Tax Planning for Transactions or Investments in Virtual Currency
Virtual currencies are becoming increasingly popular in today’s financial markets. What was once thought to be a fad has garnered much attention lately due to the extraordinary surge in values. The acceptance of certain virtual currencies (i.e., cryptocurrencies) in business transactions has gained momentum as investors use them to fund transactions, diversify portfolios and potentially profit off of price volatility. However, consumer appetite notwithstanding, virtual currencies remain largely unregulated without the backing of a central authority or bank and the use of them may result in significant tax consequences.
Virtual Currency – Where Does It Come From?
Bitcoin was the first cryptocurrency to gain worldwide attention; however, there are many others including Ethereum (Ether), Ripple and Litecoin. These cryptocurrencies are a form of virtual currency created through a competitive process known as mining. During mining, a series of complex math puzzles are solved by a mining hardware device or system that generates a record of value – a coin. Once mined and created, cryptocurrency can be traded freely and transactions involving the digital coins are tracked in a digital ledger. There are a number of resources available for tracking the conversion rate for cryptocurrencies into actual currencies, and vice-versa.
IRS Guidance on Virtual Currency
In 2014, the Internal Revenue Service (IRS) issued Notice 2014-21 (the Notice) to address the taxation of convertible virtual currency, which is virtual currency that has an equivalent value in real currency, or that acts as a substitute for real currency. The Notice states that virtual currency is treated as property rather than currency for tax purposes and general tax principles applicable to property transactions apply to transactions involving virtual currency.
Miners of virtual currency must recognize as gross income the fair market value (FMV) of mined virtual currency at the time of receipt. This becomes the miner’s cost basis in the virtual currency. This is different from typical manufacturing where gross income is not recognized until a product is sold.
Once mined, the use of virtual currency by miners and other parties for the payment of goods or services (including salaries for employees) is effectively treated as two transactions for tax purposes – 1) the sale of the virtual currency for an amount in dollars equal to the FMV of the goods or services received followed by 2) payment for the goods or services with the sale proceeds. Therefore, a buyer paying with virtual currency must first recognize gain or loss on the deemed sale of the virtual currency, and its basis in the acquired goods or services will be equal to the FMV of the virtual currency paid. Similarly, the seller of the goods or services (i.e., the recipient of the virtual currency) recognizes gain or loss upon receipt. For the seller, the amount realized is the FMV of the virtual currency, which will establish the seller’s basis in the virtual currency received. The character of the gain or loss on a virtual currency transaction is based on whether the virtual currency is a capital asset in the hands of the taxpayer. The parties may also need to address informational reporting requirements (e.g., IRS Form 1099 reporting), the collection and remittance of sales and use tax and payroll tax withholding and reporting (where employees are paid in virtual currency). Since the identities of the parties using virtual currencies are generally anonymous, there may be potential pitfalls when attempting to comply with these rules.
Virtual Currency and Investment Funds
While virtual currency held by investment funds is generally a capital asset, the Notice did not address an important question: is virtual currency a security for tax purposes? If not, certain virtual currency transactions may escape the application of anti-abuse rules that apply to securities, making it possible to monetize the appreciation in value in the virtual currency in tax efficient ways that are not available to holders of equity or debt securities. On the other hand, there may be advantages if virtual currencies are treated as securities for tax purposes. Security treatment may allow open-end funds that are taxed as partnerships and that trade virtual currency to be considered security partnerships. This may permit such funds to use income and loss allocation methods that are not available to other partnerships, which can drastically simplify allocations for active trading funds. However, there are downsides to this treatment since the contribution of virtual currency into the funds may be fully taxable as a security contribution and result in the possible application of anti-abuse rules for securities as mentioned above. Other planning and structuring opportunities may exist to avoid gain recognition under these circumstances, but alternatives must be considered and implemented prior to the contribution.
Concerns over Recent IRS Coinbase Summons
On November 30, 2016, IRS was successful in obtaining a John Doe summons to be served on Coinbase, Inc. (2016 Summons). IRS is seeking information on all U.S. persons who conducted virtual currency transactions with Bitcoin during the period January 1, 2013 to December 31, 2015. This is reminiscent of the John Doe summons that was granted to IRS in 2008, for information on U.S. persons with accounts at UBS Switzerland.
The John Doe Summons issued in July 2008 resulted in the release of approximately 4,500 names of U.S. persons holding Swiss bank accounts by UBS to IRS. It was the issuance of the John Doe Summons against UBS that ultimately led to the implementation of the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS). There is concern that the 2016 Summons could have a similar impact on cross-border transactions in virtual currencies.
On July 25, 2017, the SEC issued an investigative report concluding that market participants offering, selling or trading virtual currencies are subject to and must comply with U.S. securities laws unless a valid exemption applies. We anticipate additional guidance from IRS and its foreign counterparts, and we will continue to monitor any significant developments. Before engaging in transactions in or investments involving virtual currency, it is important to consult with a tax specialist familiar with this area.