On April 9, 2021, the Internal Revenue Service (Service) released Chief Counsel Advice 202114020 (the Guidance) regarding the tax consequences to an individual in receipt of Bitcoin Cash (BCH) following the August 2017 hard fork of Bitcoin (BTC).1 In the Guidance, the Service largely reaffirms its historic position regarding the treatment of cryptocurrencies as property, and the tax treatment of new cryptocurrencies actively or constructively received by taxpayers after a hard fork that creates the new cryptocurrencies. The Service’s position was previously provided in Rev. Rul. 2019-24 (the Revenue Ruling), in which the Service ruled a holder of cryptocurrency that experienced a hard fork that created a new currency followed by an airdrop of that new currency had taxable income equal to the value of the new currency received. In contrast a taxpayer that did not receive units of the new cryptocurrency did not have income.2 The Guidance addresses the application of the principles set forth in the Revenue Ruling to the August 2017 BTC hard fork through concrete examples. In particular, the Guidance attempts to clarify the Service’s position towards any new cryptocurrency received by a taxpayer as a result of a hard fork that created the new cryptocurrency, irrespective of whether the new currency is distributed to the taxpayer through an airdrop or through a different means. To that end, the Guidance makes clear that whether and when taxpayers recognize taxable income following a hard fork depends on whether and when the taxpayer has dominion and control over any new cryptocurrency that results from the hard fork. However, while taxpayers receiving a new currency resulting purely from a hard fork may find the Guidance helpful in confirming the appropriate tax treatment of the receipt of the new currency, with respect to cryptocurrency exchanges and airdrops that occur independent of a hard fork, the Guidance fails to fork over sufficient clarification.
Background- what in the (virtual) world is a hard fork
According to the IRS, virtual currency is a digital representation of value, other than a representation of the US dollar or a foreign currency, which functions as a unit of account, a store of value, and/or a medium of exchange. Some virtual currencies are convertible, which means that they have an equivalent value in fiat currency or act as a substitute for fiat currency, for example, Bitcoin (BTC). Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. A blockchain is a particular cryptographic data structure that transmits data in blocks that are connected to each other in a chain. Mining is the process by which computers create new blocks in the chain that validate cryptocurrency transactions and maintain the distributed ledger. Miners are rewarded for the “validation service” by the issuance of new units of cryptocurrency. Validated blockchains are immutable and therefore are secure. The perceived virtue of these distributed ledgers is that they are maintained on a distributed network of computers and the cryptocurrencies are secure without the need for a centralized authority to sanction or stand behind them and without the need for a central party or intermediary to process transactions. A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.
Although terminology is not always entirely uniform, a fork is merely a change in a blockchain’s protocol that the software uses to determine whether a transaction is valid and generate a new block. Forks occur when the user base or developers decide that something fundamental about the cryptocurrency needs to change, which can be due to a hack or a disagreement within the community. Technically, anyone can change the open-source protocols for a blockchain and create a hard fork but only those supported by the community are material in consequence. A soft fork occurs when there is an update to the protocols for a blockchain that is intended to be adopted by all users and no new blockchain or coin is created. A hard fork occurs when changes are made to the protocols of a blockchain that results in a split wherein a new version of the blockchain exists and continues to develop alongside the old version. This is the type of event addressed in the Guidance with respect to when BTC had a hard fork that resulted in the creation of BCH, a new cryptocurrency, alongside and independent of BTC. It should be noted that cryptocurrency hard forks are not rare occurrences. BTC and most other alternative cryptocurrencies have gone through hard forks, with BTC itself having gone through multiple hard forks in its history. An airdrop, on the other hand, is a means to distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers. An airdrop may follow a hard fork, but is not required to follow a hard fork, and may be done for marketing or other reasons.
Holders of cryptocurrency may hold such cryptocurrency through individual digital wallets with private keys to a particular distributed ledger address or through digital wallets hosted by exchanges, in which case the exchange has control over the private key to the distributed ledger addresses. Each such exchange may or may not provide support for particular distributed ledgers and cryptocurrencies to hosted wallets, including the new cryptocurrencies that are created following a hard fork. The guidance provided from the IRS to date largely ignores exchanges and any consequences and obligations they may have with respect to various cryptocurrency events.
