KOREA CAPITAL MARKET INSTITUTE

On December 2, 2021, the Korean National Assembly plenary session approved an amendment to the Income Tax Act aiming at delaying taxation on virtual assets. With this amendment, the virtual asset taxation scheduled to take effect on January 1, 2022 has been deferred for a year until January 1, 2023. But the taxation approach has remained the same as the previous version.  
    
Considering the basic tax principle that tax is imposed on income, taxation on gains from transfer or lending of virtual assets is deemed a reasonable regulatory decision. Nevertheless, many experts have strongly asserted the need for delaying virtual asset taxation, out of concerns about the effectiveness of tax administration. They have questioned whether Korea has established the proper tax regime to make an exhaustive investigation of and impose a tax on virtual asset transactions and resultant capital gains. It is possible to find whether profits are generated from domestic virtual assets (cryptocurrency) by using trading information provided by major virtual asset exchanges. But when virtual assets are transferred to a personal wallet and traded in foreign exchanges, there is no taxation infrastructure designed to track the income resulting from such a process. For proper taxation on virtual assets, it is necessary to figure out taxable income. But the current taxation system seems not to have been prepared for tracking down taxable income generated from virtual assets. Given such inadequate market conditions, delaying virtual asset taxation for one year and developing a proper infrastructure is considered a reasonable policy decision.      
 
Aside from deferred taxation on virtual assets, the authorities should strive to improve coherence in virtual asset taxation by closing loopholes in the tax regime. With new approaches to virtual assets emerging in the changing market landscape, their characteristics have been increasingly segmented. Given that virtual assets show distinctive features depending on their purposes, there is a growing necessity for the taxation system to reflect virtual asset-specific characteristics. In this regard, this article tries to examine the basic taxation approach to virtual assets, and to seek a direction for rational virtual asset taxation through a comparative analysis of the US tax regime. As lawmakers recently proceed with enactment of the so-called virtual asset business act, the tax regime reflecting market changes would play a vital role in promoting sound market development. So far, virtual assets are widely used as a legal term, but this article intends to use digital assets, instead of virtual assets, to represent a more comprehensive concept.     
 
 
Digital assets: segmentation and theoretical understanding of profits
 
A digital asset is traditionally defined as an intangible asset that exists in a digital format, represents the value of property, and contains the right to use. This refers to a comprehensive concept including pictures, logos, illustrations, animations, audiovisual media, presentation materials, electronic documents, e-mails, electronic data, application programs, etc. With the emergence of blockchain technology and cryptocurrency, however, digital assets have been used as a term representing cryptocurrencies. People refer to a cryptocurrency as many different terms. But as it is recently deemed to be of an asset nature, instead of a currency, the term of a digital asset increasingly takes hold. In Korea, the Act on Reporting and Using Specified Financial Transaction Information (hereinafter referred to as the Specified Financial Transaction Information Act) adopts virtual assets, not digital assets, as a legal term. Under the Specified Financial Transaction Information Act, the term “virtual assets” is defined as an electronic token with economic value which may be digitally traded or transferred.     
 
When it comes to an institutional approach to digital assets, a marked trend is the segmentation of digital asset rules. Digital asset regulations and taxation are being classified into segments according to trading risks (information asymmetries, potential loss of ledger, etc.) and trading purposes (for investment or use). Categorizing digital assets by application purpose is more effective in achieving regulatory objectives, rather than establishing the digital asset regulatory framework based on a uniform definition. When devising regulations on digital assets, it is less efficient to simply characterize them as financial products or intangible assets. Under this context, a flexible and rational approach would be defining digital assets of an investment contract nature as securities and recognizing those with the right to use goods or services as intangible or financial assets.
 
Digital assets can be classified into the payment token, the utility token, and the securities token, depending on application purposes. Hybrid tokens combining features of multiple types of tokens are commonly observed. The payment token is a type of digital asset issued as a means of trading or exchange. Bitcoin and Ethereum are the most widely known payment tokens and also referred to as the term “virtual currency”. Payment tokens are traded in the decentralized, distributed ledger network without any intermediary who is officially regulated by the government. Generally, traditional securities rules are rarely applied to those tokens which, however, are increasingly subject to payment settlement and anti-money laundering regulations. The utility token is a digital asset that provides access to goods or services within the network. It is rarely recognized as an investment portfolio since the holder is not entitled to any voting right or claim for dividend. Defined as a digital asset that entails rights and duties of a specific investment, the securities token is treated as stocks or bonds under the securities law or qualifies as an investment contract, which requires strong consumer protection measures compared to other tokens. 
 
