The Rise and Regulation of Virtual Currency

As virtual currencies, such as Bitcoin, rise in prominence and become part of an increasing number of everyday transactions, federal, state and international governments have been issuing new legislation, regulations and guidance to protect consumers and the marketplace while supporting innovation. In response to uncertainty about the taxation of virtual currency, the IRS released guidance treating virtual currency as property, not currency for federal income tax purposes in Notice 2014-21. However, Notice 2014-21 left several major issues unresolved, and practitioners and taxpayers are seeking additional guidance. This white paper explores the many questions and concerns that have been raised by Bitcoin and other virtual currencies.

 

INTRODUCTION

Actual currency (“real currency” or “fiat currency”) is commonly defined as a system of money in general use in a particular country. The U.S. dollar is an example of actual currency. Virtual currency (sometimes referred to as “crypto-currency”) is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value. While virtual currency operates like actual currency in some circumstances, it does not have legal tender status in any jurisdiction.

A 2013 report from the Government Accountability Office discussed three types of virtual currencies:

  • open-flow virtual currencies that can be used to purchase goods and services in the real economy and can be converted into real, government-issued currencies through virtual currency exchanges;
  • closed-flow virtual currencies that can be used only in particular environments, such as in an online role-playing game; and
  • hybrid virtual currencies that can be used to buy real goods and services but are not exchangeable for government-issued currencies.

Virtual currency that has an equivalent value in real currency or that acts as a substitute for real currency is referred to as “convertible” virtual currency. The most prominent example of a convertible virtual currency is Bitcoin, which can be digitally traded between users and can be purchased for or exchanged into U.S. dollars, euros, and other real currencies. The current real-time value of a Bitcoin on various Bitcoin exchanges is available on a number of websites.

 

VIRTUAL CURRENCY TRANSACTIONS

The crypto-currency concept was first described in 1998 by Wei Dai on the Cypherpunks mailing list. He suggested a new form of money that uses cryptography, rather than a central issuing authority, to control its creation and transactions. The first Bitcoin specification and proof of concept was published in 2009 in a cryptography mailing list by Satoshi Nakamoto, who left the project in late 2010. The community has since grown exponentially.

Bitcoin is an open source, peer-to-peer electronic money and payment network. The Bitcoin protocol and software are published openly, and developers around the world can review the code or make their own modified version of the Bitcoin software.

Bitcoins are created, or “mined,” electronically when users (“miners”) employ a complex algorithm to verify and record transactions. As more Bitcoins are mined, it becomes computationally more difficult to create them, so mining also becomes more difficult. This process is intended to mimic the production rate of a commodity such as gold. As of September 2016, there are close to 16 million Bitcoins in circulation.

Bitcoins in circulation are limited to 21 million, leaving fewer than five million uncirculated Bitcoins. At the current rate of creation, the final Bitcoin will be mined in the year 2140. However, this date could change based on a variety of technical factors. Although total Bitcoins are limited, each is infinitely divisible. For instance, a satoshi is one hundredth of a millionth of a Bitcoin. Thus, if a Bitcoin is worth $1,000, a satoshi is worth one-thousand of a penny.

COMMENT: The abbreviation for Bitcoin is BTC. A millibitcoin (mBTC) is one-thousandth of a Bitcoin, or 100,000 satoshis. A microbitcoin (µBTC, with “µ” standing for the Greek letter mu) is 100 satoshis.

The first Bitcoin ATM in the United States went online on February 18, 2014, in New Mexico. As of September 2016, the United States has 427 Bitcoin ATMs (also known as Bitcoin kiosks). These machines allow users to deposit cash in exchange for Bitcoins. The transactions are managed by thousands of computers linked in an international network.

There are other varieties of virtual currency besides Bitcoin, collectively known as “altcoin.” Some of these altcoins, such as Namecoin, Peercoin, Freicoin, and Deutsche eMark, use the same algorithm as Bitcoin. Other altcoins, such as Ethereum, Litecoin, Digitalcoin, Quark, and Pandacoins, use a different algorithm. As of September 2016, there are 713 virtual currencies traded in the marketplace, totaling more than $12 billion in stated value. Bitcoin represents about 79 percent of this value ($9.6 billion). Ethereum is the second largest virtual currency with a value over $1 billion, which is rapidly climbing.

Steps for Using Virtual Currency

A transaction using virtual currency has several steps. For example, an individual who wants to engage in a Bitcoin transaction downloads and installs the Bitcoin software (the “client”) on his or her computer. This application uses public key cryptography to generate a “Bitcoin address” where the user can receive payments. This address consists of a randomly generated, 36-character-long sequence of letters and numbers. The address is stored in a “digital wallet” on the user’s computer. A user can create as many Bitcoin addresses as desired to receive payments, or even use a new address for every transaction.

This process uses a number of specialized terms:

  • A digital wallet is software with which an individual or business can enter into transactions using virtual currency. The digital wallet includes a public key and a private key. The public key identifies the wallet and is used to make payments to the wallet. It is visible on the block chain. The owner of the wallet is not identified in the public key. The private key is held by the owner and is used to access and make payments from the wallet. A person who has both the public key and the private key can control the wallet, including removing its contents. There is no way to reverse a virtual currency transaction. Therefore, maintaining security over one’s wallet is critical.
  • A transaction is a section of data that has been electronically signed and sent to the Bitcoin network, where it is collected into The transaction will usually reference previous transactions. It dedicates a certain number of Bitcoins to one or more new public keys (the Bitcoin address). A Bitcoin transaction has three elements: 1) the input, which is a record of the Bitcoin address that sent the transferred Bitcoins to the sender; 2) the amount of Bitcoins being sent; and 3) the output, which is the recipient’s Bitcoin address.
  • Bitcoin transactions are recorded on the block chain, a computer file that acts as a public ledger that anyone can examine. A virtual currency’s block chain contains information on every transaction ever executed in the currency. A user can learn how much value belonged to each address at any point in history. A conventional ledger records the transfer of actual bills or notes. Bitcoins, however, are simply entries on the block chain and do not exist outside of it.
  • A block chain browser is a website where every transaction included in the block can be viewed. The viewer can see the technical details of the transaction, which can be used for payment verification purposes.

