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Saturday, August 19, 2023

Weekly SSRN Tax Article Review And Roundup: Roberts Reviews Parsons' Taxing Taxonomies

This week, Tracey Roberts (Cumberland; Google Scholar) reviews Amanda Parsons (Colorado; Google Scholar), Taxing Taxonomies.

Roberts (2020)In  Taxing Taxonomies, Amanda Parsons introduces the concept of “legibility” into the analysis of tax rules. Joining H.L.A. Hart, Roscoe Pound, Roberto Unger, Ronald Dworkin, Duncan Kennedy, Louis Kaplow, and more recently, Lee Anne Fennell, Susie Morse, Dov Fox, and Jacob Goldin, she enters the metanalysis debate around rules versus standards, formalism versus realism, efficiency versus equity, moral versus analogic reasoning, and decisionmaker discretion versus taxpayer opportunism. Drawing from Seeing Like a State, by James Scott, she explains that “legibility” is the process by which a state sorts activities into categories to make complex systems governable. For those steeped in tax policy, the concept appears to be synonymous with “simplicity.” Ideally tax systems are meant to be “simple,” as well as efficient and equitable, since simplicity supports administrability for those who govern (and collect taxes), and promotes transparency and predictability for those who must comply. 

More than for other areas of the government, “legibility” may be at a premium for tax administration; taxpayers self-report annually and those who seek to avoid or reduce their tax burdens test the tax system each year.

As a case study, Parsons examines current efforts to render cryptocurrency legible. She walks us through four possible ways of thinking about cryptocurrencies for purposes of taxing the processes by which crypto-coins are earned. First, she explains that blockchain technology permits decentralized verification of transactions. Participants devote their computers to recording transactions, adding new blocks to the ledger, and verifying other transactions. Under “proof of work” protocols, participants race to solve cryptographic puzzles. The participants that win do the work of recording and verifying transactions and maintaining the ledger and earn crypto-coins or tokens convertible to crypto-coins for this work. (Bitcoin uses the proof of work protocol.) Other systems use “proof of stake” protocols. Under this system participants “stake” (pledge) their own crypto-coins for a period of time under contracts; they are allocated work (and the opportunity to earn more crypto-coins) based on the length of the contract and amount of coins staked. On the other hand, if they register fake transactions or if their computer is not online and available to record allocated transactions, the participant is penalized and may lose some or all of their staked crypto-coins under the contract.

Categorizing the income participants earn through the proof of stake system is currently subject to litigation.  To clarify how tax may categorize these earnings and the outcomes that would result, Parsons discusses four possibilities. First, in Jarrett v. United States, cryptocurrency advocates argue that rewards/tokens/crypto-coins are self-created property and that they should not be taxed until they are sold or exchanged. Bakers make cakes, farmers grow apples, and writers write books. None are taxed until they sell the items they have created. If such crypto-earnings are not likewise taxed when “created,” then participants don’t have to report them at that time. What’s more,  through existing deferral opportunities, participants may never have to pay tax on them or their appreciation. They can enjoy the benefit of cryptocurrency value and appreciation by taking out loans and using the coins as collateral and then they can avoid tax on any part of that value through the step-up in basis at death. A second possible category is to treat participation in the cryptocurrency blockchain network as a service. By offering the computer to the network and maintaining the connection, the participant is performing services and the coins earned are compensation for services. Participants may also delegate the stake to third parties who perform the services necessary to maintain the network connection, in exchange for a small cut of the earnings. The third possible category for crypto-earnings is “interest.” When a participant stakes a coin, they are “loaning” the coins to the network. The payment of coins at the end of the contract period is equivalent to the payment of interest. Finally, Parsons argues that under a proof of stake system, when a participant offers their coins as a stake, they are providing intangible property for use by the system. Therefore, crypto-participants would be seen as earning royalty income.

From the variety and diversity of these possibilities, Parsons draws two conclusions. First, to properly categorize assets and activities policymakers must understand “the purpose, function, and mechanics of the thing or activity being categorized.” Toward this goal, she argues for institutional change, urging the Department of Treasury to develop robust expertise in emerging technologies and hire specialists to make close decisions. For example, Sotheby's might be needed to determine whether an item was a “collectible” for purposes of applying capital gains rates, and doctors might be asked to discern whether new medical equipment would qualify as a deductible medical care expense. Some may worry that this proposal to retain cryptocurrency experts to advise on tax policy would simply invite more foxes into the henhouse. Senator Elizabeth Warren has already expressed concern about the activities of the Big Five Accounting firms during their employees’ stints in Treasury in generating rules that benefit corporate clients. Furthermore, given this history, we must ask whether the category of “property received in payment for services” really matters when, unlike most poor souls who pay tax on the full fair market value of property received as compensation for services under I.R.C. §83, private equity titans enjoy the “billionaire loophole” for carried interests, paying no tax on receipt of their allocation of a 20% profits interest. Maybe “carried interest” belongs to a special category of “Rich People Stuff” that remains impervious to fundamental reform because, as Chris Lehmann argues, we, the hoi polloi, have been trained to accept it.