Concerning the three different types of digital assets, the tax regime has been segmented by taking into account their purposes and characteristics. Payment tokens are increasingly regarded as assets, instead of currencies. It is difficult to tell who issues a certain payment token, and payment tokens differ from traditional currencies, securities, foreign exchange, and products in terms of concept and nature. Although this makes it hard to regulate them with existing regulatory measures, payment tokens convertible into money are generally accepted as a form of property for tax purposes and subject to regulations on the tax treatment of property. Despite the widely accepted property nature, how the income generated from payment tokens is treated varies. The income from the transfer of payment tokens is classified as capital gains or other income, but there is a strong tendency to treat such income as capital gains, not other income. In light of this, it is noteworthy that gains from the trade of payment tokens can be characterized as capital earnings derived on the rise in asset prices.           
 
When a securities token is issued, the payment tokens provided by an investor to the issuer may be deemed as the share of a specific investment. For this reason, how to treat the profits generated from the sale of securities tokens and the income distributed from securities tokens is of great importance. The profits from the disposal of a securities token in the aftermarket are typically categorized as capital gains and taxed accordingly, as is the case with the gains from the sale of stocks. Upon the redemption of a securities token to the issuer, the redemption profits received by the holder may be treated as divided income. Furthermore, it would make sense to view any additional service provided to a securities token holder as dividend income.  
      
On the other hand, 0pinions are divided as to whether the capital gains taxation is applicable to the profits from the transfer of utility tokens. When the right to access a good or service is traded within the digital asset network, is it reasonable to recognize the income from such trades as capital gains or other income? If utility tokens are deemed to be a representation of monetary value, there is a strong possibility that the income generated from their trades is recognized as capital gains.   
  
  
Taxation on digital assets in Korea: the current status and challenges
 
In Korea, the tax treatment of digital assets, in principle, follows the provisions of the Income Tax Act. The current Income Tax Act defines the capital gains from virtual assets as other income.¹⁾ The Income Tax Act borrows its definition of virtual assets from the Specified Financial Transaction Information Act, rather than directly prescribing the definition. Under the Specified Financial Transaction Information Act, the term “virtual assets” is described as an electronic token with economic value (including but not limited to the rights thereof) which may be digitally traded or transferred.²⁾ But this definition gives rise to excessive ambiguity in the scope of virtual assets. Virtual assets can be interpreted as payment tokens in accordance with the Specified Financial Transaction Information Act. However, the scope of digital assets is expanded to include utility tokens and securities tokens as well as payment tokens around the world. Given this global trend, it remains unclear as to whether the virtual assets under the Specified Financial Transaction Information Act should be interpreted as a comprehensive concept including utility tokens and securities tokens. The tax authorities maintain the stance that virtual assets are defined as intangible assets with a property nature, but not classified as financial investment instruments under the Financial Investment Services and Capital Markets Act. As for securities tokens quite differing from payment tokens, this has introduced institutional uncertainty about whether they should be recognized as virtual assets to which the taxation system for other income applies or as financial investment instruments subject to the tax regime regarding financial investment gains. At the National Assembly, lawmakers try to enact the so-called virtual asset business act. However, the financial authorities have yet to approve the Initial Coin Offering (ICO), which could serve as an obstacle to expanding the scope of virtual assets to utility tokens and securities tokens for tax purposes. The financial authorities made it clear in September 2017 that virtual currencies-based financing in the form of securities issuance such as equity or debt securities would be deemed as a breach of the Financial Investment Services and Capital Markets Act. The authorities also raised concerns that the non-permitted fund-raising business which publicized the IOC to attract investment could increase financial fraud risks and the strong demand for speculative investment could lead to market overheating and inflict serious damages on consumers. Out of such concerns, they have prohibited all forms of IOCs including the distribution of profits from an actual IOC-based project, the allocation of a specific dividend right to a firm, and the issuance of new virtual currencies in the platform, regardless of technologies or terms. As a result, the scope of digital assets has been limited to payment tokens, and virtual assets are treated only as payment tokens for tax purposes, despite the comprehensive definition adopted by the Specified Financial Transaction Information Act. 
 
Under the Income Tax Act, the gains derived from the transfer, exchange and lending of virtual assets are taxed as other income. What is notable is that the income realized on the transfer of virtual assets is calculated in the same way as ordinary capital gains. This calculation sparks controversy over the validity of recognizing the income from virtual assets as other property. In terms of economic benefits, it is reasonable to deem virtual assets as financial assets, instead of intangible assets. However, the tax authorities have categorized the income realized on trading of virtual assets as other income, considering that virtual assets constituting a new asset class fail to satisfy the definition specified by the IFRS and thus, are classified as intangible assets for accounting purposes. This tax treatment is in line with the interpretation by the IFRS Interpretations Committee that virtual assets held for sale in the ordinary course of business are accounted for as inventories, with other virtual assets being treated as intangible assets. But the IFRS accounting treatment of virtual assets as intangible assets does not mean that the gains from virtual assets should be taxed as other income. In particular, in the case of securities tokens that are expected to get approval for issuance in Korea, a rational taxation approach would be the treatment of the income derived from trades as financial investment income of a capital gains nature, not other income. Another problem is that loss carry-forward is not allowed for virtual assets during the taxation period, although loss deduction is permitted for the same period as the profits from virtual assets are deemed as other income. 
 