To send Bitcoins, the sender inputs the recipient’s address and the amount to be transferred, and then signs the transaction with his or her own private key. This information is sent to the Bitcoin network, where Bitcoin miners verify the transaction and put it into a transaction block. As part of this process, the miners make sure that the sender actually owns the Bitcoins that are being transferred, a precaution that is intended to prevent a malicious user from spending the same Bitcoins multiple times. It may take some time for the miners to solve (or mine) the transaction, so the parties may have to wait up to 10 minutes, which is the time set for mining a block. In low-value transactions, however, the parties may not require verification, because the risk of fraud is not significant. When the transaction is complete, the recipient is free to spend the transferred Bitcoins. The miners who verified the transaction are also paid in Bitcoins.

Making Change

Transactions in a Bitcoin wallet are not combined; they remain separate transactions in the wallet. When the owner wants to send Bitcoins, the wallet will try to use different transactions that add up to the amount being sent. When the existing transactions do not add up to the correct amount, the sender must send more Bitcoins than necessary and receive the excess back as change in his or her wallet. The wallet sends the correct amount to the recipient and the change to a new address that was created to hold change from the transaction.

EXAMPLE: Moira wants to use Bitcoins to buy a computer from CompSeller, a computer retailer. She first goes to a website to find out the value of a Bitcoin today. The website that hosts her wallet has that information, and she establishes that a Bitcoin is worth $570. She goes to CompSeller’s website, where she obtains CompSeller’s Bitcoin address and learns that the computer she wants costs $1,995. That means it will cost 3 ½ Bitcoins. Moira’s Bitcoin wallet contains unspent outputs from prior transactions, including one unspent output for 4 Bitcoins. Moira instructs the wallet to split her transaction, a feature that is supported by Bitcoin. She splits the 4-Bitcoin unspent output into one output for 3 ½ Bitcoins, which she transfers to CompSeller’s Bitcoin address. The other half a Bitcoin is transferred to a newly created change account.

Some merchants charge transaction fees, but currently most do not. This may change in the future as the Bitcoin protocols are amended. Any amount that is not picked up by the seller or returned to the buyer as change is considered a transaction fee and may be considered a reward to the miner who solved the transaction block.

COMMENT: Companies like Blockchain.info and Coinbase act as intermediaries in Bitcoin transactions. As of 2016, Coinbase has over 9 million and Blockchain.info has over 8 million Bitcoin wallets, allowing Coinbase and Blockchain.info to accept Bitcoin payments on the customers’ behalf using their payment tools. More than 100,000 merchants around the world currently accept Bitcoin, including  big names like Microsoft, Dell, Overstock, Newegg, DISH and Expedia.

Price Comparisons

Users of Blockchain.info can download pricing data and compare prices among various exchanges. One can find out, for example, the total number of Bitcoin transactions that occurred on a given day, double-spends that have been detected, or the total number of Bitcoins in circulation. One can also create a free Bitcoin wallet at that website.

COMMENT: Double-spending occurs when an owner spends the same virtual currency more than once. Some electronic systems prevent double-spending by using a master authoritative source that follows business rules to authorize each transaction. In contrast, Bitcoin uses a decentralized system that replaces a central authority with a consensus among “nodes” (computers running the Bitcoin software) following the same protocol. The verification of each transaction in a block chain is intended to ensure that the inputs for the transaction have not already been spent. Bitcoin has some exposure to fraudulent double-spending when a transaction is first made, with less and less risk as a transaction gains confirmations.

 

CHARACTERISTICS OF BITCOINS

Bitcoin transactions are decentralized. This means that there is no central bank or other institution holding the value of a Bitcoin. The Bitcoin network is not controlled by a single individual or entity. Each machine that mines Bitcoins and processes transactions is part of the network.

Following are the key features and benefits of virtual currencies such as Bitcoin:

  • A Bitcoin transaction is easy to initiate. It is possible to create a Bitcoin address in seconds. There are no fees payable and no one asks any questions about the transaction.
  • A Bitcoin transaction is anonymous but transparent. This means that information regarding the transaction is available to all, but the information is not tied to a particular individual. There is no link to names, addresses, or other identifying information. A person looking at a particular Bitcoin address can tell how many Bitcoins are there but not who owns them.
  • A Bitcoin transaction has few, if any, transaction fees. This may change, but at the moment most merchants do not charge transaction fees or charge only a very small amount.
  • A Bitcoin transaction is Transactions anywhere in the world take only a few minutes, just long enough for the Bitcoin network to process them.
  • A Bitcoin transaction is It cannot be repudiated, so any Bitcoins lost cannot be recovered unless the seller sends them back to the buyer.

 

The U.S. House Committee on Small Business held a hearing on April 2, 2014, “Bitcoin: Examining the Benefits and Risk for Small Business.” Jerry Brito, senior research fellow at the Mercatus Center at George Mason University, explained that “because there is no central intermediary in Bitcoin transactions, fees associated with those transactions are relatively small.” Businesses must pay much higher fees to accept credit cards, including a fee per swipe of the card plus two to four percent of the total transaction. Businesses that use a merchant processor pay fees of one percent or less for Bitcoin transactions. “If you are a small-margin business,” according to Brito, “that difference could mean doubling your profits.”

COMMENT: The most obvious risk in virtual currency is its volatility. The value of a Bitcoin went from pennies in 2011 to $1,200 in 2013, and then back down to around $600 in 2016. According to Brito, Bitcoin’s value is unstable because it is new and thinly traded. Thus, it should even out over time, especially as more people and businesses use it.