The IRS, and the revenue authorities from many other countries, have ruled that cryptocurrency is a form of property, not a currency, for tax purposes. As property, cryptocurrencies acquire a cost basis when acquired and may result in an accession to wealth that is taxable as income. Cryptocurrencies also generate taxable gain or loss when disposed of in a taxable event. Beyond these basic principles, the IRS has issued relatively cryptic guidance on how to apply “general tax principles” to determine the treatment of particular cryptocurrency transactions and events. This has left many taxpayers, including cryptocurrency exchanges, and practitioners at a loss as to how to apply such general principles to crypto concepts and transactions that often have no clear analog in the non-virtual world.
In March 2014, the IRS issued its first guidance relating to cryptocurrency, Notice 2014-21 (the Notice).3 Relatively brief in analysis and substance, the Notice provided that for federal income tax purposes, virtual currency should be treated as property, with general tax principles applying. Beyond such treatment, the Notice essentially explained how “existing tax principles” applied to certain basic transactions involving virtual currency. For example, the Notice explained that to the extent a taxpayer received virtual currency as payment for goods or services, the taxpayer must, in computing gross income, include the fair market value of such virtual currency as of the date the virtual currency was received. The Notice stated that the basis of such virtual currency received as payment is the fair market value of the virtual currency at the time of receipt. Additionally, the Notice confirmed that taxpayers who successfully “mine” virtual currency realize gross income upon receipt of the currency.
Rev. Rul. 2019-24
After years without any further substantive guidance, in late 2019, the IRS released this Revenue Ruling to provide taxpayers guidance regarding the treatment of hard forks that create a new cryptocurrency and air drops (two types of cryptocurrency-originating transactions), as well as acceptable methods for calculating and assigning cost basis to such transactions. Concurrent with the Revenue Ruling, the IRS issued 43 FAQs that addressed a wide range of issues, often relying on general tax principles to address the tax treatment of transactions and events involving cryptocurrencies.
According to the Revenue Ruling, a “hard fork” transaction occurs when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent division from the legacy or existing distributed ledger.
From a technical perspective and purely by how cryptocurrency technology functions, the owner of an original cryptocurrency coin will automatically receive a forked coin that results from a hard fork that creates the new forked currency. But whether or not the owner received a forked coin for tax purposes as the result of a hard fork depends on whether the owner has dominion and control over the new cryptocurrency. This is further explained by the Guidance discussed below. Based on the analysis in the Revenue Ruling, the IRS suggests that, for all purposes, with respect to hard forks that create a new currency, original coin owners may come to own forked coins only if they later receive them through an airdrop or another similar type of external transfer. This analysis failed to address the fact that an airdrop may not even have any immediate tax consequences to a person in receipt of a new currency, as the person in receipt must have dominion and control of the respective digital wallet in order to experience the required accession to wealth. Further, an airdrop can, and often does, occur independent of a hard fork, e.g., an airdrop of a new coin for marketing purposes or to garner interest in a new forum for people using a new blockchain digital asset.
|Eversheds Sutherland Observations: The Revenue Ruling does correctly explain that cryptocurrency hard forks are not always followed by an airdrop of a new forked currency. However, the analysis appears to imply that if a cryptocurrency hard fork that creates a new currency is not followed by an airdrop, then the owners of the original cryptocurrency would not receive any amount of a new forked currency, not just for tax purposes but for all purposes. This implication is incorrect because, based on how cryptocurrency technology functions and from a purely technical perspective, owners of the original cryptocurrency will automatically receive a new forked currency that results from such a hard fork itself, with or without an airdrop or similar type of transfer. Whether or not an owner has received the new forked currency for tax purposes is a distinct issue. The Revenue Ruling, however, makes no such distinction and simply ignores the automatic receipt of a new currency that results from such a hard fork. Moreover, scenarios where taxpayers receive an airdrop of cryptocurrency independent of a hard fork are also not addressed.|
In the Guidance, the Service addresses the specific treatment of BCH received by a taxpayer who owned BTC during the hard fork that occurred with BTC on August 1, 2017. From the language of the Guidance, it appears that the Service is attempting to provide guidance with respect to one of the facts that was ignored by the Revenue Ruling, i.e., what happens if a hard fork creates a new cryptocurrency and a taxpayer holding the original cryptocurrency receives the new cryptocurrency following the hard fork by means other than an airdrop. Specifically, the Guidance states that “[t]he specific means by which the new cryptocurrency is distributed or otherwise made available to a taxpayer following a hard fork does not affect the Revenue Ruling’s holding.”
