Paul L. Caron

Friday, November 15, 2019

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Chason's A Tax On The Clones: The Strange Case Of Bitcoin Cash

This week, Mirit Eyal-Cohen (Alabama) reviews Eric D. Chason (William & Mary),  A Tax on the Clones: The Strange Case of Bitcoin Cash, 39 Va. Tax Rev. __ (2019).  

Mirit-Cohen (2018)This Article is right down my ally dealing with taxation and innovation. In recent years, Cryptocurrency generally, and Bitcoin specifically, have risen steeply in their market value breaking record percentage increase. Notwithstanding its speculative hype, blockchain technology through community-wide protocols has been a state-of-the-art development that had been spurring change in the fields of economics, technology, and the law. The rise in digital assets has created tax issues involving the definition of blockchain. Is it property or currency? In a series of publications including Rev. Rul. 2019-24, the IRS determined these digital assets are considered property. This Article presents the difficulty of applying such tax treatment encroach upon its administrability and making digital assets’ use impractical when looking at every transaction as subject to gain and loss recognition. It does so by focusing on implications of Cryptocurrency derivatives, also known as Bitcoin forks or Bitcoin Cash.

Prior to assessing taxability issues encompassing crypto clones, the Article does a good job in providing a comprehensive background of the underlying technology acquitting the reader to the creation of digital currencies since early 2009 until the creation of Bitcoin Cash in 2017. Bitcoin (like most cryptocurrencies) is purely “notional” property that exists only as a matter of recordkeeping. A crypto protocol is established by the community of users creating the Bitcoin system. Ownership of the crypto units is established by a set of records called the “blockchain.” Moreover, a software package (in the case of Bitsoin called “Bitcoin Core”) implements the consensus protocol for transferring interests similar to governing real property deeds that have to be signed, in writing, etc. Cryptocurrency usually has no central authority or super-user with enhanced authority but is administered collectively by the community of users. Although it does not offer any dividends, interest, rents, or royalties, cryptocurrency units are transferred using computer files that look and function like deeds to real property. In order to facilitate these transfers, owners create a private key to generate a digital signature needed to transfer the cryptocurrency. As opposed to common belief, cryptocurrency is not completely anonymous as all transactions are public and are attributed to “addresses”, which are private keys that function like usernames. Markets in which cryptocurrencies trade against the U.S. dollar are considered “fiat exchanges” within the cryptocurrency community.

When a blockchain in created it “mined” and it can be also become “forked”, that is include changes to the software that divert from existing protocol and create two plausible blockchains. Bitcoin Cash emerged that way as a “hard fork”.  The Bitcoin community had differences of opinion on how Bitcoin should be altered to encompass more types of transactions in light of its developing prominence. Some Bitcoin community members believed the transaction rate was too slow, its scale and capacity was limited,  and it did not provide a good low-cost substitute for dollars and debit cards. They advocated for changes that would help Bitcoin supplant the U.S. dollar or some other official currency by providing a greater capacity to clear transactions without having to pay high fees. Other community members resisted these changes, believing that alternative means called “Segregated Witness” or “Lightning Network” could better restructure Bitcoin blocks and solve Bitcoin’s scalability problem. Because there was no agreement within Bitcoin community members as to the type and manner of such structural changes, in August 2017 members of the Bitcoin community created Bitcoin Cash by distributing to exiting owners equal number of Bitcoin Cash units. The architects of Bitcoin Cash essentially cloned existing Bitcoin’s blockchain and grafted new features onto the clone all while allowing existing users to use their private keys to control the new units of Bitcoin Cash. Anyone who owned 1 BTC before August 1, 2017 would see their ownership recorded on two separate blockchains. One blockchain used the old 1 MB block limit. Another blockchain used the new 8 MB limit of Bitcoin Cash. After Bitcoin cash was created, over seventy different cryptocurrencies based on Bitcoin were formed. Yet, Bitcoin Cash became the most popular of cryptographic money, at present positioning 6th as far as market.

