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November 7, 2012
Digital Currency: A New Worry for Tax Administrators?

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by David D. Stewart and Stephanie Soong Johnston

Controversies surrounding presidential candidates are old hat in any given election year, but 2012 could very well be the first time that hackers, presidential tax returns, and a mysterious digital currency called bitcoin all had starring roles in one of the oddest politically motivated tax capers in recent memory.

In early September it was reported that a group of hackers claimed to have broken into PricewaterhouseCoopers's Franklin, Tennessee, office in late August and copied Republican presidential candidate Mitt Romney's sought-after tax returns to thumb drives.

The hackers then said they had sent the thumb drives to local Democratic and Republican offices, along with ransom notes demanding that $1 million -- all in bitcoins -- be paid by September 28 to one of two accounts to destroy or release the cyberkey required to access the files contained on the thumb drives. (For prior coverage of the hacker incident, see Tax Notes, Sept. 10, 2012, p. 1253, Doc 2012-18670, or 2012 TNT 174-2.)

That deadline has since come and gone, and the incident was declared a hoax by many. But the news certainly accomplished one thing: shining the spotlight on bitcoin, a decentralized, peer-to-peer Internet currency that has been growing in popularity and prominence in the digital age -- and in doing so has raised a series of legal questions, especially in the area of taxation.

A 'Bit' of History

The currency was created in 2009 by Satoshi Nakamoto -- likely a pseudonym for the programmer or programmers responsible for developing the system. It is distinct from virtual currencies used in online gaming communities. Virtual currencies, such as World of Warcraft gold, function within the universe of the game but may be bought and sold using real-world currency. The function of virtual currencies is limited by their utility to other game players. (For discussions of the tax implications of virtual economies, see Tax Notes Int'l, Jan. 15, 2007, p. 149, Doc 2007-997, or 2007 WTD 10-8; and Tax Notes Int'l, Nov. 21, 2011, p. 579, Doc 2011-22984, or 2011 WTD 224-18.)

Bitcoins function as a unique currency with its own free-floating exchange. It has no government and no central bank and is intended to be used worldwide. Think of it as the Esperanto of currency.

Users can also send and receive bitcoins using unique Internet addresses and store their bitcoins -- each of which is broken down into 100 million units known as satoshis -- in a virtual wallet. The stored bitcoins, which offer some degree of anonymity to users, can then be used to buy everything from coffee and T-shirts to LSD tablets and drug-fueled energy drinks.

Tax Analysts sought out members of the bitcoin community as well as tax experts to identify what the implications are for tax administrators. Some believe that the system could be used to facilitate tax evasion, while others contend that the open nature of the transactions would deter such evasion. All believe, however, that bitcoins raise significant questions. For tax administrators, the challenge is how to approach a system that is outside the traditional streams of commerce and finance. For users, the challenge is how to navigate an ambiguous regulatory climate in which guidance is difficult to come by.

Bitcoin Basics

To get a sense of the possible tax issues associated with bitcoins, it's helpful to understand the basics of what the currency is, how it is made, how it works, and how it is being used to create and run a growing, real-world economy.

Tax Analysts contacted several experts whose opinions differed on whether bitcoins should even be considered a currency. Some noted its lack of government backing, some suggested that it is better thought of as a digital commodity, still others considered it more akin to a barter economy.

However, at its most basic level as a medium for exchange within the community, bitcoins do function as a currency. Users began using the code BTC to designate bitcoins, but BTC is not recognized by the International Standards Organization, which has authority over currency codes.

The bitcoin economy functions similarly to one of the many economies in the world in which U.S. dollars trade in parallel to the local currency. In such cases, buyers and sellers agree to a price using a reference currency with the exchange rate determining the price in the secondary currency.

Coffees from San Antonio-based BitBrew can be purchased only by using the bitcoin system. (Tax Analysts/Derek Squires)For example, BitBrew, a San Antonio-based retailer, offers for sale small-batch organic and fair-trade coffees. Twelve ounces of whole bean Karmic Sumatra sold for BTC 1.55 (express shipping included) as of October 2012 or just under $19. Grinding costs an additional BTC 0.04 per 12 ounces.

The coins themselves have no physical form and transfer from computer to computer via a system of cryptographic hashes. Bitcoin users can store their currency using software on their computer or use a web-based service to hold the coins in an account known as a wallet. Moving coins from user to user is done through a peer-to-peer system that operates through unique addresses. These 30-plus character addresses are visible on the network, but only the address creator knows to whom the address belongs.

