The ATO has published a Class Ruling in relation to the tax treatment of creditor claims and administration processes flowing from digital currency exchange Digital Surge’s administration. A Class Ruling is a type of public ruling that aims to explain the tax outcome of a specific transaction or dealing to a specific class of persons. The primary purpose of a class ruling is to provide certainty to persons and otherwise obviate the need for individuals to seek their own private rulings.
Background
Less than a month after FTX was placed into bankruptcy in November 2022, Digital Surge entered voluntary administration as a significant proportion of its assets were under the control of FTX pursuant to a broker agreement entered into between the two exchanges. At the second meeting of creditors, it was resolved that the company would enter into a Deed of Company Arrangement.
A Deed of Company Arrangement, or a DOCA, is a document whereby the reconstruction of an insolvent company’s business as approved by its creditors is implemented. Through a DOCA, a company can continue to trade and can otherwise rely on the financial compromise aspects of the DOCA in relation to creditor claims. For creditors, there are advantages to a DOCA, as there is the potential for a better dividend than would be received if the company had gone into liquidation.
However, while the company is subject to a DOCA, the words “subject to deed of company arrangement” must be inserted in brackets after the company name on every public document and instrument. One way to avoid this is to use a creditors’ trust arrangement by which the company is quickly moved from a DOCA and into another arrangement. A creditors’ trust arrangement typically involves changing creditor rights against the company into rights as beneficiaries of a trust whose funds are set up by the DOCA. This was the case for Digital Surge, who shortly terminated the DOCA and entered into a Creditors’ Trust.
Unlike an ordinary insolvency process which involves creditor claims being primarily denominated in fiat currency, Digital Surge’s circumstances posed an interesting question – if customers deposited crypto-assets into the exchange, and the exchange went bankrupt, what would they be entitled to? Crypto-assets, or perhaps the AUD-equivalent amount of fiat currency?
The terms and conditions of the Digital Surge exchange meant that customers deposited crypto-assets and fiat currency into accounts maintained by the company. However, once customers transferred funds, Digital Surge became the legal owner of the assets. Instead of a direct ownership right over the underlying assets, customers held a right to demand payment from Digital Surge. This payment was to be based on the value reflected in their accounts, but the form of payment – whether in crypto-assets or fiat currency – was at Digital Surge’s discretion.
Under insolvency rules, the value of creditors’ claims was locked based on crypto-asset prices at the point in time of administration.
Questions before the ATO
The ATO was asked to consider the possible tax events that would arise from the above arrangements. At a high level, the ATO’s findings are as follows:
A CGT event occurs when there is a transaction or change in ownership in relation to a CGT asset. A CGT asset can include most forms of property, including intangible property such as a legal right to payment from another person. A capital gain will occur when the capital proceeds from a CGT event exceed the cost base of the CGT asset. A capital loss will occur when the capital proceeds from a CGT event are less than the cost base of the CGT asset.
The CGT event that occurs under 2(a) and 2(b) above is CGT event C2. Pursuant to section 104-25 of the Income Tax Assessment Act 1997 (Cth) (ITAA 97), CGT Event C2 occurs when an intangible CGT asset is cancelled, surrendered, satisfied, or “ended” in a similar manner:
Taxable Event A
When the DOCA was terminated, the ATO has ruled that CGT event C2 occurred for creditors as their claim under the DOCA was effectively released. However, this claim was “replaced” by an equivalent AUD-value entitlement against the Creditors’ Trust which was set up contemporaneously to the DOCA termination.
The proceeds from the CGT event C2 therefore are the total of any money or market value of property received in respect of the event. By way of example, the likely effect of this is as follows:
Taxable Event B
When the Creditors’ Trust makes a payment to a creditor, CGT event C2 occurs as the creditor is effectively having part of their CGT asset (being the right to receive payment) satisfied.
The proceeds from the CGT event C2 are equivalent to the market value of any money or property received from the Creditors’ Trust. However, the cost base is calculated in a modified manner in accordance with the apportionment rule in section 112-30(3) of the ITAA 97. This means that if a creditor receives a partial payment, their cost base for the given CGT event will be proportional to how much of that payment makes up of the total claim. By way of example, the likely effect of this is as follows:
For Digital Surge’s creditors, the ATO ruling means that the effect of the administration process and distribution process is tax neutral.
A copy of the Digital Surge class ruling can be found here.
Conclusion
The Class Ruling provides helpful clarity for creditors of Digital Surge. By recognizing that no capital gain or loss arises when a creditor’s claim is effectively replaced with an equivalent right under the Creditors’ Trust, the ATO ensures tax neutrality. This is particularly important for creditors, who should not face tax consequences merely due to the insolvency process or through the ordinary course of dealing with their crypto-assets on the platform.
Steven Pettigrove – Partner, Piper Alderman
Luke Higgins – Associate, Piper Alderman