Virtual Currencies, a New Hope for Local Businesses or the Authorities’ Tax Trap?

Is Israel encouraging the use of virtual currencies and promoting new legislation or is it in fact trying to suppress the new method of commerce?

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The State of Israel is trying to make some order in the virtual currency market which has engrossed the country and the entire world. At the beginning of the year, the Israeli Tax Authority published a professional draft document, “Taxation of Activity in Virtual Currencies (such as Bitcoin),” in an effort to begin developing a clear and uniform policy on this emerging sector. The publication of this draft was apparently intended to elicit responses to the definitions and terms set forth in the document from the public, particularly tax experts and market players, and to encourage them to suggest tools for the Tax Authority to address the challenges presented by the increasingly common practice of commerce in Bitcoin and other virtual currencies.

The last two years have seen a significant amount of business activity by companies and individuals being carried out in virtual currencies. Most virtual currencies can be divided into two types: international currencies such as the Bitcoin, the Litecoin and the Ethereum; and local virtual currencies, which are designed to develop local trade within regional or other defined communities.

Among the many virtual currencies appearing nearly daily throughout the world are Ithacash, prevalent in the vicinity of Ithaca, New York, numerous virtual currencies in California and the D-Cent emerging in Europe with the encouragement of the European Union.

The most common local currencies in Israel are the Florentin Shekel, used in the Florentin neighborhood of Tel Aviv, the Pishpesh Shekel used in the Jaffa area and the Jerusalem Lira used in central Jerusalem.

After an extended discussion, the Israeli Tax Authority determined, as set forth in their draft document, that the virtual currencies shall not be considered currencies under Israel’s tax and banking laws, but shall be treated as assets governed by Israel’s accounting and tax laws.

This determination is significant in a number of ways. These include influencing how the currencies are presented in the financial statements of business and companies and seriously affecting their ability to trade and operate easily and quickly in virtual currencies.

An individual or business owner executing a transaction in virtual currency must report the transaction within thirty days of the transaction. Reporting must be made using Form 1399 and must specify the profit or loss stemming from the transaction. If appropriate, a capital gains tax or at least a tax advance shall be paid on the transaction.

This reporting procedure is likely to prove burdensome to those seeking to use virtual currencies to carry out transactions as part of their day-to-day business procedures, and the increased reporting requirements are likely to create higher accounting costs. The result could be a reduction or lack of profitability, thus deterring law-abiding business owners from working with virtual currencies. Such a reaction could thwart or at least discourage a business evolution which is increasingly gaining momentum around the world.

The Tax Authority’s draft document also discusses enterprises engaged in creating (“mining”) new currencies or trading in virtual currencies and addresses how they conduct their activities and report to the tax authorities. However, there appears to be no comprehensive approach to the issue, possibly because the tax authorities still lack practical experience in dealing with such businesses.

With respect to the Value Added Tax (VAT) law, the draft document refers to virtual currency as an intangible asset and considers these assets goods for the purpose of the transaction price, billing date, taxable value and tax rate. If an individual or business uses virtual currency to purchase an asset or service, the transaction will be treated as a barter transaction. There are specific rules applied to determine the price of a barter transaction (see clause 10 of the Israeli VAT Law), and the transaction shall actually be divided into two parts for reporting purposes. The buyer must first report the sale of currency at the currency’s market or fair value and then report the purchase of the product or service.

Again, it is apparent that both the income tax and the VAT procedures are likely to create a great deal of inconvenience for business owners or enterprises interested in operating and trading in virtual currencies on a regular or day-to-day basis.

We recommend that the tax authorities and legislators consider more flexible solutions in order to encourage commerce that is both easy and convenient. In addition, it would be beneficial for them to investigate the fundamental differences between international virtual currencies and local ones, which are designed to assist and reinforce local businesses within the surrounding community.