|Eversheds Sutherland Observations: It is not entirely clear whether the Service considers the receipt of the new forked currency from the hard fork described in Situation 1 and Situation 2 in the Guidance as an airdrop. However, given the fact that the Service specifically referenced the term airdrop in the scenarios described in the Revenue Ruling but does not do so in the scenarios described in the Guidance, and the fact that the analysis in the Guidance explicitly states that “[t]he specific means by which the new cryptocurrency is distributed or otherwise made available to a taxpayer following a hard fork does not affect the Revenue Ruling’s holding,” strongly implies that the Guidance is meant to address the tax consequences of an owner of cryptocurrency receiving new forked currency resulting from a hard fork that creates the new currency independent of any airdrops that may or may not occur.|
In addressing the specific question regarding whether the receipt of BCH following the BTC hard fork constituted gross income to the taxpayer, the Guidance presents two different scenarios. In the first scenario, Situation 1, the taxpayer directly holds the private key to a unit of BTC and has immediate control of the BCH following the BTC hard fork, and can initiate transactions with it. In accordance with the Revenue Ruling, the Guidance concludes that the BCH received by the taxpayer from the BTC hard fork resulted in gross income to the taxpayer because the taxpayer immediately had dominion and control over the BCH and therefore had an accession to wealth under Section 61. Additionally, the timing of when the taxpayer had dominion and control over the new BCH determined the date of receipt and fair market value (FMV) to be included in the taxpayer’s gross income.
In the second scenario, Situation 2, the taxpayer does not hold and have control over the key to the distributed ledger following the BTC hard fork. Rather, the taxpayer in Situation 2 is a customer of a cryptocurrency exchange (CEX), which hosts the taxpayer’s digital wallet, controls the private key and, at the time of the BTC hard fork, chooses not to immediately support BCH. As a consequence, the taxpayer is unable to transact with the new currency, even though, from a purely technical perspective, the taxpayer did “receive” the new currency as a result of the hard fork by virtue of the taxpayer’s ownership of the BTC. In Situation 2, the CEX makes a decision to support BCH as of January 1 of the following tax year, at which point the taxpayer is able to conduct transactions in BCH. The Guidance provides that at such later time the taxpayer does have an accession to wealth because the taxpayer at that point has dominion and control over BCH.
Relying on the same general tax principles first espoused in the Notice and then reiterated in the Revenue Ruling, the Guidance finds that a taxpayer may only have gross income in connection with the receipt of a new cryptocurrency following a hard fork that created the new currency if and when the taxpayer actually has dominion and control over the new cryptocurrency. Stated differently, the Guidance is primarily about whether the taxpayer has income, with the timing of when the income is recognized being a collateral consequence of the timing of the whether decision, which in Situation 2 was made by CEX, not the taxpayer. Consequently, while Situation 1 presents facts and circumstances that result in the taxpayer’s immediate accession to wealth under Section 61, Situation 2 does not (at least initially) because the cryptocurrency exchange prevents the taxpayer from exercising dominion and control over BCH until after the cryptocurrency exchange initiates such support of BCH and allows the taxpayer to transact with it.
|Eversheds Sutherland Observations: While the Guidance does reaffirm the Service’s position in the Revenue Ruling and its direct application to the 2017 BTC hard fork, and addresses one of the facts ignored by the Revenue Ruling, taxpayers, including cryptocurrency hosting exchanges, and practitioners may be disappointed with the lack of clarification or refinement with respect to the Service’s position towards cryptocurrency exchanges and towards airdrops that occur independent of hard forks. With guidance to be released regarding virtual currencies still remaining on the Service’s Priority Guidance Plan, taxpayers can be hopeful that these types of events, i.e., hard forks and airdrops, will be addressed more broadly. But for now, holders of cryptocurrency are generally left to rely upon “general tax principles” to determine the appropriate treatment of their cryptocurrency transactions. Particularly in light of the IRS’s continued push towards greater compliance and enforcement in the cryptocurrency space, more guidance from the IRS is needed to help taxpayers, including cryptocurrency exchanges, understand and meet their substantive and compliance obligations with respect to these unprecedented virtual realities.|
1 CCA 202114020 (Apr. 9, 2021).
2 2019-44 I.R.B. 1004 (Oct. 9, 2019).
3 2014-16 I.R.B. 938 (Mar. 25, 2014).