In the financial landscape of Australia, many funds do lots of different things. Some hold and develop land, others trade shares, and some have more modern strategies such as investing in or trading crypto assets.
Based on our experience in the funds advisory market, many crypto funds are failing to address a major tax risk.
Crypto funds structured as trusts with more than 50 investors may inadvertently become a Public Trading Trust (PTT) which causes the trust to be taxed as a company. There are often historical issues where the PTT classification hasn’t been considered for many years. There are ways out of the PTT regime – but funds must be very careful.
What is a public trading trust?
Public Trading Trusts are trusts that are taxed as companies with a flat 25% or 30% tax rate.
Notably, for a trust to be considered a Public Trading Trust, it must fulfil two key requirements. Firstly, the trust must have more than 50 members. Secondly, the trust must not solely undertake an “eligible investment business.”
When these conditions are met, Public Trading Trusts are treated akin to companies for tax purposes. This treatment involves the trustee of a Public Trading Trust paying tax on the trust’s net income at the company tax rate. This shift alters the nature of the units in these trusts, treating them more like shares in a company, and distributions by a Public Trading Trust take on characteristics similar to dividends.
If a trust earns more than 2% of income from sources outside the “eligible investment business” definition, it would cause the fund to be a PTT and taxed as a company. There is very little margin for error.
The key question for funds with 50 members is – are they carrying on an “eligible investment business”?
What is an “eligible investment business”?
The “eligible investment business” exemption from the PTT regime is of particular interest for funds that hold or trade in crypto assets. As per the definition, an “eligible investment business” involves investing or trading in specific financial instruments, such as secured or unsecured loans, shares, futures contracts, forward contracts, life assurance policies, and more.
Notably, the definition of “eligible investment business” does not explicitly mention crypto assets. The only relevant category for crypto is “any similar financial instrument”, to the items listed in section 102M. The term “financial instrument” is not defined unfortunately. This grey area creates significant ambiguity, and it is currently unclear whether the Australian Taxation Office (ATO) would consider crypto assets as “financial instruments” at all, and whether they are “similar” to instruments on the exhaustive list.
One crucial question arises for all Australian crypto funds that use trusts. That is, are cryptocurrency investments considered an “eligible investment business” by being a “similar financial instrument” under section 102M? Alternatively, would the crypto asset be a “financial arrangement” under the Taxation of Financial Arrangements (TOFA) rules?
Many funds have not considered this question – which may cause huge tax exposure.
Is cryptocurrency a “financial instrument”?
Cryptocurrencies, by their nature, present unique challenges for legal and tax classifications. As speculative instruments, their volatility and relatively recent emergence into the mainstream financial market raise questions about their status under Australian tax law. It is unclear which kinds of crypto assets will be “financial instruments’ and which ones are not.
It is our position that each activity and investment in crypto assets must be assessed individually, and no broad strokes can be made about particular crypto assets being financial instruments or not. Some liquidity pool arrangements or staking could be treated as financial instruments or arrangements potentially, though it depends on the exact nature of the protocol.
The ATO had not provided definitive guidelines on the treatment of cryptocurrency activities within funds. Without specific legislation or rulings, we are left to interpret and speculate on the possible treatment of such activities.
Disclaimer: This is a fictional case study.
The Degen Fund invests in emerging crypto projects by purchasing tokens and sometimes staking them to earn further income. It has 100 investors.
In the 2022 financial year, it made $100,000 of income and distributed it to investors under the usual rules for managed Investment trusts and did not consider the Public Trading Trust rules. The investors paid tax on their share of the $100,000, and the Degen Fund paid no income tax.
The ATO commenced an audit and concluded that the Degen Fund is a Public Trading Trust due to the activities not being an “eligible investment business”. Therefore the fund is liable for $30,000 in income tax plus a 25% penalty for lack of reasonable care ($7,500).
The fund retained none of its income to cover this tax and has to sell assets to cover the $37,500 it owes the ATO. The investors are not willing to give the money back due to the recession. The fund is forced to sell assets to cover the liability under the funds trustee indemnity provision, and investors take legal action against the fund manager as they believe the fund manager was negligent by not getting tax advice and the investment documents were misleading on the tax outcomes.
Degen Fund is now out of business 🤷♂️
What can be done?
Many approaches can be taken:
- Seek advice on the fund activities to take a position on whether the investment is part of an “eligible investment business”
- Aggregate investors to get below the 50 member cap – noting the grouping rules for associates in Subdivision 6C.
- Any non-eligible investment business investments are done in a subsidiary company to the fund itself; or
- Consider an overseas fund structure especially if there are a significant number of international investors.
Specialist tax law advice is necessary to traverse this issue. In the event of an audit, a fund that has distributed earnings and then is required to pay tax itself may collapse an otherwise profitable fund, or trigger a legal dispute with investors.
How we can help
This ambiguity highlights the potential risks faced by crypto funds. Until further clarification from the ATO, Parliament or case law, Australian trust funds should exercise extreme caution when incorporating crypto assets into their investment strategies.
Fund managers considering cryptocurrency investments must keep abreast of updates from the ATO and other relevant legislative bodies. Additionally, they should seek appropriate tax advice to navigate the complexities of the tax landscape.
As we await more definitive legislation and rulings on this matter, one thing is clear: the financial landscape is evolving, and with it, the need for clear legal and tax guidelines is more important than ever.