Tax Implications of Cryptocurrency

Virtual currency or cryptocurrency has become popular in today’s financial markets and may be here for some time. Investors increasingly turn to virtual currency to fund transactions and provide portfolio diversity. The rising popularity of virtual currency has created some significant tax issues.

On November 30, 2016, the IRS was successful in its petition pursuant to Codesection 7609(f) in obtaining a John Doe summons to be served on Coinbase, Inc. The IRS is seeking information regarding all US persons who conducted virtual currency transactions on Bitcoin during the period January 1, 2013 to December 31, 2015, reminiscent of the 2008 John Doe summons granted to the IRS for information on US persons with accounts at UBS Switzerland. The July 2008 John Doe Summons resulted in the release by UBS to the IRS of about 4,500 names of US persons who held Swiss bank accounts. The issuance of the John Doe Summons against UBS severely compromised the offshore tax world and led to the implementation of FATCA and the CRS. The effect of the John Doe summons issued to Coinbase, Inc. will be watched closely.

Unlike other IRS summonses, a John Doe Summons does not list the name of the taxpayer under investigation because the taxpayer is unknown to the IRS. A John Doe Summons allows the IRS to obtain the names of all taxpayers within a certain group.

Coinbase, Inc. provides bitcoin wallet services and is a virtual currency exchange who assists merchants and consumers to buy, sell, and use bitcoin currency. A consumer converts bitcoin payments to a fiat currency (legal tender backed by the government that issued it) that is then transmitted to the merchant. A virtual currency exchanger resembles a traditional currency exchanger, but it can exchange virtual currency for government-backed currency and vice versa. A virtual currency exchanger is linked to the conventional banking system and money transmitters: it can receive conventional checks, and credit card, debit card, and wire transfer payments in exchange for virtual currency. A virtual currency exchanger is governed by legislation such as FinCen, is deemed to be a money transmitter under the Bank Secrecy Act, and probably falls within the scope of the CRS, which results in the disclosure of information between more than 100 tax authorities. Wallet services allow a user to quickly authorize virtual currency transactions with another user through the use of a traditional money account held at the exchanger.

According to the IRS Notice 2014-21, a virtual currency is not legal tender but it is intangible personal property. The notice gives examples of the tax treatment of various transactions using virtual currency such as:

• ·       Wages, salaries, and other income paid to an employee with virtual currency must be reported on a form W-2, and is reportable by the employee as ordinary income and subject to employment taxes paid by the employer;

• ·         Virtual currency received by a self-employed individual in exchange for goods or services is reportable as ordinary income and is subject to self-employment tax.  A payer must issue a form 1099;

• ·         Virtual currency received in exchange for goods or services by a business is reportable as ordinary income; and

• ·         A gain on the exchange of virtual currency for other property is generally reportable as a capital gain if the virtual currency was held as a capital asset and as ordinary income if the virtual currency is held for sale to customers in a trade or business.

Reporting is effected in USD: thus whenever virtual currency is used, a barter transaction takes place, and the parties must know the FMV of the virtual currency on that day. A taxpayer must track which virtual currency lot was used for each transaction in order to properly determine the gain or loss for that particular transaction. Given that the valuation of a convertible currency is a peer–to-peer demand, the exact FMV in legal tender of a virtual currency is not always certain.

Shortly before the petition was filed with the US District Court for the Northern District of California to obtain the John Doe summons, on September 21, 2016 a report was issued by the Treasury Inspector General for Tax Administration (TIGTA), entitled “As the use of virtual currencies in taxable transactions become more common, additional actions are needed to ensure taxpayer compliance”.

The TIGTA report highlights that not much was done by the IRS to ensure tax compliance by US persons who use convertible virtual currencies despite the fact that, as of April 21, 2016, one bitcoin was equivalent to about USD$443, and bitcoins had a total FMV of more than USD$6.8 billion. The TIGTA report points out that the reporting requirements set out in IRS Notice 2014-21 are flawed in that the reporting payer and the recipient payee must report the payment and receipt of virtual currency in USD; information forms 1099-MISC, 1099-B, 1099-K, and W-2 do not inform the IRS that the payments were made in virtual currency. As a result, the IRS has one fewer means of tracking a US person with cryptocurrency on hand. Thus even though cryptocurrency is property for US tax purposes, no US mechanism requires a Bitcoin holder to report that holding to the IRS. Because the identity of the parties using virtual currencies is generally anonymous, the inevitable result is tax evasion.

The fear of tax evasion is confirmed by the IRS agent whose affidavit formed the petition for the John Doe summons to Coinbase, Inc. In his affidavit the agent cites two examples - of which he had knowledge - of tax evasion involving convertible virtual currency:

In the first example, Taxpayer I originally worked with a foreign promoter who set up a controlled foreign shell company which diverted his income to a foreign brokerage account, then to a foreign bank account and lastly back to Taxpayer I through the use of an ATM. Once Taxpayer I abandoned the use of his offshore structure in favor of using virtual currency, the steps described above were the same until his income reached his foreign bank account. Once there, instead of repatriating his income from an ATIM in the form of cash, Taxpayer I diverted his income to a bank which works with a virtual currency exchange to convert his income to virtual currency. Once converted to virtual currency, Taxpayer I’s income was placed into a virtual account until Taxpayer I used it to purchase goods and services. Taxpayer I failed to report this income to the IRS.

And in the second example:

Two separate corporate entities with annual revenues of several million dollars traded bitcoins resulting in the under reporting of income. Both taxpayers admitted to disguising the amount they spent purchasing bitcoins as deductions for technology expenses on their tax returns. The bitcoin transactions were discovered after repeated requests for the original documentation necessary to substantiate the technology expense items claimed on the tax returns.  

US persons who reside in Canada and convert virtual currencies on exchanges other than in the United States, should be advised that their FBAR filings should disclose all of their holdings of convertible virtual currencies.

reprinted with permission from the Canadian Tax Highlights, a Canadian Tax Foundation Newsletter.