 

ASSOCIATION WITH ILLEGAL ACTIVITIES

One problem with Bitcoin’s reputation and general public image is its association with various illegal transactions. Bitcoins were the favored currency of drug dealers who used the online black market at the Silk Road website. When a group of law enforcement agencies (including the FBI, DEA, and IRS, among others) shut down the Silk Road in 2013, they confiscated 174,000 Bitcoins, worth $34 million at the time.

The FBI issued a report in April 2012 that analyzed the likelihood and consequences of illegal activities involving Bitcoin. These include money laundering, theft of Bitcoins, and theft of services to mine Bitcoins (using software to take over computers and make them mine Bitcoins). Another illegal technique known as “ransomware” uses a computer virus that locks computer or mobile phone files and will not release them until a Bitcoin payment is sent to a designated address.

Bitcoin is vulnerable to hacking.

EXAMPLE: Mt. Gox, a Japanese Bitcoin exchange, collapsed in 2014 reportedly due to theft by hackers of more than 850,000 Bitcoins, worth $460 million at the time. The exchange filed for bankruptcy. However, Japan News claims that fraud accounts for 99 percent of the loss, and only about 7,000 Bitcoins were lost because of cyber-attacks. In 2015, Mt. Gox CEO Mark Karpeles was charged with embezzlement and is currently awaiting trial in Japan. He is alleged to have embezzled $2.6 million from the Bitcoin exchange to fund his own personal projects.

EXAMPLE: A major Bitcoin exchange, Bitfinex, was hacked and nearly 120,000 Bitcoins, worth $65 million, were stolen in August 2016. Bitcoin value crashed, and Bitfinex was forced to temporarily suspend its trading. Bitfinex reports that it has not yet identified how the theft was carried out. The Bitfinex theft represents the largest loss of Bitcoins by an exchange since Japan’s Mt. Gox.

Bitcoins have also been used as a way to evade taxes and facilitate financial crime.

EXAMPLE: A two-island country in the West Indies, St. Kitts and Nevis, does not tax its citizens and has a citizenship by investment program through which people can essentially buy a citizenship for $250,000 to $400,000. Many governments have limits on money transfers that would make it very difficult for a wealthy citizen to purchase a St. Kitts citizenship, but Bitcoins allow people to circumvent those restrictions. For example, an individual in China can purchase Bitcoins in his or her home and then use a smartphone to transfer the Bitcoins to St. Kitts without the Chinese government being aware of it. In 2015, 4,279 U.S. citizens (20% rise from 2014) renounced their U.S. citizenships and some became citizens of St. Kitts and Nevis reportedly to avoid complying with the Foreign Account Tax Compliance Act (FATCA) and paying taxes on foreign accounts.

Financial regulators have become involved with certain activities involving virtual currencies.

EXAMPLE: In December 2015, the Securities and Exchange Commission (SEC) charged two Bitcoin mining companies, GAW Miners and ZenMiner, both owned by Joshua Garza, with operating a Ponzi scheme to defraud investors lured in by get rich quick claims. According to the SEC, the scheme paid early investors with the funds of later investors, and the mining operation did not have sufficient computing power to generate the promised results. Garza sold $20 million worth of purported shares in a digital mining contract called a Hashlet. Over 10,000 investors fell for the fraud.

The SEC has issued related investor alerts and is in the process of reviewing a registration statement from an entity that wants to offer virtual-currency-related securities (Winklevoss Bitcoin Trust). The SEC is also monitoring for potential securities law violations related to virtual currencies.

 

VIRTUAL CURRENCY USED IN ONLINE GAMES

Virtual currencies are comparable in some ways to currencies used in large-scale online games, also known as “massive multiplayer online role-playing games” (MMORPGs). Some of these games, such as Second Life, include the use of virtual money to purchase items for use in the games.

Second Life was developed by Linden Lab, and virtual currency called the Linden Dollar is used in the game. In some cases, this virtual money has been used to facilitate transactions outside of the games themselves. However, a vibrant market for virtual goods also exists outside of the game, in which individuals sell or auction virtual land and other property in exchange for actual currency such as dollars. Linden Lab runs one currency exchange, LindeX Market, where Linden Dollars trade for real dollars, with the current rate being approximately 250 Linden Dollars per U.S. dollar.

These games generate significant revenue for their developers: As of 2016, the gross domestic product (GDP) of Second Life has been estimated at $500 million (10 years earlier in 2006, the GDP was estimated at $64 million). Also, about 3,000 individuals earned more than $20,000 in income, in U.S. dollars, each year from their activities in Second Life. As a result, the use of virtual currency in this context is analogous to the use of virtual currency such as Bitcoins, and the tax consequences that apply to one may also be applicable to the other.

Another similarity between game currency and other types of virtual currency is its potential use in criminal activity. The FBI has noted that organized criminal groups have been using an online roleplaying game to launder money. The criminal purchases virtual currency used in the game with criminal activity proceeds. This virtual currency is then used to purchase in-game virtual items that can be sold to other players for “clean money.”

 

U.S. TAX TREATMENT

The IRS recognizes that virtual currency may be used to pay for goods or services, or held for investment. The IRS issued guidance providing answers to frequently asked questions (FAQs) about virtual currency, offering Bitcoin as an example of convertible virtual currency (Notice 2014-21). Those FAQs provided only basic information on the tax implications of transactions with virtual currency. Many practitioners hope for additional refinement of these rules soon, particularly in connection with de minimis transactions and other reporting situations.