When buying BitBrew coffee for instance, one completes a traditional online checkout process, but instead of making the payment then, the seller generates a unique address. Using a bitcoin wallet, the payment can be sent to the address where it is credited against the purchase and the merchandise is shipped.

Because of the length and complexity of the addresses, the bitcoin system makes extensive use of QR codes, which convert text into an image that can be read by any smartphone. Ownership of an address is known only to the address creator. However, larger transactions, which require more extensive hashes, could, in theory, be traceable. To get around this, some users that want to maintain anonymity have used techniques developed for money laundering to break down large blocks into smaller amounts that can be hidden within the system.

Bitcoin Mining

One innovation of the bitcoin economy is that the currency is not sold but rather distributed through a "mining" program.

To distribute bitcoins, the system creates what is in essence a math problem that must be solved by the user's computer. Because of the complexity of the problem, most computer users will see limited success in mining using a PC's processor. Serious miners have built specially designed rigs using the processors from computer graphics cards, which are uniquely suited to solving the problems.

Under the bitcoin program, the available pool of recoverable bitcoins will halve as part of a planned diminution of the distributions toward a goal of a finite currency supply. To allow for smaller transactions after an as-yet theoretical appreciation in the value of bitcoins, the currency can be traded to the eighth decimal place.

Distributed bitcoins trade as cash within the community and are also traded on an exchange that resembles a foreign currency trading system.

What separates bitcoins from tradable scrips such as Disney Dollars or Canadian Tire Money is that the coins trade on a floating exchange rather than having a fixed exchange rate pegged to a national currency. They function independently from any central bank and are created at a predetermined rate that is not subject to change for the economic cycle.

Bitcoins can be purchased in small quantities through money transfers. One company allows for the use of the MoneyGram bill payment system. A user that registers with only an e-mail address is given a unique account to which he sends the funds. Within 30 minutes, the money is credited to an account on a bitcoin exchange operated out of Japan.

The transfer agent, BitInstant, has registered with the U.S. Treasury Department's Financial Crimes Enforcement Network as a money services business. It imposes limits on the size of transactions that are lower than regulatory requirements and says that it regularly audits activity logs to detect money laundering activities.

Once the money has been credited to the Japanese exchange (Mt. Gox), it can be converted into bitcoins at the market rate. The bitcoins then are stored in an online wallet at the exchange, but can be transferred to the user's computer-based wallet through the bitcoin network.

At no point in the process of purchasing bitcoins is the user's identity verified beyond the requirement that he produce a valid e-mail address.

A Growing Circulation

According to Bitcoin Magazine, the currency has attracted more than 1 million users, and there are 8.5 million bitcoins in existence. The upper limit of bitcoins, however, is fixed at 21 million because of the way the bitcoin mining process works. The value of bitcoins varies widely. In June 2011, prices hit nearly $32 before soon plunging to $10.25. As of October 11, 2012, their closing value was at about $12 on Mt. Gox. At current rates, there is about $102 million in bitcoin value in circulation, with the potential to climb much higher should demand remain stable as the number of coins available from mining declines in November.

That may not seem like a lot of money for tax administrators to focus on at the moment, but what matters most is the potential for bitcoin to gain tremendous value and develop into a mainstream digital currency, said Matthew Elias, founder of the Cryptocurrency Legal Advocacy Group (CLAG), a nonprofit organization based at the University of Mississippi School of Law.

"I think one of the most important and most overlooked [questions] is the entire issue of taxation," he said. "When they're created, is it a taxable event? When they're spent or purchased on an exchange, is that a taxable event? There are a number of questions that come up from the tax angle alone that are interesting to explore."

Jim Carr, a partner with KPMG LLP's International Corporate Services in Santa Clara, California, also sees potential for Internet-based currencies to garner government attention.

"It's entirely possible that the volume of transactions using virtual currencies could become significant enough to eventually attract the attention of the tax authorities," he said, adding that as virtual economies evolve and grow more sophisticated, new and creative ways of using such an exchange medium are likely to emerge. "Those two things could ultimately result in new statutes or regulations that seek to mandate tax reporting for certain types of transactions involving such currencies."

Security Issues

Tax Analysts spoke with a computer security expert, who requested anonymity, on the bitcoin system, its users, and the potential for money laundering and tax evasion. The computer security expert said the anonymous nature of bitcoins appeals to groups that think of themselves as anarchists and libertarians.

"Really what has attracted the hacker community is that it has an anarchist or anti-federalist swing to it just by its development and the fact that you can trade money anonymously and untraceably, because bitcoin exchanges don't trace where the money is going," the computer security expert said. "You are essentially just exchanging cryptographic hashes."

