What you should know in using Bitcoin as a consideration to a commercial contract?

[Note: This article was first published in July 2014 by IACCM. Here is link https://www.iaccm.com/news/contracting-excellence-journal/?newsletterid=35. The applicable law and jurisprudence may have significantly changed since this article was first published. This is not a legal advice. The views expressed are my own and cannot be attributed to my present or past employers. The article is reproduced in my capacity as the author of the same and to test the technical aspects of my venture www.articles.legal]

That digital, virtual currency (or commodity) not issued by any government, bank or central organization – commonly known as a Bitcoin. Yet, it’s more popular than ever! Is it here to stay? If it appears in your contracting world, what must you know now?

Author Ashish Chandra put the stethoscope on the Bitcoin and its effect on the global community – and found it alive and finding its feet!  He discovered some interesting implications commercial and contract managers need to know about if and when it becomes a contracting issue.

IMPLICATIONS FOR CONTRACTING

The Bitcoin payment option would pose several head scratchers for contract professionals.  You will need to consider several things, including…

• Ensure it is actually legal in your jurisdiction
  This is the first question parties must consider before including Bitcoin in the contract.
• It’s legal today – but may not be tomorrow!
  Most countries that have not specifically banned Bitcoins have taken a “wait and watch” approach. A real risk could be that even if it’s valid the day you make your Bitcoin exchange or sign your contract agreement, it may not be the day payment is due. So you would need to ensure suitable provisions are included in the contract to ensure future payment obligations of the parties are protected should Bitcoin subsequently be declared illegal.
• Could a Bitcoin contract end up being taxed twice?
  Because Bitcoins have not been declared “fiat currency” in any country  – and in some they’re considered either as “property” or a “payment service” – any commercial contract providing for payment of consideration through Bitcoins could be subject to dual taxation ie the subject matter of the contract could also be liable to taxation:
  • direct taxon the income arising pursuant to the contract and indirect tax (eg VAT/GST etc) on the goods/services sold under the contract) and
  • taxation on the exchange of Bitcoin either as property or as a payment service.
• Beware of falling foul of money laundering laws
  In jurisdictions where Bitcoins are not specifically banned, you would need to take extra care to comply with “Know Your Customer” (KYC), anti-money laundering and anti-terrorist finance laws. This would become even more important where the contract is being signed by a “paper” company in a tax or other legal-friendly jurisdiction. Necessary due-diligence, information requirements, representations, indemnities and corporate guarantees should also be considered carefully in these cases.
• Take foreign exchange laws seriously
  In jurisdictions where payments for international trades are controlled through foreign exchange laws (e.g. the Foreign Exchange Management Act 1999 in India), you would need to comply with such laws when agreeing to provide for Bitcoins as a mode of payment of consideration under a contract.
• Can we protect against highly volatile exchange rates?
  “Hedging” the conversion rate risks may be the best way, depending on the period of holding of Bitcoins. A new form of hedging or derivative contract would be required for each jurisdiction depending upon how that country treats the Bitcoin (i.e. as currency, security, property or as a service). As per the recent news, Tera Group Inc., a New Jersey based company, has created a framework for buying and selling swaps linked to Bitcoins that would let investors hedge risk from trading in digital currency.

Bitcoin – more viable than volatile

The real culprit is misuse, not the currency itself.  True, Bitcoins have generated unprecedented volatility in exchange rates; precipitated the collapse of big Bitcoin exchanges; caused a few promoters to get arrested for several illegal Bitcoin exchanges and spawned other harmful developments. Notwithstanding, the Bitcoin is proving to be a viable substitute for the fiat currency exchanged for trading goods and services in the virtual world.

Few developed countries have fully legitimized Bitcoins. Nevertheless, as Bitcoins gain user acceptability and exchange rates stabilize, they will increasingly gain recognition from governments worldwide, and slowly become an option for payments under commercial contracts.

BITCOIN BASICS – keeping it simple

• Bitcoin is a digital currency in which transactions can be performed without the need for a central bank.
• Bitcoins have no physical existence beyond an on-line public “ledger’, known as the “Blockchain,” where all transactions are recorded.
• When you buy a Bitcoin, it is allocated to your digital “wallet.”
• The Blockchain (online ledger) registers all Bitcoin transactions, including their initial creation such as, which digital user first bought them, who since bought and sold them and who now has them in their digital wallet(Bitcoin account). It therefore serves as a public record of the chain of custody of all Bitcoins.

For the technically minded, Bitcoins are based on an open source, math-based protocol existing on an online, peer-to-peer computer network that hosts the Blockchain (Public transaction ledger).

You may access your Bitcoin digital wallet and use it to receive or send Bitcoins through a digital address together with a public key and private key that are part of the Bitcoin Network’s cryptographic security mechanism.

How can you get Bitcoins?

