Despite recent fluctuations in value, the Bitcoin phenomenon shows no sign of slowing. The meteoric rise of the cryptocurrency presents a range of issues that law enforcement agencies, legal regulators and tax authorities must consider in determining how it fits within their existing regulatory frameworks.

Given the convenience of established currency and payment systems, what is driving the ever-growing interest in Bitcoin and other virtual currencies?

National currencies were initially based on a gold standard, then gradually on the belief that the state which issues the currency will be able to guarantee its value and its stability. With the emergence of multiple financial and economic crises, the reliance on states and confidence in the financial industry have declined and virtual currencies – which were initially confined to a very few initiated people – have attracted the interest of an ever-growing part of the population. Bitcoin and other virtual currencies were initially the result of a 'bottom-up consensus' from a minority of individuals who wanted to decide by themselves what they wanted to value as money, outside of any governmental or financial authority and thus free from regulation.

More recently, the approach with regard to Bitcoin and other virtual currencies seems to be changing and their use – which was initially outside the banking system – is now in the process of being integrated into the banking system, allowing customers to benefit from the advantages offered by such systems (ie, allowing banking transactions to be cheaper, faster and even more secure than before). Thus, the ever-growing interest in Bitcoin and the other virtual currencies seems to be driven by the consistently increasing ways to use them, which are almost as numerous as new financial technology start-ups.

Has your jurisdiction taken steps to regulate virtual currencies? What is their current status?

There is no specific legal framework regulating virtual currencies in Luxembourg. However, the Luxembourg authorities and the financial supervisory body, the Commission de Surveillance du Secteur Financier (CSSF), are fully aware that some tailoring is needed in order to adapt the financial regulatory framework to reflect the challenges of new technologies, especially with regard to virtual currencies.

In this context, the CSSF issued a press release on February 14 2014, stating that virtual currencies shall be considered as scriptural money, as they are accepted as a means of payment for goods and services. Due to their nature, virtual currencies may be considered as electronic money, but not necessarily within the meaning of the EU E-money Directive (2009/110/EC), which defines 'electronic money'.

In the same press release, the CSSF noted that "nobody can be established in Luxembourg to carry out an activity of the financial sector without an authorization by the Minister of Finance and without being subject to the prudential supervision of the CSSF".

In practice, determining what can be considered as an activity of the financial sector can be complicated, due to the wide range of use that can be made of virtual currencies. In other words, the distinction between an activity of the financial sector and mere IT support to financial professionals may be quite blurred. Thus, the CSSF took the position to proceed with a case-by-case analysis of the business models proposed by each potential new stakeholder that intends to establish its business in Luxembourg. Hence, persons contemplating carrying out activities in Luxembourg that involve issuing means of payments in the form of virtual currencies, providing payment services using virtual currencies or creating platforms to trade virtual currencies must first contact the CSSF in order to determine whether a licence is required – and if so, which type of licence. This highlights the need for all future market players to seek legal advice and guidance when developing their business model in order to benefit from maximum predictability on the legal treatment of their activities.

Finally, at the European level no specific regulation presently applies to virtual currencies. Nevertheless, the European Commission's proposal for a new directive on payment services (known as the EU Payment Services Directive 2) may enhance the scope of the legislation applicable to payment services and potentially affect virtual currency market players.

How are transactions using virtual currencies as the medium of exchange taxed in your jurisdiction?

Based on a report submitted to the US Congress entitled "Regulation of Bitcoin in Selected Jurisdictions",(1) in most of the jurisdictions analysed, virtual currencies seem not to be treated as electronic money. However, the CSSF issued a press release on February 14 2014 stating that virtual currencies shall be considered as scriptural money and that, due to their nature, they may also be considered as electronic money.

The tax treatment applicable in Luxembourg will very much depend on the characterisation of virtual currencies and such status has not yet been addressed by the Luxembourg tax legislation. In addition, it appears that the Luxembourg tax authorities have issued no administrative guidance in relation to virtual currencies; nor have they undertaken any applicable practice in this regard.

That said, the above positions as to the characterisation of virtual currencies are unlikely to change fundamentally the tax treatment of virtual currencies in Luxembourg. For instance, the granting of virtual currencies may constitute a taxable event (depending on the circumstances) and any gains realised by a Luxembourg resident individual holder of virtual currencies acquired less than six months before their conversion into any official currency (eg, euros) could be treated as speculative gains (bénéfice de spéculation) and be liable to income tax (at a maximum rate of 43.6%, including a 9% surcharge for employment funds).

What are the potential risks of virtual currencies in terms of fraud? How would these be addressed in your jurisdiction? Have any specific instances emerged in which virtual currencies have been used for money-laundering or other fraudulent purposes?

No specific instances have emerged in Luxembourg with regard to virtual currencies used for money laundering or other fraudulent purposes. One of the risks of virtual currencies in terms of fraud is linked to their lack of transparency. Indeed, the identity of the person holding the virtual currencies and undertaking operations with such currencies is unknown to the other participants, even though some systems (eg, Blockchain) provide information on the exchanges and the path of each bitcoin.

Due to the absence of specific legislation on virtual currencies, and in order to avoid unexpected penalties from the competent authorities, most of the new stakeholders in the virtual currencies market are now looking to be regulated and supervised by, or to work together with, classic financial institutions, which they may rely on for all know-your-customer and other obligations arising from the anti-money laundering laws.

However, some market players prefer to continue with the initial approach to virtual currencies and wish to be totally unregulated, which may lead to certain breaches with regard to the applicable anti-money laundering laws and regulations.

As stated above, persons intending to carry out activities linked to virtual currencies in Luxembourg are invited to submit to the CSSF a detailed description of the activities envisaged, allowing the CSSF to determine whether such activities are subject to authorisation.

Is it time for international standard-setting bodies to develop standards which leave room for technological innovation while preventing the illegal use of virtual currencies? How might this be achieved? What would be the main challenges?

Despite the discussions between the European Banking Authority and the European Single Market Agency on the topic of virtual currencies and their related reports, there is currently no project on international standards to regulate the use of virtual currencies. However, at the European level, the European Commission's proposal for a new directive on payment services (the Payment Services Directive 2) may enhance the scope of the legislation applicable to payment services and potentially affect virtual currency market players.

The main challenge will be to regulate virtual currencies which are based on protocols – such as internet protocols, which themselves are not regulated at an international level. The question of internet regulation is not new and an attempt was made in this regard by the International Telecom Union (ITU). During the ITU conference in 2012, a proposed global telecoms treaty giving national governments control over the Internet was discussed. However, this proposal faced opposition from several major countries (eg, the United States and the United Kingdom). Since the beginning of 2014, there have been many initiatives from the financial authorities to regulate or at least provide market players with guidelines on the use of virtual currencies. However, the main challenge will be to mitigate the risks arising from the use of financial technology without impeding the development of these new technologies.

Josée Weydert

Jad Nader

This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription