Tax Analysts®Tax Analysts®

My Subscriptions:

Featured News

March 20, 2014
News Analysis: The Tax Implications of Bitcoin
by Stephanie Soong Johnston

Full Text Published by Tax Analysts®

Shockwaves rippled through the cryptocurrency world on February 25 when Mt. Gox, the world's largest Bitcoin exchange, collapsed without warning, leaving panicked users in its wake. Three days later, the company filed for bankruptcy protection in Japan, confirming that it had lost 750,000 of its users' Bitcoins, in addition to 100,000 of its own, because of a software bug in its system. That flaw caused a spike in incomplete Bitcoin transfers, which left the system vulnerable to hackers. Mt. Gox ultimately lost more than $500 million worth of Bitcoins.

Chaos ensued in the following days, and for a time, Bitcoin's future was in doubt. Up until the Mt. Gox debacle, Bitcoin appeared to be gaining momentum. It was introduced in 2009 as a software-based peer-to-peer payment system and digital currency; its creation is widely attributed to the mysterious Satoshi Nakamoto. The decentralized cryptocurrency, which has no government and no central bank, has raised several tax and legal questions.


The Rise of 
Bitcoin

In five years, Bitcoin grew from being a relatively obscure payment system to an accepted form of payment for many vendors, including Overstock.com. It has grabbed headlines in the mainstream media and has piqued the interest of international governments, which slowly realized that cryptocurrencies are here to stay as part of the constantly evolving digital economy.

While the Bitcoin community rallied, distancing itself from Mt. Gox and blaming its collapse on the exchange's own internal flaws rather than on the cryptocurrency itself, HM Revenue & Customs quietly issued brief 09/14 on March 3 about the tax treatment of activities involving Bitcoin and other kinds of cryptocurrencies.

The brief, which came at a crucial time for Bitcoin, clarifies the U.K. tax authority's position on the cryptocurrency and offers guidance for Bitcoin traders, exchanges, payment processors, and other Bitcoin service providers, as well as Bitcoin miners (individuals who use special software to solve complex algorithms and are given a specific number of Bitcoins in exchange). It also addresses how the U.K. tax authority views Bitcoin for capital gains tax, corporation tax, and income tax purposes.

HMRC's position on VAT is notable, as the brief makes it clear that Bitcoin mining and trading activities are exempt from the 20 percent VAT in the U.K. (However, VAT is due in the normal way for suppliers of goods or services sold in exchange for Bitcoin or other cryptocurrencies.)

The cryptocurrency community hailed the brief as a show of support for Bitcoin, particularly for Bitcoin exchanges. Previously, HMRC had classified Bitcoin as a taxable voucher, which would have meant that exchanges selling Bitcoins in the U.K. would have had to cover VAT costs by tacking on a 20 percent markup, which put U.K. exchanges at a disadvantage compared with exchanges in other countries.

"Charging VAT on the gross value of Bitcoins sold to consumers makes little sense, as it would make it uneconomic for traders to operate in the U.K. and would simply drive the market offshore," Bill Dodwell, head of tax policy at Deloitte LLP, told Tax Analysts. "It would therefore be sensible to exempt Bitcoin from VAT, which would also have the benefit of reducing the scope for VAT fraud."

Digital currency exchange Elliptic (formerly BitPrice), which spearheaded discussions between HMRC and Bitcoin businesses and users in 2013 to challenge HMRC's voucher designation, welcomed the move as well. In a March 3 blog post, Elliptic praised HMRC for giving cryptocurrencies legitimacy, especially in the shadow of Mt. Gox's demise. "Regulators and governments worldwide will be influenced by HMRC's ruling and it could have a profound effect on the long-term success of digital currencies," Elliptic said.

Governments around the world are thinking about Bitcoin -- what it is, what it does, if and how it can be regulated, and how it can be taxed, if at all -- with mixed results.


Real Talk About Virtual Money

A few countries have banned Bitcoin outright. Russia, for example, outlawed Bitcoins in early February, warning that they could be used for money laundering and financing terrorism. Vietnam's government on February 27 followed suit, announcing that trading in Bitcoin and other cryptocurrencies is illegal.

