Closing the tax gap through digital asset issuers
Introduction
IRS Commissioner Charles Rettig recently commented that the U.S. government is losing as much as $1 trillion in uncollected taxes each year, with digital asset holdings escaping taxation and contributing to a growing tax gap.
This article will offer strategies on closing the tax gap via digital assets, focusing on digital asset issuers.
To that end, the primary issues considered in this article are the tax consequences: (1) to the original creator of Bitcoin or other digital assets on the creation of such digital assets; (2) of the payment of such digital assets to miners by the original creator; and (3) of (i) the creation and (ii) payment of digital assets to miners in connection with an airdrop related to a new digital asset being issued on a protocol change.
As forms of digital assets are relatively new in their widespread use and distribution and novel in the mechanics of how digital assets are issued, acquired and traded, there is not surprisingly a very limited amount of authority regarding the tax treatment of digital assets. Specifically, the IRS issued a notice in 2014, followed by a published ruling in 2019, as well as some FAQs available on the IRS website. More recently, the IRS issued a chief counsel memorandum (the “CCM”), clarifying some of its conclusions/positions in its 2019 guidance. In its guidance, the IRS sets forth its view on a number of basic and fundamental points with respect to the taxation of digital assets:
Commentators and practitioners have continued to write on topics related to the taxation of digital assets, as the limited IRS guidance has left open many questions, both with respect to questioning premises of the IRS’s conclusions as well as issues that the IRS has not (at least publicly) considered at all.
What is notable is that there hasn’t been significant discussion—either by the IRS or by commentators at large—with respect to the taxation of the issuer of digital assets, whether that focus is on the original creator of a digital asset or an issuer in the connection an airdrop. Arguably, the lack of focus is pragmatically driven by issues surrounding the technology and structure of blockchain systems, for example, difficulties ascertaining the identity of the issuers and clarifying when there is a taxable event with respect to issuers. Accordingly, the tax treatment of the creation and issuance of digital assets remains an open and important area of discussion and this article will provide some guidance on how this area could be approached.
Law and Technology
Governments and regulators must stay abreast of evolving technologies to ensure blockchain structures and digital assets are not being used to facilitate non-compliance with existing laws.
As mentioned above, the lack of focus on issuers of digital assets appears to be pragmatically driven by issues surrounding the technology and structure of blockchain systems, for example, difficulties ascertaining the identity of the issuers and clarifying when there is a taxable event with respect to issuers.
In identifying issuers, the first step is to address the myth of decentralization of public blockchains. It is important to note that blockchain systems are distributed, not decentralized. Though those that exercise power, oversight and responsibility over these powerful financial and data structures may not be formally organized, that does not mean that the creation, control and power, operation and oversight and responsibility of public blockchains is not centralized; for example, centralized with key developers and others involved in decision-making with respect to the software that operates blockchain structures, which thereby ensures the continued existence of associated digital assets. Accordingly, it is arguable that those who control the protocol or software of the specific digital asset should be viewed as “holding” the yet-to-be-distributed digital asset in reserve, and therefore, with respect to such parties, an analysis should be undertaken on when there is a taxable event and taxable income on that event, which I will discuss as occurring on creation of a digital asset, on a subsequent payment or distributions to miners and on the creation and payment of digital assets to miners in connection with an airdrop related to a new digital asset being issued on a protocol change.
In clarifying what is considered a taxable event, as implied above, I am suggesting that new systems are created when there are changes in protocol from the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as airdrops, a taxable event should be considered to have occurred on creation of a protocol that is not compatible with the original Bitcoin protocol, creating current taxable income for the issuer receiving the newly issued digital assets.
Analysis
Please note that, with respect to the various scenarios relating to the taxability of the issuance of a digital asset, there is a threshold question as to whether the relevant parties (issuers, payors, recipients, etc.) are subject to and within the jurisdiction of the U.S. taxing authorities. While that question is a significant (and threshold) one, which would turn on the citizenship, residency and location and type of business activities of the taxpayers involved, it is not the focus of this article. The assumption herein is that all relevant parties are subject to U.S. taxation.
