Paul L. Caron

Friday, December 6, 2019

Weekly SSRN Tax Article Review And Roundup: Kim Reviews Sutherland's Cryptocurrency Economics And The Taxation Of Block Rewards

This week, Young Ran (Christine) Kim (Utah) reviews a new work by Abraham Sutherland (Virginia), Cryptocurrency Economics and the Taxation of Block Rewards, Part 1 in 165 Tax Notes 749 (Nov. 4, 2019), Part 2 in 165 Tax Notes 953 (Nov. 11, 2019).

6a00d8341c4eab53ef022ad3a74c80200d-300wi (1)Blockchain, which is the technology behind cryptocurrency, is gradually achieving mainstream adoption. On October 28, 2019, the Securities and Exchange Commission authorized a blockchain startup's pilot project where blockchain will be used to settle trades in stock such as GE and AT&T. This project may challenge the securities trading system for clearing and settlement that has been monopolized by the U.S. Central Depository Agency (DTCC). However, the tax community still has a long way to go in the realm of cryptocurrency, not to mention the underlying blockchain technology, because there are many unresolved issues related to the tax consequences of cryptocurrency. IRS Notice 2014-21 provides that cryptocurrency is not currency—rather, it would be taxed as intangible property and should be included in gross income when received. Recently, IRS Rev. Rul. 2019-24 and FAQ on virtual currency transactions clarify the tax treatment of hard forks and airdrops. To be specific, the splitting of a cryptocurrency under a "hard fork" does not create taxable income if no new cryptocurrency is received, but taxable income is generated by "airdrops" that deliver new cryptocurrency. Nonetheless, the IRS has again punted other long-awaited issues, such as the valuation of cryptocurrency and the foreign reporting requirement.

Abraham Sutherland's recent article, Cryptocurrency Economics and the Taxation of Block Rewards, is the most recent paper discussing the taxation of block rewards. The important contribution of this paper is addressing the issue of proper valuation of the cryptocurrency. With this regard, the paper is more of a challenge of Notice 2014-21, rather than a challenge of the recent Rev. Rul. 2019-24 and the relevant items in FAQ on virtual currency transactions.

The author defines block rewards as the newly minted cryptocurrency tokens created ex nihilo according to the rules of the cryptocurrency software. Block rewards provide an incentive to participate in network maintenance, which is often called "validation," and there are two different approaches of allocating such validation rights among those who have an incentive to help with that validation—i) proof of work and ii) proof of stake. The focus of the paper is proof-of-stake cryptocurrencies, as opposed to proof-of-work cryptocurrencies. The author argues that Notice 2014-21, which requires the inclusion of block rewards in gross income when received, would be considered reasonable back in 2014 where the crypto world largely adopted proof of work as a validation protocol. However, it no longer makes good sense in light of the newer proof-of-stake technology. In order to propose a single taxation policy applicable both to proof-of-stake and proof-of-work cryptocurrencies, the paper argues that the creation of block rewards should not be a taxable event; instead, block rewards should be taxed only when they are realized by sale or exchange. The author asserts that his proposal ensures the fair market valuation and equitable taxation of all tokens and significantly reduces administrative burdens.

For those who might be interested in the technical explanations of the paper, let me further compare the proof of work and proof of stake protocols. First, the proof of work protocol is adopted by Bitcoin, where the rights to publish new blocks and create the associated block rewards, together with the rights to validate such new publication rights, are all allocated according to participants' "work" on the network. Bitcoin mining is a capital-intensive business, requiring specialized computers with tremendous amounts of electricity. Such immense work relates to the act of publishing new blocks, or Bitcoin mining, and not the validation process that requires relatively trivial work. Also, Bitcoin miners do not need to own bitcoin themselves; and instead, they can immediately sell any block rewards they receive without impeding their ability to mine more blocks in the future. In fact, many miners liquidate their block rewards to finance their mining operations. Such immediate liquidation of block rewards fits well with Notice 2014-21, which requires the inclusion of block rewards in gross income when received.

On the other hand, proof-of-stake validation works differently. The author illustrates Tezos as an example of proof-of-stake protocol with real-world numbers. Tokens on the Tezos network are called "tez," and Tezos has a simple token creation policy—new tokens are created at a more or less consistent rate. To participate in the validation process to create blocks and the associated reward tokens, one must hold a minimum of 8,000 tez. Unlike Bitcoin, validation in Tezos requires ongoing ownership of a stake in the network. If a tez holder liquidates one's tez, the tez holder cannot participate. Instead, tez holders may participate in the validation process by either directly participating as validators or delegating their validation rights to such validators. In contrast, there might be tez holders who don't participate in validation. For purposes of illustration, let’s assume there are two groups of holders, one of which, “Group A Holders,” is made up of validators and delegators; and the other group, “Group B Holders,” is made up of non-validators. Validation opportunities are allocated at random according to the validator’s stake, or share, in the Tezos network. Such participation in Tezos validation results in gaining new tez. In other words, new tez are created and distributed as block rewards only among Group A Holders. This results in dilution of Group B Holders' stake. To further illustrate numerically, there are about 806 million tez in existence. With approximately 115,000 new tez created each day, resulting in approximately 42 million more tez per year. The current token creation rate is therefore about 5.21% (=42 mil/806 mil). At present, about 572 million tez, or 71% of the total (=572 mil/806 mil), are held by Group A Holders and participate in validation. The infusion of 115,000 tez created daily is shared among Group A Holders only. On average, Group A Holders will accumulate additional tez at the rate of 7.34% (=42 mil/572 mil) by the end of the year. Meanwhile, however, the supply of tez will have increased by 5.21%. Therefore, the stake of Group A Holders, or validators, will have increased by just 2.02% [={(1+0.0734)/(1+0.0521)}-1]. The author further explains that validators' gross income under Notice 2014-21 would be about 7.156% under the formula therein, not the actual gain of 2.02%, which results in inequitable over-taxation of actual gain by 354%. The flip side of this analysis is that tax authorities may defer recognition of the corresponding losses of Group B Holders, or non-validators.

Back to the doctrinal analysis, the proof of stake approach is designed to lower the barriers to participate in validation, reduce the importance of the creation rate, and eliminate the competitive consumption of real-world resources to allocate validation rights, all of which make network maintenance more efficient. However, under Notice 2014-21, which ignores the dilution effects, the reward for this innovation would be overtaxed. The author further distinguishes the tax treatment of property that is received as compensation from that of property that is created; the former is typically income when it is received, while the latter is not income when it is created. Notice 2014-21 is based on the tax position of the former, but the author argues that the reward tokens would be best understood as the latter—created property.

The latter half of the paper explores several policy options for taxing cryptocurrency: (i) annual marking to market of cryptocurrency holdings; (ii) capitalization of token costs; (iii) a return of stake doctrine similar to section 301's nontaxable return of capital; and (iv) a theory of barter compensation that excludes amounts paid to oneself from the calculation of income. Although the author proposes treating block rewards as created property to be taxed when reward tokens are sold, similar to the UNICAP rules in section 263A, the paper provides, in addition to many interesting numerical and statistical analysis illustrating the dilution effect, an interesting though experiment for readers who might prefer a different policy proposal. I wish that the author would continue to work on the valuation issue and follow-up with more complicated and diverse variables, including the fluctuating total network value of certain cryptocurrency. 

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

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