Some governments have taken no action. A spokeswoman for the Finance Ministry of Estonia told Tax Analysts that Bitcoin is not a growing concern for Estonian tax authorities.

"If such concern arises, it will be dealt with, but at the moment there is no regulation in place or planned regardingBitcoins or similar instruments," she said.

Other countries are taking a closer look at Bitcoin before publishing any official guidance for tax purposes. For example, in late December 2013, Indian tax authorities visited CoinMonk Ventures, a Bitcoin mining start-up, to discuss how miners and Bitcoin businesses may be taxed. Although the Bitcoin community is thought to be very small, the cryptocurrency began gaining traction in the latter half of 2013, according to Sathvik Vishwanath, founder of CoinMonk. Vishwanath, who also heads the Bitcoin Alliance of India, a Bitcoin advocacy association, said that tax authorities appeared to be cooperative.

"The Bitcoin community in India is totally willing to collaborate with and even accommodate the government to ensure the legal and tax treatment for Bitcoin come to existence," Vishwanath told Tax Analysts.

Switzerland's Federal Council in October 2013 adopted a postulate1 from the Swiss parliament about Bitcoins, which asks for input to evaluate the impact and risks of digital currencies.

A spokesman for the Swiss Federal Tax Administration told Tax Analysts that no guidance has been issued yet to taxpayers completing transactions in Bitcoin but noted that "based on the current laws, it is possible to determine taxation of income or fortune in digital currency or regarding the value added tax."

Sweden has taken a keen interest in the evolution of Bitcoin and other cryptocurrencies, and Skatteverket, the Swedish tax agency, discusses the tax enforcement consequences of digital currencies "very actively," an agency spokeswoman told Tax Analysts.

Skatteverket has noticed a slight increase in questions from the public regarding the tax treatment of Bitcoin, especially "whether there is an obligation to pay VAT when buying and selling Bitcoins and the tax treatment of earnings related to Bitcoin mining," she said.

She added that some issues relating to Bitcoin have been examined by the Tax Law Board, which may, on application, give binding rulings on tax issues. One recent case the board examined focused on whether individuals selling or buying Bitcoins must pay VAT. The board held that individuals are not liable to pay VAT, and Skatteverket is appealing the decision. Until then, "information to the public, via the authority's information channels, will be expanded as the clarity is reached on the issues," the spokeswoman said.

The Australian Taxation Office (ATO) is keeping a close eye on Bitcoin as well and is doing some work on monitoring Bitcoin and other payment systems as part of its normal monitoring of developments for which there may be tax consequences. However, for the most part, Bitcoin "has not yet raised any taxation issues that don't exist with either physical cash or electronic payment systems," an ATO spokeswoman told Tax Analysts.

She noted that, in general, the tax rules that apply to conventional commercial transactions also apply to transactions carried out through the Internet or with emerging payment systems, such as cryptocurrencies.

For example, sellers of goods and services that accept new types of payment tokens such as Bitcoins might still need to account for GST or include the income in a business tax return. Buyers may also need to keep detailed records about the value of a purchase if it represents a business expense, or if the purchase is an asset that might be subject to a capital gain or loss. Also, the values that buyers and sellers use in these types of transactions must be identical and consistent with market prices, according to the spokeswoman.

She also stressed that it is important for taxpayers to keep detailed records when engaging in any transactions involving Bitcoin or other payment systems by keeping track of any trades they make and citing the benchmarks by which the value of a transaction is estimated in Australian dollars. "This will minimize the risk of there being a difference of opinion between a taxpayer and the ATO over the correct valuation and treatment of a transaction for taxation purposes," the spokeswoman explained.

Singapore also weighed in on the Bitcoin issue. "Like other taxable transactions, IRAS closely monitors potential tax compliance risks posed by the use of virtual currencies by individuals and businesses," a spokeswoman for the Inland Revenue Authority of Singapore (IRAS) told Tax Analysts.

She said that individuals and businesses accepting digital currencies such as Bitcoin for remuneration or revenue are subject to normal income tax rules. Also, businesses that purchase and sell digital currencies will be taxed on the profit arising from trading and mining. While some businesses that buy digital currencies for long-term investment might get a capital gain upon disposal, no tax is due because Singapore does not charge capital gains tax.