 
The US taxation on digital assets
 
In an analysis of global digital asset tax regimes, the country that needs to be first examined is the US, one of the countries that are formulating a sophisticated taxation system for digital assets at a rapid pace. In the US, the income generated from trades of digital assets is basically deemed as capital gains and taxed accordingly. Payment tokens are treated as property and subject to the property tax regime,³⁾ but not recognized as currencies that could generate foreign currency gains or losses. If a taxpayer receives payment tokens in exchange for goods or services, this is deemed as an exchange of property and thus, the fair market value of the tokens received should be included in the computation of gross income. The profits realized on the disposal of payment tokens are considered as capital gains and taxed accordingly, and if payment tokens are used as a means of payment, the paying party would be taxed on the difference between the acquisition price and the market value of such tokens as of the date of payment. As for the receiving party, the payment tokens received are evaluated as property based on their market value as of the date of receipt. Upon the sale of payment tokens, capital gains or losses will be measured as the difference between the amount received in exchange for payment tokens and the adjusted basis calculated based on the amount spent to acquire payment tokens, transaction fees, and commissions. Gains from virtual assets are divided into a short-term gain and a long-term gain and are subject to different tax rates, depending on the asset holding period. Any capital loss derived from dealings involving virtual assets should be reported, and the IRS allows loss deduction to a certain extent and carry-forward of any loss exceeding a permissible limit to the next taxation term. Since mining of payment tokens is deemed as original acquisition, their value is estimated based on the market value and the net amount remaining after mining-related costs are deducted becomes taxable. 
 
In principle, securities tokens are subject to the same tax treatment as securities specified in the Securities Act. Upon the ICO, the taxation on the issuer is significantly affected by the characteristics of tokens issued. If deemed as securities, a token is subject to the Securities Act and receives the same tax treatment as securities. This means that the key to digital asset taxation is the judgment on a securities nature, for which the Howey test is conducted. The payment tokens received by the issuer of securities tokens during the issuance process are recognized as capital contributions for the investment purpose and thus, are not included in the taxable income of the issuer. If digital assets are classified as securities tokens and an issuer newly offers securities tokens through the ICO in exchange for payment tokens, the value of payment tokens used for the issuance is estimated based on the market value as of the date of investment. The profits from the disposal of securities tokens in the aftermarket are recognized as capital gains and taxed accordingly, as is the case with the gains from the sale of securities. Upon the redemption of securities tokens to the issuer, the profits received by the person who has acquired and held such tokens are recognized as dividend income. Any additional services provided to holders of securities tokens on the blockchain are also treated as dividend income.
 
 
Directions for the development of tax policies on digital assets
 
Since the tax treatment of digital assets can have a material impact on the directions for the development of the digital asset market, a cautious approach is required for designing the relevant tax regime that reflects the demand for issuance and trading of digital assets. The evolutionary segmentation of digital assets should also be fully taken into account. The categorization of digital assets needs to be consistently applied to the tax treatment in order to introduce a sophisticated taxation. To this end, the government should present the criteria (guidelines) for making a distinction between payment tokens, utility tokens, and securities tokens. More specifically, the criteria for securities tokens should be set to establish the institutional framework where the regulations on financial investment instruments under the Financial Investment Services and Capital Markets Act are equally applied to securities tokens. Also necessary is the application of the taxation on financial investment gains to the income derived from securities tokens. Furthermore, the gains from securities tokens should be subject to  the exemption rules, loss deduction, and loss carry-forward which are permitted under the tax regime for financial investment gains.    
 
In addition, the income from the trades of payment tokens which is currently deemed as other income needs to be treated as capital gains. There is a trend that the regulatory framework on payment tokens is built upon the provisions of the securities-related law (the Financial Investment Services and Capital Markets Act for Korea), although payment tokens are not financial investment instruments. Currently, the regulatory responses to payment tokens are formulated in the direction towards narrowing information gap through the introduction of the disclosure system to the issuance market and aftermarket, applying regulatory principles of the capital markets to various unfair trades, and imposing restrictions, equally applicable to financial investment business entities, on market entry and business activities of digital asset business entities. On top of that, payment tokens, albeit not financial investment products, represent several characteristics similar to those of investment instruments and are recognized as investment assets by most participants involved in trading. Given the economic characteristics of payment tokens as well as their capital gains nature evidenced by income implication from trades and the computing method, it is worth considering the tax treatment of payment tokens as capital gains, instead of other income.   
 

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1) Article 21.1.27 (Other Income) of the Income Tax Act
2) Article 2.3 of the Act on Reporting and Using Specified Financial Transaction Information
3) IRS Virtual Currency Guidance and IRS Notice 2014-21