Treatment of Original Issuer/Creator of Bitcoin
As this section applies to Bitcoin, it applies to Bitcoin SV as the original Bitcoin protocol.
The starting point for the analysis with respect to the taxation of the issuer of a digital asset is the tax treatment and consequence of the asset’s creation/coming into existence. Where a digital asset is a newly created asset which is distributed exclusively through mining (e.g., not created by an airdrop from an existing digital asset), the newly created digital asset might not create taxable income for the creator of the asset at the time of issuance. One basis for that position would be that the digital asset may not have current value at the time of its creation, particularly those early digital assets, such as Bitcoin, which were launched at a time when the concept of digital assets was novel and the value of such assets was highly uncertain. Accordingly, at least in the case of Bitcoin, even if one were to presume that the entire issuance of Bitcoin was held by its creator at the time of issuance, there was nothing of value created at that time, and therefore, there would be no taxable income at the time of issuance.
The next issue is the treatment of the creator/holder upon payment of that digital asset to others. The IRS has stated its position that Bitcoin and similar digital assets are properly treated as property and not currency for income tax purposes. Accordingly, if the creator of a digital asset were to utilize a digital asset in an exchange for other property or services, as a baseline matter, the exchange would be a taxable event for the creator/payor. This would result where Bitcoin is distributed to a miner in exchange for its services relating to validating transactions on the blockchain.
The creator would recognize gain equal to the fair market value of the services or property received, less any basis it would have in the digital asset (this is likely to be zero as there was nothing of value created on inception or very low as the creator/payor could add costs incurred in generating the digital asset in its basis). If there is income or gain recognized, the valuation of the services or property received would need to be determined. There is a presumption in the tax law that the amount of two items exchanged in an arm’s length transaction have equal value. Thus, the value of services rendered to the creator/payor of the Bitcoin would equal the value of the Bitcoin paid. Where the digital asset being paid or distributed is already widely traded, the valuation would be the traded value. But with a digital asset that is newly or recently issued, the taxpayer would need to determine the fair market value in order to compute its tax liability, while the government would be free to challenge that determination.
The foregoing analysis, however, posits that there is a sale or exchange. At first glance, it is not initially clear what the creator/payor of the virtual currency is receiving in exchange upon its payment to a miner. One could argue, however, that the creator/payor has received a valuable service in exchange for each block reward distribution. Notably, the IRS has clearly stated that in this exchange, the digital asset reward received by the miner qualifies as taxable income to the miner. The IRS, however, has not addressed how it would treat that same distribution as it applies to the creator/payor. Arguably, the creator/payor is compensating the miner for its work related to validating transactions. It would appear that the creator/payor is making the payment to the miner to enhance the value of its own product—e.g., the blockchain and the overall value of the digital asset issued. The validation of transactions on the blockchain enhances the value to all holders of the digital asset, including the issuer. Thus, upon the payment, the creator/payor would arguably have taxable gain equal to the value of the asset paid to the miner over the basis, if any, of the creator/payor in the digital asset.
To the extent that the payment to the miner is treated as an exchange for services, and therefore, triggers gain for the payor, there is another level to the analysis, which is whether there is an offsetting deduction for the payor. For the purposes of this article, we are assuming the issuer/payor engages in a “trade or business” for tax purposes and expenses incurred are currently deductible as ordinary business expenses versus expenses required to be capitalized and added to the taxpayer’s basis of the underlying asset.
Thus, while the issuer could recognize gain for the exchange of the digital assets for the services provided (i.e., the validation of transactions), such a payment would be in exchange for services. If this is truly a payment for services provided, then there should be a deduction available to the payor equal to the value of compensation transferred to the service provider. Not only would this deduction offset the gain, it could perhaps more than offset such gain. The gain recognized on the payment would be equal to the fair market value of the digital asset paid, reduced by any basis that the payor would have in the digital asset issued. As noted above, to the extent that the payor incurred costs that were properly allocable to the creation of the digital asset, that would add to the basis of the digital asset in the payor’s hands and, therefore, reduce any gain on a disposition. The compensation deduction, however, would be the full fair market value of the digital asset transferred, without any reduction for the basis. Thus, if the digital asset paid is worth $100 and there was $10 of basis, the gain would be $90 while the deduction would be $100.
