Blockchain Byte: wrapping tokens – a CGT event?


Posted By and on 24/10/23 at 11:20 AM

Wrapped tokens have emerged as a powerful catalyst for interconnectivity between different ecosystems. For tax purposes the Australian Taxation Office (ATO) has no formal public guidance on the implications of wrapping. However, through private rulings and community guidance, the ATO has shared its position: the wrapping of tokens is a capital gains tax (CGT) event.  

This article will summarize the ATO’s reasoning behind this decision and its implications for cryptocurrency holders. 

What are wrapped tokens?  

Wrapped tokens serve as a conduit for utilising one cryptocurrency on a different blockchain. Imagine having Bitcoin but wanting to use it on the Ethereum blockchain directly—without wrapping, it is not possible as only the Bitcoin blockchain can verify your holdings.  

Wrapping tokens is a solution to this, creating a bridge between different blockchain ecosystems and allowing users to utilise assets from one network in another.  To do this, generally you would send your native token to a ‘custodian’ who, using a smart contract, wraps your token within a special “wrapper” token and then mints a new wrapped coin.  

The wrapped token represents the value of your native token but can now be used on the blockchain it has been wrapped to. To reverse the process, the wrapped token is removed from circulation and the native token is released. 

Understanding the relevant legislation 

Taxation Determination TD 2014/26 clarifies that Bitcoin, along with similar cryptocurrencies, is considered a CGT asset for tax purposes. Section 102-20 of the Income Tax Assessment Act 1997 (ITAA 1997) establishes that a capital gain or loss is realized only when a CGT event occurs. Where a CGT asset is disposed of, it will trigger a CGT event and consequently a capital gain subject to tax or a capital loss.   

Wrapping is a relatively new area and formal guidance has not been provided by the ATO to date. Through community guidance and private rulings, the ATO has stated that its position is that when an individual exchanges a wrapped token for a native token, they are disposing of one CGT asset and acquiring another, thus triggering a CGT event.  

Is an asset truly disposed of?  

The ATO explains in a private ruling on this point that while the wrapped token is algorithmically linked to a certain quantity of native tokens, it is not the native token itself. The ATO states: 

…wrapping or unwrapping does not involve the ‘reformatting’ of the native token. The arrangement cannot be described as a single CGT asset which undergoes a transformation comparable to the variation of a share’s associated rights. Instead, the wrapped token is locked up at the bridge and an equivalent amount of native token is issued on the other side of the bridge. 

The ATO’s position therefore hinges on the notion that the token returned to you is different from your original coin. However, due to variations among wrapping merchants and custodians, this may not always hold true and careful review of the relevant wrapping contract should be made. 

Split and merged assets? 

Arguably, the original token is not disposed of– rather it is simply “locked up” or held as security. We can therefore draw parallels to the tax treatment of asset splits and mergers.  

An asset split occurs where a CGT asset is split into 2 or more CGT assets. It is not in itself a CGT event and therefore does not trigger CGT. A common example would be the subdivision of a parcel of land into two parcels of land. Provided the owner of the split assets (the parcels of land) continues to be the beneficial owner of each new asset then a CGT event will not arise.  

In the context of wrapping, the native coin is arguably split in two – first the native coin locked by the custodian and secondly the wrapped coin to be used on the different blockchain.  

In the case of wrapped tokens, the ATO purports that there is a change of legal and beneficial ownership. That is, the custodian acquires the exchanged coin and thus the ownership changes in the same manner a foreign currency exchange would. The ATO has also expressed in private rulings that they believe you will not receive the same asset in return.  

However, is this an appropriate conclusion? It of course would require a case-by-case analysis depending on the specific code of a wrapping contract, but it raises the following questions:  

  1. The first striking consideration here is whether in fact you do lose the ownership of the asset. In the wrapping arrangement, it may be that the asset is merely held, as security, by the custodian. It is not until a later event where the legal and beneficial ownership transfers. In the interim there is arguably no cancellation, redemption or change in the asset that has been split.  
  2. The second consideration is that arguably it would be an arbitrary approach to apply this to all wrapping contracts. Contracts should instead be reviewed on a case-by-case basis as many may prevent the transfer of ownership.  

The merging of two assets beneficially owned by the same taxpayer is also not treated as a CGT event – ie referring to our example above, when the two parcels of land are consolidated again in to one parcel. For wrapped coins this would be when the coin is removed from circulation and the native token is released (or, in the ATO’s mind, “issued”). 

Again, for merged assets it is not a CGT event as the owner of each asset is the same and there is therefore no disposal. This therefore again goes to the question at the core of wrapped tokens – has ownership of the original asset truly changed? If not, then on removal or release of the native token, a CGT event has again not occurred.  

From a policy perspective, treating wrapped coins as a split and merger would reduce the compliance burden on taxpayers as there are less reportable CGT events. Wrapping coins provides flexibility to trade and as the ultimate disposal of legal and beneficial ownership will trigger a CGT event, arguably therefore the tax base is not eroded, merely delayed.  

In conclusion 

To summarise, the ATO considers the act of wrapping tokens as a CGT disposal event under subsection 104-10 of the ITAA 1997. Crypto asset holders must take this into account to ensure compliance with tax obligations when engaging in such transactions. Seeking guidance from a tax professional is advisable to navigate the intricacies of cryptocurrency taxation, particularly given the fact that this limited guidance from the ATO may not apply in all cases.  

This article is part of the Blockchain Byte series by KHQ’s Tax & Structuring team. The series provides ‘byte-sized’ articles outlining key tax and structuring issues associated with crypto assets as well as updates in the Blockchain space which regularly occurTo register for the latest byte and other Tax & Structuring news, click here to subscribe.  

KHQ Lawyers - Laura Spencer

Laura Spencer Senior Associate

Laura is a lawyer in our Tax & Structuring team. She has worked in legal and advisory firms both in Australia and the UK, as well as at the State Revenue Office of Victoria... Read More

KHQ Lawyers - Harry Giannakidis

Harry Giannakidis Principal Solicitor

Harry leads our Tax & Structuring team. He has over 20 years’ experience in advising corporate clients, private family business groups (including SMEs and large family businesses) and high net... Read More