Following the historical background of the creation of Bitcoin and Bitcoin Cash, the Article argues that taxation of digital money like Bitcoin Cash introduces new issues. For example, there is the question of when was Bitcoin Cash created? Due to market fluctuations the time of creation determines the value of the cryptocoin and thus the amount of gross income. Over the course of August 1, 2017, the reported price of Bitcoin Cash fluctuated wildly. It resembled an initial public offering, in which market participants gradually became able to trade the new asset.

In Rev. Rul. 2019-24 and I.R.S. Notice 2014-21101 the Service determined the taxation of cryptocurrencies or “convertible virtual currency.” The IRS asserted cryptocurrencies are considered property and not foreign currency and that miners or taxpayers receiving cryptocurrency in exchange for services will need to include the value of the cryptocurrency in gross income. But Chason argues that crypto windfalls, like the creation of Bitcoin Cash, should not be taxed as ordinary income upon moment of creation.  He compares Bitcoin Cash to the cases of catching a strayed ball during a baseball game and cites Zelenak and Martin McMahon attacking the treasure-trove regulation and arguing for deferred taxation of lucky fans as form of imputed income until the property is sold or otherwise disposed of. Deferral of imputed income is the approach also taken in cases of commercial fishermen, big game hunters, prospectors and miners, and professional treasure hunters.

Chason explores four different approaches to taxing Bitcoin Cash: the Taxation-Upon-Creation Approach, the Deemed-Zero-Value Theory, the Tax-Free Reorganization Theory, and Open-Transaction Treatment. He begins by acknowledging the fact that upon first inspection, the Bitcoin Cash windfall appears to be a simple case of gross income as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Yet, as a matter of administrative practice Chason contends that many non-cash receipts enjoy tax forgiveness or deferral, thus as a non-cash windfall, taxation of Bitcoin Cash should be deferred as well. There are many administrative difficulties assessing the value of Bitcoin Cash or the actual moment of its creation due to its high fluctuation. The creation of Bitcoin Cash was not a “legal” event like a corporate transaction. Unlike the lucky catchers of a strayed baseball, Bitcoin Cash new owners did not have to do anything in order to claim a windfall. Bitcoin Cash holders did not even know they had income at all, which goes against the taxation-upon-creation approach and the constructive receipt doctrine. Cashon also cites the ABA Section on Taxation’s approach that the deemed value of the forked coin at the time of the realization event would be zero, which would also be the taxpayer’s basis in the forked coin. Upon the ultimate sale or exchange, most owners would have capital gains. This tax treatment is similar to other transactions such as the preferential treatment of managers of private-equity and hedge funds. But as opposed to the latter, Bictoin Cash owners are not being compensated for their human capital. Lastly, Chason discusses another plausible approach for taxing Bitocin Cash by liken it to a tax-free corporate reorganization or nonrecognition for like-kind exchanges of real property. He admits that the rationale for deferral in these transactions—continuation of investment—does not exist in the case of Bitcoin Cash and other crypto clones. Bitcoin was not a parent of Bitcoin Cash. Bitcoin and Bitcoin Cash are notional assets, not backed by any property, thus according to Chason, it is the least desirable of the three discussed so far.

The best doctrinal analogy for crypto clones according to Chason is free samples of merchandise. Free samples (like books sent to reviewers and teachers) are clearly accessions to wealth but they are exempt from taxation unless the recipient attempts to sell the merchandise or donate it to charity. Likewise, Chason claims that policymakers should extend the merchandise-sale approach to crypto windfalls, taxing the recipients when they exercise complete dominion by making a transfer on the blockchain.  Parallel to tax treatment of compensatory stock options at moment of exercise when option value is less speculative, upon transferring the cryptocoin, the owner would have gross income equal to fair market value of the cryptocurrency at the time of transfer. Chason concludes that the solution to speculative values of Bitcoin Cash is to defer realization of ordinary income, not to assume there was zero income at the time of creation. While the IRS did not take this approach in its recent ruling, this Article does a good job presenting the benefits of alternative approaches over the current regime.

Here's the rest of this week's SSRN Tax Roundup:

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