COMMENT: The lack of an exception to reporting gain above a de minimis amount has been raised as a serious problem. The typical scenario described to illustrate this issue involves the person who buys a cup of coffee with a Bitcoin, resulting in gain of a few cents or fractions of a cent for the merchant. This is not a problem with foreign currency but is a problem with virtual currency. Some have suggested that the IRS does not have the resources to police this kind of requirement, but that situation does not resolve the issue. Exempting de minimis Bitcoin transactions would probably require an act of Congress and would not be resolvable under the terms of the existing Internal Revenue Code. One possible solution is software that provides “instant conversion” tools, which would enable a person to buy Bitcoins at the moment needed for a transaction; thus effectively eliminating taxable gain or loss.

Property

Notice 2014-21 treats virtual currency as property for U.S. federal tax purposes. As such, it is governed by the same general principles that apply to property transactions generally. However, the sale or exchange of convertible virtual currency, or its use to pay for goods or services in a real-world economic transaction, has immediate tax consequences that might not apply if it were considered pure “legal tender.” Virtual currency is also not treated as currency that could generate foreign currency gain or loss.

Conversion Required

A taxpayer who receives virtual currency in payment for goods or services must include the fair market value of the virtual currency in computing gross income. This value must be measured in U.S. dollars as of the date the virtual currency was received. This fair market value is also the taxpayer’s basis (investment) in the virtual currency.

If a virtual currency is listed on an exchange and the exchange rate is established by market supply and demand (as is the case with Bitcoin), the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which in turn can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied. For other types of virtual currency, it is unclear whether the value of the goods or services given in exchange for the currency can establish its value for income and basis purposes.

Capital Gain or Ordinary Income

A taxpayer has gain or loss on an exchange of virtual currency for other property. If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis in the currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less than the adjusted basis of the virtual currency.

The character of the gain or loss depends on whether the virtual currency is a capital asset in the hands of the taxpayer. A capital asset generally is an asset held for investment purposes, such as stocks, bonds, or other investment property. Property held as inventory or other property mainly for sale to customers in a trade or business is not a capital asset. If the virtual currency is held as an investment, gain or loss on its disposition is capital gain or loss. If the virtual currency is held as inventory for sale to customers in a trade or business, gain or loss on its disposition is ordinary gain or loss.

Gain or loss from the sale or exchange of foreign currencies is always ordinary gain or loss.

COMMENT: It remains unclear whether Bitcoins will be treated as “coins” for purposes of the 28 percent capital gains rate on collectibles or will be considered a permitted investment within individual retirement accounts or in other, similar circumstances.

Virtual currency miners. Taxpayers who create or mine virtual currency are treated as financial services providers rather than prospectors and realize gross income on receipt of the virtual currency resulting from that activity. The fair market value of the virtual currency on the day it is received is includible in gross income. Prospectors, on the other hand, do not have income until the sale of the discovered treasure. Notice 2014-21 presumes that the income from mining is ordinary, and if mining constitutes trade or business and is not undertaken as an employee, any net earnings (generally, gross income less allowable deductions) constitute self-employment income subject to the self-employment tax.

Information reporting and backup withholding. A payment made in virtual currency is subject to information reporting and backup withholding to the same extent as any other payment made in property. Thus, a person who in the course of a trade or business makes a payment using virtual currency with a value in excess of $600 to a U.S. nonexempt recipient must report the payment to the IRS and to the payee. This includes payment of rent, salaries, wages, premiums, annuities, and compensation.

Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding. Also, virtual currency payments to independent contractors and other service providers are taxable, and are generally subject to the self-employment tax rules. Payers using virtual currency must normally issue Form 1099-MISC, Miscellaneous Income, to the payee.

Payers who use virtual currency to make reportable payments must solicit a taxpayer identification number (TIN) from the payee. The payer must backup withhold from the payment if a TIN is not obtained before the payment or if the IRS notifies the payer that backup withholding is required.

Third-party settlement organizations. The information reporting rules currently applicable to third-party settlement organizations (TPSOs) apply to payment processors that settle transactions in virtual currency. A TPSO is a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers. The most common example of a TPSO is an online auction-payment facilitator, which operates merely as an intermediary between buyer and seller by transferring funds between accounts to settle an auction/purchase. A TPSO must report payments made to a merchant on Form 1099-K, Payment Card and Third Party Network Transactions, if, for the calendar year, both the number of transactions settled for the merchant exceeds 200 and the gross amount of payments made to the merchant exceeds US$20,000. The dollar value of payments denominated in virtual currency is based on the fair market value of the currency on the payment date.

The banking industry. Janet Yellen, Chair of the Federal Reserve, stated during a recent Senate Banking Committee hearing that the use of virtual currency is “entirely outside the banking industry.” The central bank, according to Yellen, does not have the authority to regulate Bitcoins.

 

PENALTIES LOOM

Tax underpayments attributable to virtual currency transactions may be subject to penalties, such as accuracy-related penalties under Code Sec. 6662. In addition, failure to timely or correctly report required virtual currency transactions may trigger information reporting penalties under Code Secs. 6721 and 6722. However, the taxpayer might be able to reduce or avoid a penalty if the underpayment or failure to properly file information returns is due to reasonable cause.

The IRS stressed that it was issuing Notice 2014-21 on March 25, 2014, to give taxpayers adequate time to treat virtual currency properly on their returns for 2013. Some practitioners, however, maintain that applying Notice 2014-21 retroactively to 2013 transactions imposes an undue retroactive recordkeeping burden and penalty exposure to taxpayers who had acted on a good-faith misinterpretation of the rules during 2013.

Some commentators argue that, since the IRS released Notice 2014-21 three weeks before the due date for 2013 individual income tax returns, all taxpayers should be considered to have satisfied the reasonable cause exception for penalty relief for the 2013 tax year.  However, other practitioners suggest that the compliance costs would not be severe because most people subject to the Notice have a sophisticated knowledge of business and can obtain the necessary information to amend their returns.