The expert noted that bitcoins were used as a medium to donate to the hacker group LulzSec, an offshoot of a larger collective of "hacktivists" that targets major corporations with attacks aimed at breaching weak security and exposing private data. The group, whose name uses Internet slang to mean "laughing at your security," attacked information security firm HBGary. The group claims to have collected thousands of dollars in donations through its bitcoin address.

According to the computer security expert, the trouble with the bitcoin anonymity does not end with the anonymous addresses. In the case of the LulzSec donations, the group has used money laundering techniques to obscure large donations. Bitcoin software allows for creating as many unique addresses as one needs. The expert explained that a large donation to LulzSec was quickly broken down into smaller amounts that moved from one address to another to the point where they could be hidden within the other transactions through the bitcoin system.

What should be of concern for governments, said the computer security expert, is that the bitcoin could allow for the movement of large amounts of money easily without the controls that apply to the banking sector such as reporting requirements on large transactions. The expert noted that transferring value anonymously through bitcoins would even be easier than moving a similar amount in cash.

"If you imagine trying to move $100,000, that is heavy, even in $100 bills, but for me to move 10 cryptographic hashes containing $10,000 each, it takes me 30 minutes to move it halfway around the world," the computer security expert said. "It is easy to move money and to hide money. The difficulty lies in trying to realize the value of the money."

Currently, there are limited venues for converting bitcoins into tangible goods. Exchanges allow for the conversion of bitcoins back into national currencies and a limited number of retailers have opened that allow bitcoins to be used to purchase legitimate goods while others sell illicit substances.

Some websites offer online gambling that uses bitcoins to circumvent restrictions on funding online gaming accounts, and one notorious website called Silk Road, which is steadily growing in size and scope, exclusively uses bitcoins for the purchase of illegal drugs. According to a working paper released on August 1 by Nicolas Christin, a Carnegie Mellon computer security professor, Silk Road brings in an estimated $22.8 million annually, and that number is likely to grow.

While some merchants are engaging in questionable practices, others are selling legal goods. Bitcoin retailers offer clothing, computer hardware, and coffee.

Tax Analysts spoke with Edward Clements, who operates BitBrew. Clements said that while his sales volume makes his business more of a hobby, he is diligently maintaining business records in the same way he did while running a discount dry cleaning business.

Clements said that his business is aboveboard, but that he sees others trading in bitcoins that may be less scrupulous.

Clements participates in an online forum frequented by other bitcoin retailers who say that they are attempting to be fully compliant with regulations and tax rules. There are others that are starting new businesses that may lack experience regarding the tax and regulatory requirements. And there is a third group, according to Clements, that views bitcoins as a way to have a business while avoiding government regulation and taxes.

For some, Clements said, "the biggest attraction of bitcoin is its anonymity, and you will find many libertarians and some who call themselves libertarians on the forum who I am sure have no intention of reporting any income that they make from bitcoin sales."

Clements said he is concerned about "guilt by association" concerning the activities of some in the bitcoin community. He lamented the lack of available guidance for using bitcoins in business and said there is a concern that the U.S. government could attempt to ban bitcoins. "I think that [a ban] is becoming more and more unlikely as time goes on and as [bitcoins] gain a foothold, yet it is still a possibility that there could be a lot of red tape involved," said Clements. "There might be new restrictions placed because of this currency and its unique features. It is new and evolving and nobody really has a handle on it yet."

Challenges for Tax Authorities

Although bitcoin is still evolving, there are signs that the currency is on government agencies' radars, particularly in the United States. The FBI, for example, compiled an intelligence report entitled "Bitcoin Virtual Currency: Unique Features Present Distinct Challenges for Deterring Illicit Activity," in which the agency expressed its concerns about bitcoin's popularity with criminals engaged in money laundering and other criminal activity. The report was published for official use only on April 24, 2012, but was leaked to the public in early May. And according to Elias, the CIA and the U.S. marshals have been briefed on bitcoin as well.

"At some level, governments are certainly aware of it and there's definitely awareness by numerous governments across the world," he said. "But they're just not reacting to it."

The lack of response by governments at the moment could be due in part to the relatively small bitcoin market, which hasn't reached a critical mass yet. However, all that could change once the number of coins derived by mining drops by half in November, which, in Elias's opinion, could create a huge spike in value, perhaps reaching as high as $1,000 per bitcoin.

"Who knows at what point governments will start to take notice and what actually constitutes bitcoin being big enough," Elias said. "I think the idea is certainly big enough for at some point government and officials in charge of implementing tax policy to latch on to and take notice of."

