Insolvencies of Mt. Gox & FTX: Tax Classification of Repayments in Germany

Founded in Japan in 2010, Mt.Gox was the first bitcoin exchange worldwide. By 2014, up to 80 percent of all bitcoin transactions were processed via Mt.Gox.

Due to security vulnerabilities in the software, Mt.Gox gradually lost several hundred thousand bitcoin by 2014, ultimately resulting in a near total loss. The full extent of the catastrophe became apparent in February 2014 with the filing for insolvency. The initially small insolvency estate grew to a considerable sum, which even exceeded the nominal claims. Since then, a large number of international creditors have been fighting for their claims.

Then there was the emergence of bitcoin cash (BCH). This is a hard fork of the bitcoin blockchain, i.e. a split of the bitcoin project. In this context, the same amount of Bitcoin Cash was issued to each holder of bitcoins, which, in this case, also benefited the insolvency estate.

In the course of these events, a petition was filed at the behest of a group of creditors to convert the insolvency into a Civil Rehabilitation in order to avoid the initial lower claims being settled and the price gains being accrued to the shareholders. Through Civil Rehabilitation, it is possible not only to settle the debt in yen but also to issue bitcoins and BCH.

With the conversion of the insolvency into a Civil Rehabilitation, the revaluation of the claim was carried out at market value. To secure the liquidity of the estate, the insolvency administrator also sold several thousand bitcoins. This leaves approximately 140,000 bitcoins for distribution in the insolvency estate.

Mt. Gox

Mt. Gox was the first major cryptocurrency exchange before it filed for bankruptcy in 2014 after losing over 850,000 BTC - both in Japan and in the USA. As the insolvency estate grew, the insolvency in Japan was converted into a civil reorganization (minji saisei) at the request of a group of creditors.

With the conversion of the insolvency into a civil reorganization, the coins were revalued at market value. One bitcoin was valued at 749,318.83 yen and one BCH at 97,481.19 yen. Since then, these values have been used to calculate the payments to the insolvency creditors from 2024 onwards. The proceedings have not yet been concluded.

The repayments to creditors were made partly in bitcoin, bitcoin cash and partly in fiat currency. The payouts were based on a fixed exchange rate of (from today's perspective: only) USD 483/BTC from 2014, which may also be relevant for the tax valuation.

FTX

FTX, one of the largest crypto exchanges, filed for bankruptcy in 2022. Repayments depend on the realization of the remaining assets and will also be made partly in fiat currency and partly in cryptocurrencies. The first payouts are expected in March 2025.

In order to clarify the tax consequences of the repayments from the insolvencies, the first question to be answered is whether the investors are entitled to separation or segregation rights, i.e. whether the compensation payments represent the repayment of their own coins. This is not the case in either of the two insolvencies, Mt. Gox or FTX. As the customer funds on both platforms were not held separately from the company's assets, the investors are only entitled to claims against the insolvency estate, but not to the repayment of “their” specific coins that they had in their account at the time of the insolvency.

It can therefore be assumed that the original investment was initially lost as a result of the insolvency - which does not constitute a sale for tax purposes within the meaning of Section 23 of the German Income Tax Act (EStG) and would therefore be irrelevant for tax purposes.

The individual investor would then have a (new) monetary compensation claim against the insolvency administrator. The servicing of such a claim is also irrelevant for tax purposes.

However, if the payment is made in cryptocurrencies, this could be seen as an exchange of the insolvency claim in fiat currency for a claim in crypto. This means that at the time of the choice to be compensated in crypto, a new acquisition of the distributed coins could be seen, which in turn is important for the question of whether the distributed coins can be sold immediately tax-free or whether the one-year holding period under Section 23 EStG must be observed.

The ability to hold cryptocurrencies in your own wallets independently of exchanges or banks and to take full responsibility for their safekeeping is considered one of the great achievements of blockchain. Whenever centralized exchanges have suffered major losses due to hacker attacks, the crypto-affine media have reminded us that damage caused by such hacker attacks on exchanges can be avoided simply by the investor holding the crypto assets themselves and managing the corresponding private keys themselves. “Not your key - not your coins!” is a reminder that as long as coins on exchanges are held in third-party custody, the security of the crypto assets stored there is not guaranteed.

The question that now arises is whether coins that investors hold on a crypto exchange are no longer treated as their assets for tax purposes. Is a coin in the investor's own wallet a different asset to a coin in the collective wallet of a crypto exchange? Under civil law, there may be considerable differences here. Under civil law, the crypto assets on an exchange may only represent claims against the exchange. But is this also relevant for tax purposes?

The German Federal Ministry of Finance (BMF) explains the term wallet in its letter dated 10.05.2022. With regard to trading platforms, the BMF writes

• “in some cases, a common wallet is also used for a large number of people, in contrast to the above description.” 

And further:

• “For the time of acquisition or disposal, (...) trading via the platform is decisive. The same applies if taxable persons do not have their own wallet, but the units of a virtual currency or other token are held in custody by the trading platform.”

For tax purposes, the BMF therefore always treats coins and tokens acquired on a trading platform as the investor's own. This means that even in the event of a disruption such as insolvency, the tax status of the coin does not change. The coin is still deemed to have been acquired by the participant at that time and for that amount. This is a fiction that the tax authorities have established independently of the actual allocation under civil law and to which they have bound themselves through the BMF letter dated 10.05.2022.

Depending on whether the coins lost through insolvency were held as business assets or private assets, and depending on whether repayments are made in cryptocurrency or fiat currency, the tax treatment differs considerably.

The tax treatment of repayments from insolvencies of crypto exchanges such as Mt. Gox or FTX depends crucially on whether the coins were held as business assets or as private assets.

• Business assets: Repayments in fiat lead to taxable business income. Repayments in cryptocurrencies are initially a tax-neutral transfer. A subsequent sale of the cryptocurrencies is taxable. The acquisition costs of the unreimbursed coins must be derecognized as a loss at the latest when the insolvency is concluded.
  (Of course, the specific accounting treatment both upon entry into insolvency and for subsequent reimbursements depends on whether a balance sheet or merely an income surplus statement is prepared).
• Private assets: repayments in fiat money are tax-neutral and repayments in cryptocurrencies are tax-free. Repayments in cryptocurrency are not considered a new acquisition and can therefore be sold immediately and completely tax-free without waiting for a further year.

Some uncertainty remains with regard to the peculiarity that claims in the Japanese insolvency system are denominated in YEN by law. As a result, the investor's choice to request payment in crypto instead of YEN could be regarded as an exchange between the foreign currency claim in YEN and the cryptocurrencies. (In our opinion, the fiction of the attribution of the wallets in the BMF letter stands in the way of this, irrespective of the civil law assessment). In this case, a (new) one-year period would have to be waited from the time of the election in order to then be able to sell the BTC and BCH received tax-free.