Mining

Using a “goldrush” metaphor, one way of getting Bitcoin in your digital wallet is by “mining” them through cracking algorithms. It’s like a reward to the miner for having solved the math-based algorithm, a game of skill, not chance.

The number of Bitcoins in existence will never exceed 21 million.  This controlled supply of 21 million Bitcoins multiplied by its smallest unit can create 21 trillion Bitcoin units.

Trading

You can receive Bitcoin in your digital wallet through peer-to-peer transfer or when a seller of goods or services (virtual or actual) receives Bitcoins from the buyer as sale consideration.

Currency exchange

You can buy Bitcoin through exchange of a fiat currency. The currency denominations are “BTC” or “XBT”.  Currently 1 BTC = ~640 US$. In late 2013, the virtual currency traded for over $1,100 per Bitcoin before dropping precipitously. Bitcoins are easily divisible as the smallest unit of the currency is one-hundred-millionth of a Bitcoin.

Bitcoin growth

The Blockchain reflects usage of Bitcoins within past years to the present. Please click on the links below to view line graphs showing how the Bitcoin has been progressing:

• Total Bitcoins in Circulation
• Market Price of Bitcoins (USD)
• Total number of transactions

Bitcoins can benefit the economy

• Bitcoins can never be counterfeited.
• Bitcoin Exchanges record all transaction data about all trades of each Bitcoin and this data is publicly available. The creator, transferor or transferee of Bitcoin may remain anonymous but all exchanges of Bitcoins are public information.
• Bitcoin can be used by people who have access to internet but are not bankable i.e. don’t have bank account or credit cards.
• Bitcoin payment processing is far cheaper than the processing or transaction fees presently charged by the existing payment gateways (or sometimes NIL). This could potentially reduce the price of goods and services which can be traded online.
• Being a global virtual currency, Bitcoins are immune to exchange rate fluctuation of a typical fiat currency which depends upon the economic status of its sponsored country.
• Payment for cross border trade can be more hassle free and cheaper, which is a great incentive for global ecommerce … and one can use Bitcoin to buy on eBay / Amazon on Cyber Monday!!

Regulatory issues

Lately, various governments have been attempting to regulate Bitcoins either by…

1. declaring them specifically as property or service and accordingly issued appropriate tax advisories on taxability for mining and trading in Bitcoins (for example: Australia, US, Canada, Singapore, Brazil, Germany); or
2. keeping a hands-off approach i.e. neither deliberately banning it nor specifically regulating it but keeping them under watch or observation with risk advisory to its citizens; or
3. banning the same.

Items a. and c. are objective and clear however b. is ambiguous and the Bitcoin industry appears to be skeptical about doing business in those countries, because they are not sure what category Bitcoin will fall into and what would be the tax impact (if at all Bitcoins are specifically made legal) or whether their business could be shut and they could face criminal trials.

Because Bitcoins are positioned as currency for the virtual world, Bitcoin enthusiasts and entrepreneurs could use this regulatory arbitrage in their favor and set up shops in regulatory and tax-friendly jurisdictions.

Regular currency and Bitcoin compared

The recent extreme volatility in the exchange rate of Bitcoins has given shivers to financial and securities regulators the world over. The real Bitcoin damage started when The Silk Route used Bitcoins to trade illegal drugs while hiding the identity of the payer and payee. Hacking into the private keys of Bitcoins (stealing Bitcoins from digital wallets) also occurred.

Some believe regular currency or other commodities are not better, supporting their view with examples like the following, all of which exist in the real world with real currency and other commodities:

• The uncontrolled surge in oil, gold, property prices and sudden slump in 2008;
• Billions of dollars exchanged by the underworld and used for terrorist financing;
• Recent political agendas of various governments to bring unaccounted wealth back home from offshore havens; and
• Bank account hacking, Nigerian frauds, credit card frauds and phishing scams.

What is the outlook for Bitcoin?

Fraud will always threaten innocent people. Bitcoin is money, and money has always been used both for legal and illegal purposes. The Bitcoin wasn’t really developed to replace fiat currency. It is here to stay in the long run and governments need to frame uniform and flexible regulations to enable the Bitcoin to develop as a payment currency for the virtual world. They need to quickly adopt a balancing approach to cater to the payment system needs of this community.  Currency is not the problem: we are – unless we are watchful, aware and operate with integrity.

Next steps – my further thoughts

• We must immediately check the volatility, blatant abuse by money launderers and technical compatibility and interoperability for world-wide acceptance.
• Apart from framing enabling regulations, the international standards-setting body for payment industry and internet should frame and adopt standards for worldwide uniform adaptability of Bitcoin and protocols for mining and running the exchanges.
• We must find flexible and innovative means to comply with KYC/AML regulations. One way could be to link the IP address under the new IPv6 regime to an individual or organization against proper KYC and such IP address to be recorded at the Blockchain.