Regarding GST treatment, "virtual currencies are not considered as 'money,' 'currency,' or 'goods' for GST purposes," the spokeswoman said. "Instead, the supply of virtual currency is treated as a supply of services, which does not qualify for GST exemption."

Also, if digital currencies are used to pay for goods and services, such transactions are classified as barter trades in Singapore. GST would be charged if both the supplier and the customer are registered for GST purposes, but if a customer uses Bitcoin to pay a supplier outside Singapore, the customer does not have to charge GST because the supply will be zero rated.

A GST-registered business selling Bitcoins outright would also need to charge GST on those sales, unless it's a sale to a customer outside Singapore. However, if the business acts as an agent for another party, GST must be charged on the commission fees it receives, unless the service is supplied to a customer outside Singapore, the spokeswoman added.

The German Federal Ministry of Finance took a slightly different approach by recognizing Bitcoins as "a unit of account," comparable with foreign exchange accounting units that are not legal tender. In the German government's view, Bitcoin is a financial instrument similar to "private money," and Bitcoin mining amounts to private money creation, whose profits are subject to a capital gains tax of 25 percent unless they are held for more than a year.

A few countries have posted public statements about Bitcoin and when and how taxpayers should report them. The Canada Revenue Agency, for instance, published a fact sheet2 in November 2013 that explains what digital currency is and clarifies that existing tax rules apply to digital currency transactions.

"Barter transaction rules apply where Bitcoins are used to purchase goods or services," a CRA spokesman told Tax Analysts, citing Interpretation Bulletin IT-490,3 which says that in a barter arrangement between arm's-length persons, the value of whatever is received is "at least equal to the value of whatever is given up."

In cases where Bitcoins are bought and sold like a commodity, any resulting gains or losses may be classified as income or capital depending on the circumstances, the spokesman added, citing Interpretation Bulletin IT-479R,4regarding transactions in securities, to determine whether transactions are capital or income in nature.

The Norwegian Directorate of Taxes also published a statement in November 2013 explaining that Bitcoins are assets liable to tax, just like other taxable assets in Norway, according to Hans Christian Holte, director-general of the Norwegian Tax Administration (Skatteetaten), noting that his department has not and cannot make a decision on whether Bitcoin is a currency.

"Thus profits from trading Bitcoins are liable to tax, like profits from the trade of other assets, and losses from trading can be deducted," he told Tax Analysts, adding that the tax rate is 27 percent and that Bitcoins owned at the end of the year are taxable under the wealth tax as assets valued to the market price in Norwegian krones at the end of the year.

Businesses that sell Bitcoins will be liable for 25 percent VAT on turnover, in line with the tax administration's view that Bitcoins are electronic services and not financial services, which are exempt from VAT.

Many countries have offered some kind of guidance about the taxation of Bitcoins, but none has attempted to regulate the cryptocurrency. However, the Japanese government reportedly announced plans that it would set rules for trading Bitcoin and impose taxes on the digital currency. According to a March 5 report in the Nikkei Asian Review,5 the government will call for taxing all Bitcoin transactions. Purchases made with Bitcoin will be subject to an 8 percent consumption tax beginning April 1, and trading gains as well as corporate revenue arising from Bitcoin-related transactions will also be subject to tax.


No Guidance Yet From the U.S.

While several of the world's largest economies have gone public with their opinions about what Bitcoin is and how a taxpayer should report it for tax purposes, the United States has remained curiously mum so far on the subject.

In May 2013, the Government Accountability Office published an extensive report for the U.S. Senate Finance Committee, urging the IRS to implement measures to offer taxpayers information on virtual economies and to issue reporting requirements for digital-currency-related transactions involving real-world goods and services. The report noted that because virtual economies and digital currencies are relatively new phenomena, the extent to which their use leads to taxpayer noncompliance is unclear. As a result, it's understandable that the IRS has not yet implemented a compliance approach tailored to address virtual economies and digital currencies, according to the GAO.

The IRS posted a statement6 on its Web page to help taxpayers understand how transactions in virtual economies may have tax consequences, but more should be done, according to the GAO.

