Denmark proposes taxing unrealized crypto gains as it does with some traditional financial contracts

On Oct 24, 2024

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Denmark is proposing a new taxation model that would tax unrealized gains on cryptocurrencies at 42%, aligning digital assets with existing rules for certain financial contracts.

This approach involves calculating gains and losses annually based on the change in the value of the taxpayer’s holdings, regardless of whether the assets have been sold. The taxable income would reflect the difference between the value at the start and end of the year.

Under this inventory-based taxation system, gains would be included as capital income, while losses could be deducted from gains in the same category within the same year. Unused losses could be carried forward to offset future gains. This method aims to provide a consistent framework for taxing financial instruments, including cryptocurrencies.

Denmark’s traditional financial instrument taxation

Denmark handles some traditional financial contracts under the rules established in the Kursgevinstloven (Capital Gains Tax Act), specifically in Sections 29–33. However, only certain types of investments and accounts are subject to taxation on unrealized gains.

Inventory-based Taxation (Lagerprincippet):
Gains and losses on financial contracts are taxed annually based on their value at the beginning and end of the fiscal year, regardless of whether the contract is sold (realized). This system ensures taxation even on unrealized gains.
Separation Principle (Separationsprincippet):
Financial contracts are taxed separately from the underlying asset. This means that the value changes in the financial contract matter for taxation purposes, not necessarily the movements of the underlying asset.
Tax Deduction Limitations (Fradragsbegrænsning):
While companies can generally deduct losses on financial contracts, there are exceptions. For example, losses on specific equity-related contracts, such as those tied to subsidiary or group shares, are limited. These losses can only be deducted from gains on other financial contracts.
For Individuals:
For individual taxpayers, losses on financial contracts can only be deducted from gains within the same category (i.e., financial contracts). Losses can be carried forward and used in future tax years but are subject to limitations.

Some equity exchange-traded funds (ETFs) in Denmark are taxed on unrealized gains annually. These are typically ETFs that accumulate and reinvest dividends and are taxed at rates of 27% or 42% on unrealized gains each year.

Aktiesparekonto (Stock Savings Account) allows individuals to invest in listed shares and share-based mutual funds with a 17% tax rate on returns. The taxation is based on the unrealized gains at the end of the year, following the ‘lagerprincippet’ (inventory principle).

These investments are exceptions to the general rule, where traditional financial contracts like stocks and bonds are usually taxed on realized gains. The ‘lagerprincippet’ is applied to these specific investment types to encourage long-term investment strategies by taxing annual value increases rather than waiting until the investment is sold.

Impact on crypto trading through new system

The new system may be considered less burdensome for low-frequency traders, as they would have fewer assets to value annually, reducing administrative workload. Frequent traders might benefit from improved accuracy in reported income without the need to track individual transactions meticulously. Instead, they would focus on the overall change in their holdings’ value over the tax year.

However, taxing unrealized gains raises liquidity concerns. Taxpayers might owe taxes on gains without selling assets to generate cash for payment. Recognizing this challenge, the recommendation includes possible measures to ease liquidity constraints, such as carryback rules or provisions to mitigate the effects of sudden price drops after the tax year ends. These measures aim to alleviate financial strain from taxing gains that exist only on paper.

Implementing an inventory-based taxation model could significantly impact crypto investors in Denmark. Taxing unrealized gains may affect investment strategies, as investors might need to account for potential tax liabilities even when holding assets long-term. This could influence trading behavior, leading investors to realize gains or losses strategically to manage tax obligations. The requirement to pay taxes on paper gains might also impact the attractiveness of crypto investments compared to other asset classes.

Liquidity issues are particularly notable in the crypto market, where asset values can fluctuate dramatically over short periods. Taxing gains that exist only on paper might strain investors’ resources, especially if the market experiences a downturn shortly after tax assessment. Even with measures to alleviate liquidity problems, investors could face challenges meeting tax obligations without liquidating assets, introducing additional risks and uncertainties.

Increased scrutiny of crypto taxation in Europe

This move by Denmark aligns with increasing global regulatory scrutiny of crypto. As reported by CryptoSlate, researchers from the Federal Reserve Bank of Minneapolis and economists at the European Central Bank (ECB) have recently discussed ways to address the challenges of cryptocurrencies like Bitcoin. Some have even suggested measures to “eliminate” Bitcoin, highlighting growing concerns among regulators about the impact of digital assets on traditional financial systems.

ECB economist Jürgen Schaaf raised concerns that the rising price of Bitcoin disproportionately benefits early adopters, potentially leading to significant economic disadvantages for latecomers or non-holders. He argued that Bitcoin does not increase the economy’s productive capacity and that wealth gains for early investors come at the expense of others. Schaaf suggested that policies should be implemented to curb Bitcoin’s expansion or potentially eliminate it, warning that pro-Bitcoin policies could further skew wealth distribution and threaten societal stability.

However, the Satoshi Action Fund has drafted a solid rebuttal to the ECB paper, succinctly highlighting the flaws in the arguments.

Some observers view Denmark’s proposed taxation model as part of this broader effort, potentially aiming to reduce crypto usage by imposing stricter tax obligations. By aligning crypto taxation with certain financial contracts and taxing unrealized gains, the government could seek tighter crypto market regulation, possibly discouraging speculative investment.

Why is Denmark looking to tax unrealized crypto gains?

The proposed model aligns with Denmark’s existing taxation of financial contracts, promoting consistency across different financial instruments. By treating crypto similarly, authorities aim to streamline the tax system and reduce complexities in crypto taxation. This reflects an effort to integrate cryptocurrencies into the established financial regulatory framework.

However, implementing such a taxation system requires careful consideration of its impact on investors and the broader crypto ecosystem. Balancing the need for effective taxation with the potential burden on taxpayers is crucial to avoid unintended consequences. These could include driving crypto activities underground, pushing investors to jurisdictions with more favorable tax regimes, or reducing the competitiveness of Denmark’s financial sector.

The government’s recommendation signals a significant development in crypto taxation, emphasizing the desire to adapt tax laws to accommodate emerging financial technologies. How this proposal will affect Denmark’s crypto market remains to be seen, but it highlights the ongoing evolution of regulatory approaches to digital assets.