 

TREATMENT BY STATE GOVERNMENTS

New York. On June 3, 2015, The New York State Department of Financial Services (NYDFS) established a “BitLicense” regulatory framework for New York virtual currency businesses. The framework—the first statewide effort in the country—requires licensees to have strong compliance and supervisory policies and procedures. Firms engaged in virtual currency activities that operate in or serve customers that reside in New York must apply for a BitLicense and must have, among other things, anti-money laundering/know-your-customer, consumer protection and cybersecurity programs. Shortly after the BitLicense regulations were adopted, a number of prominent Bitcoin companies ceased operations in New York, publishing statements that the regulations are unnecessary and an obstacle to free market innovation. The BitLicense has been widely criticized for the expensive and arduous application process. To date, the NYDFS has issued only four charters or licenses:

1) In May 2015, the NYDFS granted the first charter under the New York Banking Law to a Bitcoin exchange, itBIT Trust Company;

2) In September 2015, the NYDFS granted the first BitLicense to a Bitcoin services firm, Circle Internet Financial;

3) In October 2015, the NYDFS granted a second charter under the New York Banking Law to a Bitcoin exchange, Gemini Trust Company; and

4) In June 2016, the NYDFS awarded a second BitLicense to a distributed ledger startup, XRP II, an affiliate of Ripple Labs.

California. In June 2014, California repealed its ban on using currencies besides the U.S. dollar (Assembly Bill (AB) 129). This change was meant to accommodate the increasing use of alternative methods of payment, including virtual currencies like Bitcoin. Prior to the repeal, people using digital currencies, community currencies, and reward points were technically violating the law but they were not penalized. The law affects exchange media such as Amazon’s Coins and Starbucks’ Stars, as well as Bitcoin.

However, California will not have a “BitLicense” type of law any time soon. A bill to require virtual currency company to be licensed was introduced in February 2015 (AB 1326), but was withdrawn by its sponsor, Assemblyman Matt Dababneh, the following September for further study. Colin Gallagher, Chair of the Bitcoin Foundation Education Committee, praised the move, saying “This is a victory we should celebrate. California should not be allowed to fall prey to the same blunders that have cast New York in a financial stone age, and we deserve the freedom to be innovators (without state sanction) both in the making of new decentralized systems as well as in our daily actions and explorations of new systems.”

Connecticut. On June 19, 2015, Connecticut enacted legislation (Conn. Pub. Act No. 15-53) amending the Connecticut Money Transmission Act to require licenses for all virtual currency businesses operating in Connecticut. The legislation not only subjects the businesses to requirements imposed on money services businesses, such as currency exchanges and money transmitters, but also establishes additional standards. Virtual currency businesses must maintain a surety bond sufficient to account for the potential volatility of the digital currency. Further, the Connecticut Banking Commissioner has broad authority to impose conditions when granting a virtual currency license and may disapprove an application if the license would expose consumers to an undue risk of financial loss.

North Carolina. North Carolina followed Connecticut and enacted a similar virtual currency statute that integrates the regulation of virtual currency into existing money transmitter statutes. On July 6, 2016, House Bill 289 (HB 289) was signed into law, expanding the state’s Money Transmitters Act to cover activities related to Bitcoin and other blockchain-based digital currencies. Similar to the Connecticut law, HB 289 permits the Commissioner of Banks of the State of North Carolina to impose heightened requirements on virtual currency businesses, such as additional insurance coverage to address cybersecurity risks inherent in virtual currency transmission. The law culminates more than a year of engagement between members of the U.S. blockchain and digital currency industry and local regulators. Prominent digital currency advocates largely voiced support for the measure as a step forward for the domestic industry. Perianne Boring, President of the Chamber of Digital Commerce (CDC), one of the strongest advocates for the bill, characterized the law as making history by providing an alternative, legislative-based model to industry specific rulemaking.

New Jersey. In April 2015, two Assembly members introduced a bill titled Digital Currency Jobs Creation Act (A4478) which would provide tax breaks for virtual currency businesses in New Jersey to promote the creation of jobs within the state. However, the bill died.

New Hampshire. In February 2015, eight New Hampshire state representatives introduced a House Bill (HB 552) which would make New Hampshire the first state to officially accept Bitcoin as payment for taxes and fees. However, this bill died as well.

Kansas, Texas and South Dakota have issued guidance regarding virtual currency, which tends to treat Bitcoin exchanges as money transmitters, provided they meet certain conditions.

 

Conference of State Bank Supervisors (CSBS)

On September 15, 2015, the Conference of State Bank Regulators (CSBS) released the CSBS Model Regulatory Framework for State Regulation of Certain Virtual Currency Activities (Model Framework). The Model Framework encourages states to license and supervise virtual currency businesses to protect consumers and the marketplace while supporting innovation. The Model Framework covers companies involved with third-party exchange or transmission of virtual currency, as well as services that facilitate the third-party exchange, and the storage or transmission of virtual currency (i.e., wallets, vaults, kiosks, merchant-acquirers, and payment processors). The Model Framework also provides a definition of virtual currency that focuses on the unit of account itself rather than the software enabling its use. The Model Framework recommends a Nationwide Multistate Licensing System (NMLS) to process and evaluate license applications. This system would allow states to share information, including licensing and enforcement data. The Model Framework does not require licensees to have cyber insurance, but it does mandate procedures for how private keys are transferred or recovered if a licensee fails.

 

Financial crimes enforcement network (FinCEN)

The U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) treats dealers in foreign exchange, providers and sellers of prepaid access, and money transmitters as “money services businesses” (MSBs). An MSB must maintain an anti-money laundering (AML) program, and comply with registration, reporting and recordkeeping requirements. Money transmitters are also subject to the Bank Secrecy Act (BSA), as implemented by FinCEN regulations. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (Patriot Act) makes it a crime to operate an unlicensed money transmission business. Licensing such businesses is primarily intended to protect consumers.

