Subsequent transfers of the NFT are recorded and publicly verifiable on the same distributed ledger.
An example of use of NFT can be traced in the metaverse such as Axie Infinity where the game allows one to collect and mint NFTs that symbolize digital pets called Axies, which they may breed, nurture, gather, and trade.
Another example is Sandbox which is a Metaverse game built on Ethereum that allows players to purchase virtual land and personalize it with playable games and activities. Sand is the principal money in the Sandbox. One may buy and sell land and estates (a group of lands) on the Sandbox map. An individual has the option of selling these properties on the Open Sea NFT marketplace.
In conclusion, as the new regime is taking over the new government, the big task ahead is for the tax administrators to come up with a detailed set of guidelines for officials on the tax treatment of crypto transactions to avoid confusion and litigation. This is can be made possible by adopting the CARF (Crypto Asset Reporting Framework) model rules currently being developed by Organization for Economic Cooperation and Development (OECD).
Author: Eddie Opiyo