"The fact that misinformation is circulating and the possibility of growth in the use of virtual currencies outside virtual economies suggest that it would be prudent to take low-cost steps, if available, to mitigate potential compliance risks," the GAO wrote in the report.

National Taxpayer Advocate Nina Olson went a step further when she identified the lack of clarity over the taxation of Bitcoins as one of the "most serious problems" dogging the IRS, in her 2013 annual report to Congress.

According to the report, Bitcoin transactions have increased over the past year, and taxpayers are confused about the tax treatment of the transactions, as well as their reporting obligations.

"People who are trying to comply with these rules have complained that they are unsure about them," Olson wrote. "Thus, IRS-issued guidance would promote tax compliance, particularly among those who want to report digital currency transactions properly, and it would reduce the risk that users of digital currencies will face tax consequences that they did not anticipate."

The IRS has said it continues to study virtual currencies and "intends to provide some guidance on the tax consequences of virtual currency transactions."

Treasury has also said it will coordinate with the IRS and is expected to weigh in on how taxpayers should treat Bitcoin, according to recent remarks by Karl Walli, senior counsel (financial products) at the Treasury office of the Tax Legislative Counsel.

One possible reason why the IRS has not said much publicly about the tax treatment of Bitcoin is that it may be taking a wait-and-see approach, according to Jonathan Zelnik, of KPMG's Washington National Tax practice, to determine whether special guidance is needed. It's not clear whether most Bitcoin-using taxpayers are holding them for speculative purposes or using them to purchase and sell goods and services. Once it becomes apparent that Bitcoins are becoming more widely accepted as a form of payment, that's when the IRS might want to step in.

"You could understand why a tax administrator would say, 'Let's see what happens with this. Is this even going to be around next year or two years from now? Do we want to commit resources and time to a project that may be more or less important in the future?'" he told Tax Analysts.

The IRS has several questions to consider in determining how Bitcoin should be classified for tax purposes, Howard Wiener, also of KPMG's Washington National Tax practice, told Tax Analysts.

The first question is whether Bitcoin is a currency. If it is, the special currency rules of the code apply. If it is property that is not a currency, the further question is whether it is ordinary or capital, he said. That depends on many factors as well: who holds Bitcoins and why they acquired them. The question whether the cryptocurrency is deemed to be a currency or not is a difficult one. After all, there is no clear definition of currency under the tax code, and arguments could be made on both sides of the Bitcoin, so to speak.

"Once you work through the decision tree and determine whether it's property and further determine whether its capital or ordinary, then general tax principles should follow," Wiener said. "It's ultimately going to come down to a question of characterization. There shouldn't be a need for special rules for Bitcoin."

In the end, the IRS could very well end up punting the task of making an official determination whether Bitcoin is a currency to Congress because it doesn't think it has the authority to do so, he added.

However, according to Omri Marian, assistant professor of law at the University of Florida and an expert on Bitcoin, the IRS should have enough authority to issue partial or preliminary guidance, or, at the very least, define Bitcoin for tax purposes to help taxpayers report their income and losses this year.

While he speculated that the IRS probably wants to take its time to get its guidance right the first time, this will be the first filing season that Bitcoin will have significant implications for some taxpayers. Without some kind of guidance, the IRS "is going to see contradicting positions from taxpayers," he told Tax Analysts.

"If there is no guidance, then the IRS will be confronted with contradicting views from taxpayers and the IRS would have to respond somehow," Marian added. "That means the IRS would be led by taxpayers and not leading [the taxpayer]. This may put the IRS in an awkward position."

Wiener noted that another reason why the U.S. may have been slower to comment on the tax treatment of Bitcoin compared with other countries is that the U.S. tax system "has unique complexities, particularly in distinguishing between different forms of property that other countries may or may not have."

Marian also pointed out that perhaps other countries were under more pressure to come out with an official position on Bitcoin because of the way their tax systems are set up. In the U.S., he said, everything is included in income from all kinds of sources, and it's clear that income arising from Bitcoin transactions is income. The question is what type of income it is and how and when one reports it.