Moreover, there could potentially be a favorable rate arbitrage as well. The gain that would be triggered could (depending on length of holding period and other factors discussed below) be treated as capital gain, currently taxed at rate of 20%, but the compensation deduction would be an ordinary deduction, with a top marginal rate of 37% (though the specific rate that would apply would depend on a number of factors). The analysis, however, on this point of the potential rate arbitrage is somewhat more nuanced for a number of reasons and not within the scope of this article.
Treatment of Issuance in Connection with an Airdrop
As outlined above, in clarifying what is considered a taxable event, I am suggesting that new systems are created when there are changes in protocol to the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as airdrops, a taxable event should be considered to have occurred on creation of a protocol that is not compatible with the original Bitcoin protocol, creating current taxable income for the issuer receiving the newly issued digital assets. Accordingly, this section would apply to new protocols, such as the current iteration of BTC and BCH, and consequently provide governments with significant sources to close the tax gap.
The IRS has issued guidance with respect to the treatment of the recipient of digital assets upon the occurrence of an airdrop, maintaining that it creates current taxable income for the recipient receiving the newly issued digital assets (though it recently modified that view to the extent that the recipient does not have dominion or control over the digital assets, it would have not have current taxable income until such time that it does have control).
What is less clear, as noted above, is whether a person/party viewed as an issuer or creator of the new digital asset created pursuant to an airdrop should be viewed as receiving additional property (and therefore, currently taxable).
The analysis of the taxability to the issuer of digital assets not in the context of the independent creation of a digital asset such as Bitcoin, but rather in connection with an airdrop, shares some points with the foregoing discussion of the original issuer/creator above, but in a number of ways is significantly different.
Upon the occurrence of a protocol change, holders of outstanding amounts or units of digital asset A typically automatically receive (as a function of an airdrop) units, or coins, of digital asset B. In addition, an amount of digital asset B will be created and held in reserve to be issued equal to the amount of the existing but not outstanding digital asset A. For example, if there were 100 coins of digital asset A originally created, and 70 of them have been paid out to miners but another 30 are still held in reserve yet to be distributed to miners, then the holders of the outstanding 70 units of digital asset A will be airdropped 70 units of digital asset B. In addition, there will be another 30 units of digital asset B held in reserve to be distributed to future miners of digital asset B.
The IRS (and by and large, the commentators) have also not discussed the tax treatment of a person or party that would or could be treated as the creator or issuer of a new digital asset in connection with an airdrop. As noted above, the IRS has stated its position that taxpayers that receive new digital assets from an airdrop have taxable income. However, there has not been significant discussion of the treatment of the creators or issuers of digital asset B. I argue in this article that, just as the IRS has ruled that other recipients of the new digital asset from the airdrop would be currently taxable, the creators/issuers of digital asset B should also be taxable as well.
As stated above, it is arguable those who control the protocol or software of the specific digital asset should be viewed as “holding” the yet-to-be-distributed digital asset in reserve. Thus, for purposes of this article, we are assuming that such individuals will be treated as holding such yet-to-be-distributed digital asset B, and therefore, it would need to be determined whether they would have taxable income at the time of such airdrop or on a subsequent payment or distributions to miners.
Specifically, while the creation of a new digital asset might have no or little immediate value, the digital asset created as a result of an airdrop would likely have significant value, as its circulation is immediately substantial (as all of the holders of digital asset A also now hold units of digital asset B and the protocols are already in place for its use and trading going forward). Thus, the lack-of-initial-value theory for no taxability on the creator of Bitcoin discussed above would presumably not apply. Accordingly, the issuer with respect to the airdrop would have gain equal to the difference between the value of the digital asset issued and its basis (if any) in such digital asset. Just as the IRS has ruled that other recipients of the new digital asset from the airdrop would be currently taxable, the creators/issuers of digital asset B should also arguably be taxable as well.