Ajay Vinze, professor of information systems at the W. P. Carey School of Business at Arizona State University who is doing extensive research on bitcoin and its viability, agrees that the market isn't big enough at the moment, but what could catch governments' attention is if the currency really explodes in popularity.

"I think governments are aware of it, and if anything they're not amused by it because you're seeing this large amount of transactions happening, which are in some ways unaccounted for, so you're creating this unnecessary informality in the economy," he said. "I'd be willing to bet that the governments in Europe and Asia are paying attention to this because value is transacting through this process. And it is the role of government to keep track of this to make sure that value is being transacted in a legitimate way."

Tax Analysts' requests for comments from the IRS and FinCEN on the U.S. government's focus on bitcoins went unanswered. But Tax Analysts was able to reach the Intra-European Organisation of Tax Administrations (IOTA) to get a sense of how aware European tax authorities are about this emerging digital currency.

In September, the organization held a workshop in Tbilisi, Georgia, titled "Auditing Individuals and Legal Entities in the Use of e-Money" to discuss the issues and challenges that arise when auditing Internet-based activities. The event attracted representatives from 23 countries.

"There's an awful lot happening on the Internet environment which is fascinating at the moment and introducing new challenges for auditors when it comes to virtual currency," said Jerry Taylor, IOTA's technical taxation expert. Bitcoin came up by name during the course of discussion, but only as part of a wide-ranging conversation on the future challenges of auditing Internet-based currencies that tax administrations will face in the immediate future.

"As far as taxing virtual currencies, I don't think we have a great deal of fervor for the subject," Taylor said. "I think what did come out of the meeting more than anything was a general awareness of the potential problems that exist for tax administrations, and I think it was a bit of a wake-up call to some of the administrations that these problems are actually out there."

Taylor also explained that some countries were more aware of the challenges that Internet currency taxation presents than others. "In general, the Nordic countries are advanced in their IT controls, and as a consequence have a better grasp of the problems than perhaps those countries that are still lagging behind either in resources or technical facilities," he added.

Technical prowess aside, some governments may not be devoting immediate attention and resources to figuring out how to treat digital currencies such as bitcoin because of more pressing economic concerns, particularly in the EU, Taylor said.

Continual education to make administrations more aware of the tax issues that arise from Internet currencies is key for governments to prepare themselves and move toward more concrete answers to questions surrounding government treatment of digital currencies.

"Hopefully we'll take this issue forward, and it won't drop because we've had one workshop," Taylor said.

Big Question Marks

Governments may be somewhat aware of bitcoin and other Internet-based currencies, but coming up with ways to monitor economic activity driven by such currencies, as well as creating solid guidance on the tax treatment of such monetary systems, is easier said than done, given the questions that the currency raises.

For Carr, virtual currencies have the potential to facilitate real-world economic transactions in the same manner as real-world currencies, such as the dollar or the euro, with a caveat.

"There are some obvious differences and limitations, an important one being that our global financial infrastructure is not currently set up in a manner that would allow easy tracking of such transactions," he said.

Also, it's challenging to differentiate between real-world economic exchange of value between taxpayers, as with bitcoin, and virtual currencies that are limited to and facilitate online gaming, such as Second Life or World of Warcraft.

"It requires a careful examination of the underlying economics, as well as the legal rights and terms involved in the transaction to understand exactly what a specific virtual currency represents," Carr added. "As a result, it's difficult to develop any rule of thumb regarding characterization."

Certainly, the call for official government guidance is strong from a growing community of bitcoin users that want to continue the bitcoin evolution while also abiding by the law, particularly when it comes to taxation. CLAG, the group founded by Elias in April 2012, embraces the goal of "promoting a clear regulatory environment for cryptocurrencies" such as bitcoin.

The organization published its first memorandum, "Staying Between the Lines: A Survey of U.S. Income Taxation and its Ramifications on Cryptocurrencies," to provide some legal insight on the taxability of cryptocurrencies such as bitcoin. In the memo, the organization argued that crytocurrencies are compatible with tax regulation structures. It also stressed the importance for taxpayers to determine on their own whether taxes are due on a bitcoin-related transaction based on whether one has "experienced a realization event."

Such events would include selling goods, like BitBrew, or selling bitcoins themselves for cash. In instances where a taxpayer has provided a service in exchange for bitcoins, a realization event has probably occurred, and any gain or loss would likely be calculated using fair market values for the service provided, according to the memo.

