Wrapped tokens remake other crypto assets into versions that work well on certain blockchains. They keep the same 1:1 value as the original crypto.
For example, Take Bitcoin, for instance. It can’t directly function on Ethereum’s blockchain. So, people create a “wrapped” version of Bitcoin that can. This allows Bitcoin to be traded on Ethereum. A tokenised (or “wrapped”) version of bitcoin on the Ethereum blockchain can enable such trading. This is because the wrapped token maintains a 1:1 value ratio with the asset it represents.
On 9 November 2023, the Australian Taxation Office (ATO) updated its non-binding web guidance on the tax treatment of dealing in wrapped tokens. Many in the crypto industry have expressed their concern with the harsh approach to these arrangements.
Taxation of Wrapped Tokens
The process of creating wrapped tokens involves smart contracts, which are automated protocols executing or enforcing contract terms on the blockchain.
To wrap a token, users send their crypto assets (the original asset) to a smart contract address. This action results in the minting of a wrapped version of the crypto asset (the wrapped asset), while the original asset gets ‘locked’ in the smart contract, preventing double spending. The reverse process can also occur, where the wrapped asset is deposited into a smart contract and the original asset is recovered, called unwrapping.
According to the ATO’s new view, the act of wrapping or unwrapping a crypto asset triggers a capital gains tax (CGT) event. This means that gains and losses are brought to account, and the 12 month CGT discount period is reset.
Further to the ATO’s view, this is because the process of wrapping and unwrapping crypto assets involves exchanging one crypto asset for another, even though the economic substance of the transaction remains unchanged. The capital proceeds for CGT purposes are equivalent to the market value of the wrapped token at the time of exchange.
To illustrate this concept, let’s consider a scenario.
You purchase 1 Bitcoin (BTC) for $60,000 in January 2022.
In April 2022, you wrap this Bitcoin into 1 Wrapped Bitcoin (WBTC) using a smart contract. At the time of this exchange, the market value of WBTC was $70,000.
This wrapping process triggers a CGT event.
You make a capital gain of $10,000, which is the difference between the market value of WBTC at the time of wrapping and the original purchase price of the BTC. In the event that you unwrap the WBTC at a later point in time, this will likely give rise to another CGT event.
Many crypto users are upset at the ATO’s position on wrapping. It ignores the practical reality that wrapping is not an economic realisation, so it is the wrong point in time to trigger tax.
The ATO does not tax a variation of share rights for instance. There have been suggestions that this approach should be extended to crypto assets, as wrapping a token changes the rights i.e. BTC to wBTC, the wBTC cannot be used on the Bitcoin blockchain but can be used on the Ethereum blockchain instead.
The ATO has not been receptive to this point of view and prefers this very narrow interpretation of Australian tax law at the expense of taxpayers. Change is not expected unless parliament enacts new legislation (very unlikely) or the position is challenged in a Court or Tribunal. Cadena is seeking cases to litigate to clarify this legal issue.
Wrapped tokens are a significant innovation in the crypto world, enhancing liquidity and interoperability across different blockchains. However, users may unknowingly expose themselves to significant tax liabilities in the absence of tailored tax guidance. Always seek professional advice to navigate these complex scenarios.
Disclaimer: This material is produced by Cadena Legal, a NSW-registered legal practice. It is intended to provide general information and opinions on legal topics, current at the time of first publication. The contents do not constitute legal advice and should not be relied upon as such. Contact us here for advice.