The argument would be based on the IRS’s recent embrace of the notion of dominion and control being an important factor in its most recent ruling. The creators, by developing and/or managing the protocol and software of the new digital asset B, would enhance the value of their existing holdings of digital asset B. The fact that the reserve of the new digital asset B would be available to be distributed to miners (as a result of their efforts), and thereby available to further enhance the value of the creators’ existing holdings, reflects their control over the reserve. Thus, because their actions and their continued control over the protocol enhanced the value of their existing assets (i.e., their existing holdings in digital asset B), the IRS could argue that the creation of that digital asset B results in a taxable event for such creators. While not entirely clear what the scope or magnitude of such gain would be, the strongest position appears to be that it should be measured in reference to the new digital asset B held in reserve available to be distributed (i.e., available to be paid to miners), as the payment to the miners is what would enhance the value of the creators’ existing assets.
The foregoing analysis and discussion is with respect to the creation of digital asset B in connection with an airdrop. To the extent that digital asset B is subsequently distributed or paid to miners, presumably the analysis above regarding the recognition of gain on the payment of the digital asset in exchange for services would then be applicable here as well. To the extent the issuers of digital asset B are treated as the owners of the digital asset, and to the extent the payment to the miners is viewed as in exchange for services (as discussed above), there would presumably be gain to the issuers/payors, but potentially offset by a deduction, as outlined above.
There would be one potential difference in the treatment on the payment to a miner. To the extent that the creator/issuer recognized income on the creation of the digital asset at the time of the airdrop, such income would create basis and reduce the amount of gain on the exchange/payment to the miner. This is as opposed to the creator of an entirely new digital asset, which would likely not have recognized any gain at the time of creation and would have little to no basis at that time.
Conclusion
As mentioned above, governments and regulators must stay abreast of evolving technologies to ensure blockchain structures and digital assets are not being used to facilitate non-compliance with existing laws.
There has been a lack of focus on issuers of digital assets presumably driven by issues surrounding the technology and structure of blockchain systems, for example, difficulties ascertaining the identity of the issuers and clarifying when there is a taxable event with respect to issuers.
I have argued that those who control the protocol or software of a specific digital asset should be viewed as “holding” the yet-to-be-distributed digital asset in reserve.
In clarifying what is considered a taxable event, as implied above, I am suggesting that new systems are created when there are changes in protocol from the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as airdrops, a taxable event should be considered to have occurred on creation of a protocol that is not compatible with the original Bitcoin protocol, creating current taxable income for the issuer receiving the newly issued digital assets.
Accordingly, the analysis in this article is most relevant to new protocols such as the current iteration of BTC and BCH, which would provide governments with significant sources of tax to close the tax gap.
About the Author
Johnny Jaswal is the Managing Director and General Counsel of the Jaswal Institute, responsible for providing regulatory, legal, government relations, strategic and related investment banking advisory services. He has a wealth of experience advising on regulatory matters, mergers, acquisitions, divestitures and capital raising activities.
Johnny represents global blockchain and digital asset companies and is responsible for leading international advisory services. In addition to advising governments and regulatory authorities on digital asset legislation, Johnny has formed/executed the global M&A, capital raising, regulatory and tax strategies for multiple businesses.
Prior to founding his advisory firm, Johnny was a member of senior management on the corporate development and strategy team of TMX Group, which owns a portfolio of financial and technology assets including the Toronto Stock Exchange, an investment banker at TD Securities, which is among Canada’s top-ranked investment banks, a business lawyer at Blake, Cassels & Graydon LLP and Goodmans LLP, two of Canada’s top law firms, and an engineer in several sectors.
Johnny has a Master of Business Administration from the Schulich School of Business, a Juris Doctor from Osgoode Hall Law School, a Bachelor of Engineering: Electrical Engineering from Ryerson University and has been admitted to the Ontario Bar.
This article is for informational purposes only and does not, and is not intended to, constitute legal advice. No person or entity may rely on this article for legal or other advice from Johnny Jaswal/the Jaswal Institute. The article speaks solely as of the date written. Future factual changes or developments, and future court cases or regulatory guidance, could affect the analysis or conclusions presented in the article. Johnny Jaswal/the Jaswal Institute are not under any obligation to update the article to reflect future events or factual changes, or for any other reason.
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