FinCEN issued guidance on March 18, 2013, on the use of virtual currency, including Bitcoin. These regulations distinguish between currency of a state, or “real currency,” and “virtual currency.” FinCEN defines virtual currency as “a medium of exchange that operates like a currency in some environments but does not have all the attributes of real currency.” In particular, convertible virtual currency has an equivalent value in real currency or acts as a substitute for real currency. FinCEN regulations also conclude that “administrators” (which are engaged in the business of issuing and redeeming virtual currencies) and “exchangers” (which are engaged in the business of exchanging virtual currency for real currency, funds, or other virtual currency) of convertible virtual currency are money transmitters, and therefore MSBs, whereas “users” of convertible virtual currency are not MSBs. As of September 1, 2016, FinCEN has registered 27,927 MSBs.

EXAMPLE: In May 2015, Ripple Labs Inc. and its wholly-owned subsidiary, XRP II, LLC, were the subject of FinCEN’s first virtual currency enforcement action when they were fined $700,000 for violating the BSA by operating an MSB and selling XRP a.k.a. Ripple (the third largest virtual currency in the world after Bitcoin and Ethereum) without registering with FinCEN, and by failing to implement sufficient AML protections. The Ripple entities were operating as “exchangers” and “administrators” and, therefore, were money transmitters that had to be registered with FinCEN and maintain proper AML programs. According to FinCEN Director Jennifer Shasky Calvery, “Virtual currency exchangers must bring products to market that comply with our anti-money laundering laws. Innovation is laudable but only as long as it does not unreasonably expose our financial system to tech-smart criminals eager to abuse the latest and most complex products.”

In January 2014, FinCEN issued two administrative rulings providing additional insight into whether conduct related to virtual currency qualifies someone as a money transmitter. Application of FinCEN’s Regulations to Virtual Currency Mining Operations (FIN-2014-R001) concluded that a user who creates or mines virtual currency solely for his or her own purposes is not a money transmitter under the BSA. Application of FinCEN’s Regulations to Virtual Currency Software Development and Certain Investment Activity (FIN-2014-R002) concluded that a company purchasing and selling virtual currency as an investment exclusively for the company’s benefit is not a money transmitter.

FinCEN Form 114, Report of Foreign Bank and Financial Accounts (known as FBAR), must be filed by U.S. persons with an interest in foreign accounts with an aggregate value of more than $10,000. A business that transfers virtual currencies or that exchanges virtual currencies for real currencies is a money transmitter and a financial institution for FBAR purposes. A U.S. individual who stores Bitcoins with any of the Bitcoin exchanges located in foreign countries (as most are) is arguably subject to FBAR reporting if the value of the Bitcoin holdings exceeds $10,000 at any time during the year, according to the American Institute of Certified Public Accountants (AICPA). However, in June 2014, an IRS official stated that Bitcoins were not reportable on FBAR, at least for the 2014 filing season. To date, no official guidance from the IRS has been issued regarding future tax years.

An online wallet stores copies of private keys for accessing Bitcoin addresses and does not have control or custody over Bitcoins. Therefore, an online wallet service should not be considered a money transmitter, and a person who uses a foreign online wallet does not appear to be subject to FBAR reporting requirements.

 

FATCA

The Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions (FFIs) to report to the IRS information on financial accounts held by U.S. taxpayers, or by foreign entities controlled by U.S. taxpayers. In addition, individuals with at least $50,000 in foreign financial assets must file Form 8938, Statement of Specified Foreign Financial Assets. Foreign assets that are subject to FATCA reporting requirements include accounts with any FFI.

Bitcoin exchanges accept deposits in the ordinary course of business and therefore may be considered financial institutions for FATCA purposes, although the law on this subject is undeveloped at this time. The AICPA recommends that Bitcoin deposit accounts be reported in the summary information in Part I of Form 8938. Specific information should be given in Part V. However, online wallets do not need to be reported for FATCA purposes. Because Form 8938 is attached to the taxpayer’s return, persons who are not required to file a return need not file Form 8938.

 

TREATMENT BY OTHER NATIONS

Other countries have also been working to clarify the tax treatment of virtual currencies.

Virtual currency can be exchanged tax-free in the European Union. In October 2015, The European Court of Justice (ECJ) ruled that virtual currency, such as Bitcoin, should be treated like fiat currency and consumers should not be taxed when trying to buy or sell it. The ECJ ruled that Bitcoin transactions “are exempt from VAT (value-added tax) under the provision concerning transactions relating to currency, bank notes and coins used as legal tender.”

In August 2013, Germany declared Bitcoin to be a “unit of account” that can be used for tax and trading purposes in the country. Bitcoin is not classified as e-money or foreign currency but is rather a financial instrument similar to “private money.” The classification means that while personal use of virtual currency is tax-free, commercial enterprises using Bitcoin are taxed.

The HM Revenue & Customs (HMRC, United Kingdom tax authority) changed its classification of Bitcoin and other virtual currency from a tradable voucher to private currency. Exchanging or mining Bitcoins is exempt from VAT in the United Kingdom, but accepting Bitcoins for goods and services is subject to VAT.

This closely mirrors similar tax guidance issued in Singapore, which treats Bitcoins like a product subject to its goods and services tax (i.e., like neither currency nor pure capital gains).

China has tried to discourage the use of virtual currency such as Bitcoin. Its largest e-commerce website, Alibaba Group Holding, Ltd, has banned the sale of Bitcoin and other virtual currencies. This ban includes mining software and hardware for virtual currency. None of Alibaba’s platforms has accepted Bitcoin as a payment method, and the company’s payment affiliate, Alipay, does not support websites that use Bitcoin. These rules come as a result of regulations from China’s central bank, enacted in response to concerns about Bitcoin’s volatility. Many third-party payment systems have stopped processing transactions for Bitcoin purchases.