Second, as a matter of rules, Parsons argues that the government would best be served by reducing the number of categories or reducing its reliance on categorization. Instead, by “lumping” or “flattening” the categories to reduce their number, the system could be simplified and made more legible. For cryptocurrency earnings, she suggests two categories: (i) “passive” income (which is currently subject to loss limitations, interest deduction limitations, and withholding requirements internationally) and (ii) “active” income which is not subject to these requirements. Note that while this proposal may address some key concerns about the use of cryptocurrencies in the international context, it does not address the timing question, the main issue in Jarrett v. United States: when do crypto-participants recognize income? It also would not address the deterrent effect of tax reporting or its use as a mechanism to enforce other rules.

As Parsons notes, “categorization is the mechanism through which the tax system effectuates a variety of normative and policy goals.” While most would agree that the complexity of the tax code should be reduced, even more essential in crafting a category might be to keep front of mind the norms and goals the category is supposed to serve. What is the telos of the tax system? Why is governance needed? It’s no coincidence that Max Baucus (D–Montana) and Charles Rangel (D–NY-13) introduced The Foreign Account Tax Compliance Act (FATCA) the very year that Bitcoin had its debut and cryptocurrencies first became broadly available. FATCA generally requires that foreign financial institutions and certain other non-financial foreign entities report on the foreign assets held by their U.S. account holders or be subject to withholding of certain payments. New technologies frequently arise at the point that governance becomes more effective. Omri Marian has argued that cryptocurrencies are super tax havens and has offered a conceptual framework for their regulation. He has also underscored the necessity of international coordination to ensure that the regulation works. Therefore, rather than hiring specialists within each emerging technology field, it might be better to hire generalists with international experience, unwavering loyalty in service to the country, and broad expertise recognizing the essentials of analogous transactions.

Parsons’s meta-analysis might be enhanced by clarifying how legibility theory differs from existing oft-discussed tax policy norms and by expanding upon the proposed solutions to address timing issues. Nevertheless, her clear and cogent description of theory, her discussion of the role of categories within the tax system, and her explanations of why categories are important are all wonderfully generative.

For example, Taxing Taxonomies has stimulated the following line of thought. One way of categorizing participation in both proof of stake and proof of work systems is as a lease of personal property. Participants provide their computers for use as part of a distributed network; both proof of work and proof of stake systems look very similar to other existing distributed networks used to advance science. For example, Berkeley’s Open Infrastructure for Network Computing (BOINC) allows you to devote your computer to Berkeley scientists to use for scientific research while you sleep. The main differences between leasing your computer to say, BOINC’s distributed network, and entering into contracts with cryptocurrencies, appear to be that: (i) BOINC leases the computer services for free (and contributes to cutting edge science, which, at the most theoretical levels, is a public good), and (ii) crypto currencies pay in-kind rental fees to lease computers (and use the computers to facilitate wild speculation, money laundering, illegal sales, and tax evasion, while at the same time draining energy from the grid and accelerating climate change).

In essence, a crypto-participant enters into a lease contract to provide access to and use of a computer as part of a distributed network. Under a proof of stake system, staked coins may be seen to function as a pledge or a bond. Participants that put more at risk for longer periods of time are given a preferential right to earn income. Failure to maintain access and use is a breach of the lease. If the computer is not available when needed, if it validates bad transactions, or if it fails to build new blocks or validate transactions when called upon to do, the lease is breached and the participant’s earnings may be “slashed” (the stake may be lost). To reduce exposure, participants may transfer their stake or contract to a third-party delegate to maintain the network connection and keep the computer running (functioning as a property manager in exchange for a small fee of 5 – 10%). The staked coins function as a bond to ensure performance and provide for immediate collection of penalties in case of failure or breach. Under such a scheme, the income should be categorized as rental income. Like rental income from every other leasing activity, it would be considered passive income under the passive activity loss rules and under international tax rules. For cash method taxpayers, the income is earned at the time the coins / tokens / in-kind compensation are received. For accrual method taxpayers, the income is earned at the time the computer is used.

Taxing Taxonomies is likely to advance the work of Treasury, the IRS, and other policymakers seeking to unravel the cryptocurrency Gordian Knot. Further, it will likely spur a little meta-analytical swordplay among even the least theoretical and most hide-bound of generalists among us.

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

https://taxprof.typepad.com/taxprof_blog/2023/08/weekly-ssrn-tax-article-review-and-roundup-roberts-reviews-parsonstaxing-taxonomies.html

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