Cryptocurrencies are regulated at federal level in the US. They are characterized as money, property, commodity and a security by the Financial Crimes Enforcement Network (FinCen), the Office of Foreign Assets Control (OFAC), the Internal Revenue Service (IRS), the Commodity Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) respectively.
The industry participants are waiting for answers and clarification as there are uncertainties to the taxation of cryptocurrency and blockchain technology due the multi-classification.
On 30th May, the American Institute of Certified Accounts (AICPA) sent a letter to the IRS for the second time asking for more specification on cryptocurrency taxation beyond Notice 2014-21 which treats cryptocurrency as property. The first letter by AICPA to the IRS was sent two years back on June 10, 2016.
Annette Nellen, CPA, CGMA, Esq., chair of the AICPA Tax Executive Committee said, “We recommend the IRS release immediate guidance regarding the tax treatment of virtual currency transactions, similar to that of Notice 2014-21 so that authoritative guidance exists.”
American Bar Association’s Tax Section also addressed in a letter to the IRS during the first quarter of this year about the issue,“Specifically, we request additional guidance that will address items from the original Notice 2014-21, and new issues that are relevant to the 2017 tax year, such as chain splits, forks that have arisen subsequent to the release of the original notice.”
A unique challenge is created for deciding a USD translation for virtual cryptocurrencies that newly come into existence for US tax purposes due to the cryptocurrency event including chain splits, forks, airdrops and giveaways are subject to price discovery.
Example, in an attempt to solve the mining problem, Ethereum Classic “forked” on 29th May. The change demanded all users of the original blockchain to update their software and disable the feature that makes mining more difficult. This feature was coded to switch from Power of work to Power of Concept. For now the developers of Ethereum have decided to stick to Power of Work.
Tax treatment of forks, chain splits, airdrops, giveaways, or other similar activities that are unique to blockchain technology and cryptocurrencies are not addressed by Notice 2014-21.
By making an “Election to Include a Virtual Currency Event as Ordinary Income in Year of Transfer” within 30 days of the event, wherein the taxpayers will have to report virtual currency events, suggested a letter by AICPA to IRS.
The virtual currency event is reported as ordinary income when a taxpayer later disposes of the virtual currency received in a prior event, that is if the taxpayer does not make the election.
If the virtual currency is a capital asset in the hands of the taxpayer, future disposition of the asset would generate a capital gain or loss and the income reported would become the basis in the virtual currency.
Cost of Acquiring Cryptocurrencies
Cryptocurrencies can be acquired by the users by exchanging it, borrowing it for fiat currency, by using other cryptocurrencies or even ICO tokens or by “mining,” this is the process of having the computers compete to solve complex mathematical problems.
When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income states the Notice 2014-21, Section 4, Q&A-8. This means that mining is similar to service activity. Therefore, it is important to treat the cost of mining virtual currency as expenses incurred in providing services which are expended as paid or incurred.
A news site Salon.com gave its users an option to allow Salon.com to access the unused computing power, as an alternative to seeing the advertisement, this is a new case of permissioned use of cryptomining. Any Moneros mined by salon would be taxed appropriately, even though this is alternative form of monetization to traditional advertising by Salon.
Cryptocurrency mining should be treated as ordinary income in the year it is mined, and the expenses of mining to be deducted as incurred, suggests AICPA’s letter to the IRS. This is because consistent matching of income and expenses in other service activities. The equipment of cryptocurrency mining should be capitalized and depreciated like other property whose useful life extends beyond one year.
How the expenses incurred by taxpayers in crypto asset lending transactions or in attaining ICO tokens should be handled is not addressed by AICPA’s letter to the IRS.
Nellen added,“The rapid emergence of virtual currency has generated several new questions on how the tax rules apply to various transactions involving virtual currency and activities and assets related to it. Moreover, the development in the number of types of virtual currencies and the value of these currencies make these questions both timely and relevant to a growing number of taxpayers and tax practitioners.”
Initial coin offering (ICOs) companies which increasingly utilize the Ethereum blockchain platform are anticipating a formal statement from the SEC on its classification of Ether (ETH) so that they have regulatory clarification between securities classification by the SEC and commodities classification by the CFTC. In the absence of a pronouncement from the SEC, the IRS’s job of addressing these new questions could be all the more challenging.
Acceptable valuation documentation & computation of gains and losses of cryptocurrencies
Based on its decided value in the market, cryptocurrency currency has equal value in fiat or acts as a substitute for real currency.
Exchange rates established by market supply and demand used to determine the fair market value of virtual currency in USD as of the date of payment or receipt as mentioned in Notice 2014-21, Section 4, Q&A-5. It also suggests to use the “reasonable manner that is consistently applied” to calculate the correct market value of the virtual currency.
AICPA’s letter to the IRS suggests that as there are differences in the cryptocurrency pricing on different exchanges, guidance and examples are necessary to define the “reasonable manner.”
As long as taxpayers can calculate the valuation and in how they make this determination for every cryptocurrency transaction, they should be allowed to use an average of different exchanges.
They have to choose specific identification or FIFO as long as the method is consistently applied from year to year to calculate their cryptocurrency gains and losses.
This significant as many companies started developing cryptocurrency and blockchain-oriented accounting and tax software. The US tax payers depend on it for reasonable and consistent method for determining fair value of their cryptocurrency gains and losses for US tax purposes.
Foreign reporting requirements for cryptocurrencies: Some virtual currencies are traded on centralized exchanges that operate in jurisdictions outside the US. The exchanges are either a pure virtual currency exchange or a virtual currency exchange which allows virtual currencies to exchange into fiat currencies. These foreign virtual currency exchanges have custody of customers’ virtual currencies and an exchange failure results in the loss of customer funds which are similar to a Foreign Financial Institution (FFI) because they behave in the same manner.
Notice 2014-21 does not address tax foreign reporting requirements for cryptocurrencies.
Taxpayers should report the value of cryptocurrencies and fiat currencies held at those foreign exchanges for FBAR and FATCA purposes if they meet the necessary threshold, but not when a taxpayer holds cryptocurrency in a wallet which the taxpayer owns, controls and is in possession of a private key, suggests AICPA’s letter to the IRS.
“Virtual currency transactions, in which taxpayers increasingly engage, add a new layer of complexity to the analysis of a client’s reporting requirements. The issuance of clear guidance in this area will provide confidence and clarity to preparers and taxpayers on application of the tax law to virtual currency transactions” concluded Nellen.