"For users of bitcoin who may be concerned about being impacted by current tax policy, I would recommend that if you have any inkling that you may be under a tax jurisdiction, you should certainly do your best to abide by whatever rules you think you're impacted by and play it on the safe side," Elias said. "Just be cautious with it."

The Government's Role

While the legal community can make some cogent arguments for the tax treatment of bitcoins, theory is no replacement for clear guidance from governments, and until the digital currency gains legitimacy, it's unlikely that such guidance will arrive anytime soon.

Because some people are using bitcoins for nefarious purposes, such as shopping on Silk Road, the currency's evolution into a legitimate cash system may be hindered, according to Vinze.

"If you see more legitimate businesses, like Amazon, [accepting bitcoins as payment,] that will be a whole different ballgame," he said. "I don't see that happening right now because there's no real incentive for them to do that, since there aren't enough users using it."

However, some in the bitcoin community hope to change the course of the currency's evolution toward widespread acceptance. Late September saw the launch of the Bitcoin Foundation, an organization devoted to standardizing, protecting, and promoting bitcoin while maintaining the currency's open-source, decentralized nature, as well as its independence.

Although the foundation is in its infancy, its board members hope to work with government regulators not only to understand the technology but also to push for solid guidance about its legal and tax treatment.

"We would certainly like to have those conversations, if for no other reason but to help regulators understand the technology better so they can make better decisions," Patrick Murck, legal counsel for the Bitcoin Foundation, said.

Clear guidance would also help the Bitcoin Foundation run its own operations, since it is trying to pay for everything in bitcoin, including salaries, said Peter Vessenes, the foundation's executive director.

"How do we W-2 someone for their bitcoins? Do we mark-to-market every time a transfer happens? Payroll companies cringe," he said.

Despite the legal uncertainties surrounding bitcoin, opportunities abound for governments to work with the bitcoin community.

"Since it's an open protocol, there are tons of ways governments could partner up on Bitcoin -- for instance, businesses could publish their addresses to a tax authority, making audit easy," Vessenes said. "Or, you could even instrument point of sale with direct, instant tax payments. This might even be appealing for low-margin businesses; trade away a bit more transparency and float in exchange for a super-low-fee payment network and auto filing and payment of fees."

The need for governments to address the legal questions raised by bitcoin is apparent, and government treatment of the currency will be crucial in determining how successful bitcoin will be in the future.

The biggest question for Elias is whether governments will be able to fold the treatment of bitcoin into existing tax policy or create a new regime to cover it.

"That's a very important question," he said. "What will be decided going forward is going to have a major implication for the future of bitcoin."

More Than a Niche Currency?

Though bitcoin volumes are not currently high enough to cause serious issues regarding effective tax collection, the market is still developing, and users are betting on the currency's future.

According to Murck, bitcoin has the potential to become much more than a niche currency, but it needs the guidance and understanding of regulators.

"I think if some of these bigger issues and bigger threats to the community and to the open-source project aren't addressed, it will become a niche currency, which would be a shame because the technology is very interesting and very disruptive in the space," he said. "Our goal is to support the open-source community and be a part of its future success wherever that is, whether it's creating barter economies or facilitating fast transactions, maybe inter-bank transactions."

As an advocate for improving the legitimacy of bitcoin, Murck urges those running bitcoin exchanges to abide by the guidelines concerning know your customer and anti-money laundering in FinCEN's 2011 Prepaid Access Regulations.

Murck argued that the bitcoin system is not ideal for individuals seeking to evade taxes, but that it is being held back by uncertainty over tax issues among its users. He noted that businesses currently operating in the community are making a best guess at how to report bitcoin earnings, but there are misgivings about what position the tax administrations will take.

"It can be tricky to understand how to book bitcoin if they're buying and selling them or if they're earning them through services -- is it treated as income, or is it treated as capital gains? So there are some good guesses as to how that should go down, and potentially treat it how you would treat barter income," he said. "But there's still a bit of uncertainty out in the community and having a clear rule and guidelines in place would certainly help."

According to Murck, the full potential of bitcoin could be realized through clearer guidelines and a better understanding by financial and tax regulators.

"Part of making that happen is to talk to regulators, the IRS, and tax professionals and helping them understand that bitcoin is not this nefarious thing, it's just software, it's a community, and there's nothing inherently nefarious about either of those things. With any community or any technology, people may choose to focus on the positive or negative," Murck said. "Hopefully, we can help people see the more positive stories about bitcoin."

David D. Stewart is a legal reporter with Tax Notes International.
Stephanie Soong Johnston is a reporter with Tax Notes International.

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