"In other jurisdictions this is not necessarily the case because some have so-called scheduler systems, where income is taxable only to the extent you can fit it to a specific schedule," he said. "Scheduler systems are under much more pressure to say something about Bitcoin."

Even if the U.S. officially classifies Bitcoin for tax purposes, it could be possible that if countries view Bitcoins in different ways, it opens up the possibility of tax arbitrage, according to Marian.

"If an asset is a capital asset in one jurisdiction but is a currency in another jurisdiction, maybe I can somehow exploit it to get a double benefit," he said. "This is the basis of international tax planning, to utilize differences in how jurisdictions classify the same thing."

Then there is the question of enforcement: How can a tax administration ensure that taxpayers are complying with their? Bitcoin-related reporting obligations? Contrary to popular belief, the peer-to-peer system is not anonymous. Legitimate transactions are stored and made public on the Bitcoin network, making ownership fairly transparent and traceable. Also, most users will use a third-party provider to manage their Bitcoin wallets.

While the IRS could conceivably have all the information it needs related to any given transaction, and could enforce U.S. Bitcoin rules by pressuring U.S.-based Bitcoin service providers, the story would be different from a cross-border perspective. If the intermediary is located in, for example, Russia, the IRS probably won't be able to do anything about it under the current treaty framework, according to Marian.

"This is where you need international cooperation," he said, suggesting a solution akin to the Foreign Account Tax Compliance Act to facilitate cooperation in enforcing Bitcoin taxation. Under such a solution, governments would target Bitcoin exchanges instead of banks to get data on noncompliant taxpayers.

It's not a foolproof solution, he admits. After all, the only reason FATCA works is that the U.S. has leverage against foreign financial institutions with business in the U.S. That wouldn't be the case with Bitcoin exchanges.

"I don't know what leverage the U.S. would have in this context. This is where international cooperation is going to be much harder because then Russia will actually have to enforce some sort of leverage on behalf of the U.S. and the political implications are huge," he said.

Thinking too far ahead about the future of Bitcoin may be putting the cart before the horse. After all, there are many things about Bitcoin that are unknown or unknowable at this time. One is the uncertainty of Bitcoin's valuation. According to Coinbase.com, a Bitcoin was worth $42 on March 7, 2013; exactly one year later, the value shot up to $637 -- with plenty of fluctuations along the way.

The Bitcoin story has taken many twists and turns in the past month alone. Shortly after the Mt. Gox debacle, Flexcoin, a Bitcoin exchange in Canada, collapsed a day after hackers exploited weaknesses in its software code and stole all its Bitcoins.

Judging from the strange evolution of this mysterious cryptocurrency, it is no wonder that there are no concrete answers yet about its proper tax treatment. One thing is certain, however: Bitcoin -- and cryptocurrencies in general -- will continue to fascinate and confound tax practitioners, government officials, and cryptocurrency fans and hackers alike for the foreseeable future.


FOOTNOTES

1
 Available at http://www.parlament.ch/f/suche/Pages/geschaefte.aspx?gesch_id=20133687.

2 Available at http://www.cra-arc.gc.ca/nwsrm/fctshts/2013/m11/fs131105-eng.html?rss.

3 Available at http://www.cra-arc.gc.ca/E/pub/tp/it490/README.html/.

4 Available at http://www.cra-arc.gc.ca/E/pub/tp/it479r/it479r-e.html.

5 Available at http://asia.nikkei.com/Politics-Economy/Policy-Politics/Japan-to-regulate-Bitcoin-trades-impose-taxes.

6 Available at http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Tax-Consequences-of-Virtual-World-Transactions.


END OF FOOTNOTES

About Tax Analysts

Tax Analysts is an influential provider of tax news and analysis for the global community. Over 150,000 tax professionals in law and accounting firms, corporations, and government agencies rely on Tax Analysts' federal, state, and international content daily. Key products include Tax Notes, Tax Notes Today, State Tax Notes, State Tax Today, Tax Notes International, and Worldwide Tax Daily. Founded in 1970 as a nonprofit organization, Tax Analysts has the industry's largest tax-dedicated correspondent staff, with more than 250 domestic and international correspondents. For more information, visit our home page.

For reprint permission or other information, contact communications@tax.org