While Bitcoin is not illegal in Taiwan, Taiwan’s Financial Supervisory Commission banned Bitcoin ATMs, calling Bitcoin a “false currency.”

In Bangladesh and Bolivia virtual currency has been banned altogether.

Japanese legislators passed a law in May 2016 requiring virtual currency exchanges operating in Japan to register with Japan’s Financial Services Agency (FSA). The law also brought virtual currency exchanges under the country’s anti-money laundering and know-your-customer rules by classifying virtual currency as a type of prepaid payment instrument.

Bitcoin use is growing in Argentina, a nation with a history of periods of high inflation. Many Argentinians consider Bitcoins a safer investment than the official currency. As a consequence, Argentina may ban digital currency.

 

Financial Action Task Force (FATF)

The Financial Action Task Force (FATF) is an inter-governmental organization representing most of the world’s major economies, including the United States. It was established to combat money laundering, terrorism financing and “other related threats to the integrity of the international financial system.” In June 2015, FATF published Guidance for a Risk-Based Approach to Virtual Currencies. The guidance is intended to aid national authorities seeking to develop regulatory regimes. The report includes benefits of virtual currencies as well as potential risks of money laundering and terror financing. While summarizing approaches taken in other jurisdictions, the guidance advises countries to take a risk-based approach to identify and mitigate money laundering and terrorist financing risks; urges member nations to gain a deeper understanding of how virtual currencies function; and recommends that all virtual currency exchanges should be registered and licensed, subject to the same regulations as other financial institutions and money transfer businesses.

COMMENT: Some predict that the FATF guidance will have the same effect as BitLicense had on New York-based Bitcoin startups but on a global scale by hampering further development of Bitcoin technology.

 

DERIVATIVE MARKET

A Dublin-based market in 2013 announced the creation of Bitcoin Options Spreads, enabling both long- and short-term positions to be created on the virtual currency. Since then, other entrepreneurs have joined the fray, dealing in options involving virtual currency.

EXAMPLE: In March 2014, TeraExchange announced that it would start handling Bitcoin derivatives swap agreements, which would give investors a way to hedge against the extreme variation in prices for Bitcoins.

EXAMPLE: Hong Kong-based BitMEX is another derivatives exchange that has worked to introduce a range of novel instruments to the digital currency space. Among these is a “fear index” for Bitcoin, which tracks the digital currency’s volatility and allows traders to make bets on its movements.

EXAMPLE: In February 2015, a new Bitcoin derivatives trading platform called Crypto Facilities launched in London. Crypto Facilities currently lets customers trade just one instrument, a forward contract on the Bitcoin price, where a trader can lock in the price of a Bitcoin by selling or shorting a forward.

Virtual and real currencies are subject to different market dynamics. Bitcoins can be difficult to hedge against because many traditional financial instruments cannot be used to mitigate the risk. The fact that Bitcoin transactions are anonymous also makes it hard to track down market manipulation. The volume of the virtual currency derivatives market is relatively low but is growing.

 

Commodity Futures Trading Commission (CFTC)

The U.S. Commodity Futures Trading Commission (CFTC) regulates commodities futures, their markets, and certain foreign exchange instruments. As interest in Bitcoin derivatives has increased, the CFTC has turned more of its attention toward virtual currencies.

EXAMPLE: On September 17, 2015, in In re Coinflip. Inc., the CFTC settled its first Bitcoin enforcement action against an unregistered online platform for facilitating the trading of Bitcoin options contracts. The CFTC charged San Francisco-based startup Coinflip Inc., d/b/a Derivabit, and its founder and CEO Francisco Riordan with conducting activity related to commodity options without registering with the CFTC. In the settlement order, the CFTC held that Bitcoin and other virtual currencies are commodities covered by the Commodity Exchange Act (CEA) because Section 1a(9) of the CEA defines commodity to include “all services, rights, and interests in which contracts for future delivery are presently or in the future dealt in.”

EXAMPLE: On September 24, 2015, in In re TeraExchange, LLC, the CFTC issued a cease-and-desist order to a registered swap market called SEF (swap execution facility) after finding that the SEF publicly claimed that certain Bitcoin trades represented actual market liquidity when they were in fact prearranged wash trades.

EXAMPLE: On June 2, 2016, in In re BFXNA, Inc., the CFTC issued an order filing and simultaneously settling charges against Hong Kong-based Bitcoin exchange, BFXNA, Inc., d/b/a Bitfinex, for offering illegal off-exchange financed retail commodity transactions in Bitcoin and other virtual currencies, and for failing to register as a Futures Commission Merchant as required by the CEA. The order required Bitfinex to pay a $75,000 civil monetary penalty and to cease and desist from future violations of the CEA.

As long as interest in Bitcoin derivatives persists, the CFTC is likely to continue to actively regulate them in the coming years.

 

TAX ISSUES

The following tax issues with respect to virtual currencies have arisen since the IRS issued Notice 2014-21 and have not yet been resolved.

PFIC and CFC Implications

It is not clear whether virtual currencies should constitute passive assets for purposes of the 50 percent asset test for passive foreign investment companies (PFICs). However, income from the sale or exchange of virtual currencies should constitute passive income for purposes of the 75 percent gross income test for PFICs. This is because virtual currencies do not give rise to any income; income from the sale or exchange of virtual currencies should be includible as subpart F income for purposes of the rules applicable to controlled foreign corporations (CFCs).

Hedging and Notional Contracts Considerations

A taxpayer hedging the risk of fluctuation in the value of its virtual currency is not guaranteed ordinary income treatment under the specialized tax rules applicable to hedging transactions. It is also not clear whether the tax rules applicable to notional principal contracts would apply to swaps or other derivatives when the payments are calculated by reference to published virtual currency exchange rates, because it is not clear whether they would be considered a specified index.

