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Cryptocurrency exchanges, market makers, payment companies and digital asset treasury operations routinely hold proprietary assets with third-party custodians like BitGo, Copper, Fireblocks, Zodia Custody and many more. The terms of these custody arrangements can trigger unexpected CGT consequences on assets that were never intended to be disposed of.
Recently, Cadena Legal has been engaged to review a number of custodian agreements which sometimes create unexpected outcomes for customers.
A CGT event can occur from entering into custody arrangements, or it can fall into various exemptions. In particular, arrangements that fail to establish "absolute entitlement" or security interest risks when assets are pledged as collateral are key triggers. This article addresses balance sheet assets only, it does not assets held on trust for customers (like under the proposed DAP reform) or trading stock assets.
The Analytical Framework
First, we must set out how the basic CGT analysis must be done.
Step 1: Does a CGT event happen?
The most relevant events for custody arrangements are:
• CGT Event A1: Disposal, including change of ownership
• CGT Event E1 or E2: Trust created over a CGT asset, or transferred to an existing trust respectively
• CGT Event D1: Creating a contractual right in another entity
Step 2: Does an exemption apply?
Key exemptions include:
• No change in beneficial ownership (A1): No disposal if beneficial ownership unchanged
• Absolute entitlement (E1 and E2): No event if beneficiary has absolute entitlement at all times
• Section 106-60: Security arrangements disregarded if conditions met
Step 3: Consequences
If no exemption applies, the CGT event occurs, and a capital gain or loss is calculated at market value. There is also a new cost base on reacquisition.
If an exemption is applied, no tax is triggered at that time.
Absolute Entitlement Is a Very High Bar
CGT Event E1 and E2 does not occur if a beneficiary is “absolutely entitled” to a trust asset. If absolute entitlement exists from deposit, no E1/E2 occurs. If it does not, E1/E2 may trigger on deposit.
The leading authority is Herdegen v Federal Commissioner of Taxation, where Gummow J defined a bare trust as one where the trustee holds property "without any duty or further duty to perform, except to convey it upon demand to the beneficiary." However, TR 2004/D25 (still in draft after 20 years) outlines the ATO view that "bare trust" is not the whole test, absolute entitlement is a slightly different bar. Absolute entitlement requires:
1. A vested and indefeasible interest in the asset
2. The ability to call for transfer immediately
3. No basis for the trustee to resist the call
This derives from the rule in Saunders v Vautier, an old equity case from the 1800’s. Subsequent cases have narrowed the concept: Kafataris v DCT (multiple beneficiaries cannot be jointly absolutely entitled to land); Oswal v FCT (trustee's power of sale defeats absolute entitlement).
Custodian Terms That Compromise Absolute Entitlement
Standard and basic custody agreements can include:
• Security interests over deposited assets for unpaid fees
• Withdrawal controls, approval processes, cooling-off periods
• Settlement network participation rights
• Omnibus pooling without entitlement to specific tokens
• Trustee discretions over timing or conditions of return
If any term allows the custodian to resist an immediate, unconditional demand for transfer, absolute entitlement may not exist. Custodians use detailed contracts and trust deeds, and generally, the longer the agreements and trust deed, the less likely it is a bare trust, and absolute entitlement is more difficult to show.
Foreign Custodians using Trust Structures
Australian CGT applies Australian equity concepts regardless of governing law. A structure qualifying as a bare trust under Singaporean or Swiss law may not establish absolute entitlement under Australian principles.
Common issues:
• Civil law jurisdictions lack equivalent beneficial or equity ownership concepts
• Trust protectors with veto powers may provide grounds for a trustee to resist a beneficiary's demand, meaning not ansolute entitlement
• Discretionary elements, even ones required to comply with legal requirements such as AMLCTF monitoring, can defeat absolute entitlement per TR 2004/D25
Users must get tax and legal advice on offshore custodian arrangements through an Australian lens, not just the custodian's home jurisdiction.
Pledging Assets and Security Arrangements
This most commonly happens for exchanges or other businesses to pledge assets held by a custodian. This usually triggers a CGT event, likely D1 (creating a right).
However, section 106-60 disregards CGT events when assets are used as security for a debt or obligation. If met, the security/vesting event is ignored, and the transfer back is also ignored.
Requirements:
1. Debt or obligation owed by the asset owner
2. Asset used as security for that obligation
3. Acts done for the purpose of "enforcing or giving effect to or maintaining" security
PR 2014/6 is the only public guidance on section 106-60 relating to the Equities First secured lending product on shares. In that arrangement, the Lender could "sell, buy and otherwise deal with" secured shares during the security period.
The ATO ruled:
• Initial transfer, section 106-60 applied, therefore no CGT event
• Lender trading shares "for the purpose of deriving a profit on its own account" when assets are rehypothecated, therefore not taxable to the borrowers under section 106-60(2)
The lesson is that carefully crafted arrangements can satisfy section 106-60.
However, users should be careful of rehypothecation-based products including staking or earn products offered by custodians. If the counterparty can use pledged assets for their own trading or lending, this may not meet the requirements, unless there is also a security interest granted over the assets. This area is highly complex and custodians, and customers of custodians, should obtain Australian advice if operating in Australia.
Conclusion
Crypto custodian arrangements are still mostly governed by foreign laws and global terms but are not designed for Australian CGT optimisation despite marketing heavily to Australian exchanges.
Businesses holding material balance sheet digital assets using custodians should:
1. Audit all custody arrangements. Identify terms that could compromise absolute entitlement or affect the characterisation of collateral arrangements.
2. Distinguish between custody tiers or products offered. Many custodians offer different structures for different clients or service levels. Understand exactly which structure applies to your assets.
3. Review collateral documentation separately from general custody terms. Collateral arrangements may be governed by different agreements with different consequences.
Both custodians and users should obtain advice to make sure the products don’t lead to tax surprises. The cost of advice is trivial compared to an unexpected capital gain on significant holdings.
Disclaimer: This material is produced by Cadena Legal, a NSW-registered legal practice. It is intended to provide general information and opinions on legal topics, current at the time of first publication. The contents do not constitute legal advice and should not be relied upon as such.