Like-Kind Exchanges

Certain types of property cannot be traded in a tax-deferred like-kind exchange, including  stocks, bonds, notes, or other securities or evidences of indebtedness, partnership interests, certificates of trust or beneficial interests, choses in action, and foreign currencies. Virtual currencies are not expressly included in the list of ineligible property, so it is not clear if they could be part of a like-kind exchange.

Intangible personal property can qualify for a like-kind exchange, but the regulations do not provide much additional guidance. The exchanged properties must be of like kind; properties that are of like class do not qualify. Whether intangible personal properties are of like kind depends on the nature or the character of the rights involved, as well as the nature of the underlying property. This regulation was clearly drafted with more traditional intangibles such as copyright in mind, and its application to exchanges involving virtual currency is unclear. It also is not clear whether a like-kind exchange could involve one type of virtual currency for another—for instance, Bitcoin exchanged for Ethereum.

Mark-to-Market Rules of Code Secs. 465 and 1256

It is not clear whether a taxpayer who deals or trades in virtual currencies could take advantage of the elective mark-to-market rules that are available to dealers in commodities and traders in securities and commodities. Additionally, because a derivative contract with respect to a virtual currency would not be considered a “Section 1256 contract,” it would not need to be marked-to-market either.

Treatment of Mining Pools as Entities

Miners who engage in pooled mining might be treated as a partnership or other entity for U.S. federal tax purposes. Special tax rules apply to entities, including ongoing reporting obligations.

Potential Exclusions from Specified Foreign Financial Asset Reporting

The rules applicable to the reporting of “specified foreign financial assets” do not appear to contemplate property such as virtual currencies and appear outside of the scope of the reporting obligations by U.S. individuals.

Charitable Contributions of Virtual Currencies

Though Notice 2014-21 indicates virtual currency is property, it is not clear that such treatment also applies in the context of charitable contributions. Cash is regarded as intangible personal property for purposes of the charitable deduction rules, and money of a bullion or numismatic nature has been ruled in to be tangible personal property and has been treated as such for the charitable tax rules.

Foreign Tax Credit Implications

It is not clear whether the gains from the sale or exchange of virtual currency will be sourced under the rules applicable to personal property sales and treated the same for purposes of determining a taxpayer’s foreign tax credit limitation.

Constructive Sales and Straddles

The rules applicable to constructive sales do not contemplate monetization transactions with respect to virtual currencies. It is also not clear whether the rules applicable to straddles apply equally to virtual currencies and that virtual currency constitutes personal property of a type that is “actively traded.”

Barter Transactions

In the 1970s, “barter clubs” were formed as a means of avoiding income tax obligations by allowing their members to trade services or goods among themselves, and thus avoid receiving cash. Members of the club earned “trade units” by offering their own services, which could be exchanged for other goods and services listed by the club. The IRS concluded that such transactions became taxable when the trade units were received, rather than later, when the trade units were redeemed. In other words, a member of a barter club received income for his or her services on receipt of trade units because the receipt of trade units constituted the receipt of valuable property that could be redeemed for goods or services at any time. This made the receipt of trade units a taxable event.

If virtual currency is treated as property under Notice 2014-21, the exchange of units of the currency for other property looks much like the exchange of two pieces of property for each other, or barter. This is consistent with the IRS position that a taxpayer receiving virtual currency in an exchange must include the value of that currency in income. Although the IRS has not expressly compared the exchange of virtual currency to barter exchanges, concepts underlying the IRS’s policy on barter, such as the actual receipt doctrine and the constructive receipt doctrine, could be applied to virtual currency. It remains unclear exactly how much of the law that has developed around barter exchanges (such as an analysis of a trade unit’s liquidity or nonassignability, that is, of substantial limitations or restrictions on the use of the units) would apply to virtual currency transactions.

 

AICPA Request for Additional Guidance

On June 10, 2016, the American Institute of Certified Public Accountants (AICPA) asked the IRS for more guidance on virtual currency beyond Notice 2014-21 to provide clarification to taxpayers and practitioners and to boost compliance with federal tax laws.

The AICPA identified 10 additional areas where guidance would be helpful:

1) Acceptable valuation and documentation;

2) Expenses of obtaining virtual currency;

3) Challenges with specific identification for computing gains and losses;

4) General guidance regarding property transaction rules;

5) Nature of virtual currency held by a merchant;

6) Charitable contributions;

7) Virtual currency as a “commodity;”

8) Need for a de minimis election;

9) Retirement accounts; and

10) Foreign reporting requirements for virtual currency.

Virtual currency transactions add a new layer of complexity to a client’s reporting requirements. “The issuance of clear guidance in this area will not only reduce the confusion and burden for tax preparers but also allow taxpayers to accurately comply with IRS rules,” Troy K. Lewis, CPA, Chair of the AICPA Tax Executive Committee, wrote in the June 10 letter to the IRS.

 

CONCLUSION

The IRS has joined other jurisdictions in publishing guidance regarding the income tax consequences of convertible virtual currency transactions but left many tax issues unaddressed. Notice 2014-21 applies existing general tax principles to transactions using virtual currency and states that virtual currency should be treated as property rather than currency for U.S. federal income tax purposes. Although the immediate implications of the Notice are apparent, the long-term consequences are still being considered. As virtual currencies grow in popularity, federal, state and international regulators will continue to refine and revise their approaches to virtual currencies and their users. Persons that are engaged in “mining” activities, investments, or any other use of virtual currencies should closely monitor the activities of the regulators to stay abreast of this rapidly developing area of law.

AUTHOR

Elena Eyber, J.D.

Editor, Wolters Kluwer Tax & Accounting US

All stories by: Elena Eyber, J.D.

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