Closing the tax hole for digital asset issuers

introduction

IRS Commissioner Charles Rettig recently commented that the U.S. government is losing up to $ 1 trillion in unrecovered taxes every year, with holdings of digital assets avoiding taxation and adding to a growing tax gap.

This article provides strategies for closing the digital asset tax gap, with a focus on digital asset issuers.

To that end, this article mainly addresses the tax consequences: (1) to the original creator of Bitcoin or other digital assets in creating such digital assets; (2) the payment by the original creator of such digital assets to miners; and (3) of (i) creating and (ii) paying for digital assets to miners in connection with an airdrop in connection with a new digital asset issued due to a protocol change.

Since forms of digital assets are relatively new in their widespread use and distribution, and new in terms of the mechanisms of issuing, buying and trading digital assets, it is not surprising that the powers over the tax treatment of digital assets are very limited . In particular, the IRS issued a notice in 2014, followed by a published decision in 2019, as well as some FAQs available on the IRS website. More recently, the IRS has issued a Chief Counsel Memorandum (the "CCM") clarifying some of its conclusions / positions in its 2019 guidance. In its guidance, the IRS sets out its view on a number of fundamental and fundamental issues related to the taxation of digital assets:

  1. The IRS treats digital assets as property, not currency, for tax purposes. The result is that an exchange of digital assets for other assets, unless there is another exception in the tax code or general tax principles, is a taxable exchange subject to the current realization and recognition of income – even if a similar transaction using a Fiat currency would not be taxable.
  2. Miners who acquire digital assets as a result of validation of transactions are treated as if they had taxable income upon receipt of the digital assets. The IRS also advised that such a miner may be engaged in a trade or business for US tax purposes. The IRS has not commented on whether the issuer of such digital assets is in a trade or business.
  3. The IRS found in the 2019 decision that a taxpayer who receives additional digital assets from an airdrop has ongoing income for the fair market value of the digital assets received.
  4. The IRS then changed and refined its position in the CCM, stating that the recipient is only liable for tax in connection with an airdrop if that recipient has dominion and control over the newly received digital assets. If the recipient was able to use the digital assets issued in the Airdrop (in the case of the CCM, BCH) immediately, the recipient was taxable at that time. However, if the exchange / medium on which the recipient held the newly received digital asset did not immediately enable the trading and use of that asset, the recipient would not be taxable until that recipient had dominion and control over the use of that digital asset Well.

Commentators and practitioners have continued to write on topics related to the taxation of digital assets as the limited IRS guidelines have left many questions unanswered, both relating to questioning the premises of the IRS Conclusions and to questions raised by the IRS has not taken into account (at least publicly) at all.

Notably, there has been no significant discussion by the IRS or by commentators as a whole about taxing the digital asset issuer, whether that focus is on the original creator of a digital asset or an issuer following an airdrop. The lack of focus is probably driven pragmatically by questions about the technology and structure of blockchain systems, for example difficulties in determining the identity of the issuer and clarifying when a taxable event has occurred in relation to the issuer. Accordingly, the tax treatment of the creation and dispensing of digital assets remains an open and important area for discussion and this article will provide some guidance on how that area might be addressed.

Law and technology

Governments and regulators need to keep pace with evolving technologies to ensure that blockchain structures and digital assets are not used to facilitate non-compliance with existing laws.

As mentioned earlier, the lack of focus on issuers of digital assets appears to be pragmatically driven by issues related to the technology and structure of blockchain systems, such as difficulties in determining the identity of the issuer and clarifying when a taxable event is related to issuers.

When identifying issuers, the first step is to tackle the myth of the decentralization of public blockchains. It is important to note that blockchain systems are distributed, not decentralized. While those who exercise power, oversight and responsibility over these powerful financial and data structures may not be formally organized, it does not mean that the creation, control and power, operation, oversight and responsibility of public blockchains are not centralized; for example, centralized with key developers and other decision-makers in relation to the software that operates blockchain structures, thereby ensuring the continued existence of the associated digital assets. Accordingly, it can be argued that those in control of the protocol or software of the specific digital asset should be viewed as the "reserve holders" of the digital asset yet to be distributed and therefore an analysis should be made of these parties when a chargeable event and income is present on that event, which I will discuss as digital asset creation, subsequent payment or distribution to miners, and digital asset creation and payment to miners related to an airdrop related to a new one digital asset that is issued when the protocol changes.

In clarifying what counts as a chargeable event, as implied above, I suggest that new systems be created when the protocol changes from the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as Airdrops, then when creating a protocol that is not compatible with the original Bitcoin protocol, a chargeable event should be considered to have occurred, creating a current one taxable income arises for the issuer who receives the newly issued digital assets.

analysis

Please note that in relation to the various scenarios related to the taxation of the issuance of a digital asset, a threshold question is whether the relevant parties (issuer, payer, recipient, etc.) of the US tax authorities. While this question is significant (and a threshold) that would relate to the citizenship, residence and location, and types of business of the taxpayers involved, it is not the focus of this article. It is assumed that all relevant parties are subject to US taxation.

Treatment of the original issuer / creator of Bitcoin

Since this section applies to Bitcoin, it applies to Bitcoin SV as the original Bitcoin protocol.

The starting point of the analysis with regard to the taxation of the issuer of a digital asset is the tax treatment and the consequences of the creation / creation of the asset. If the digital asset is a newly created asset that is solely marketed through mining (e.g. not created by an airdrop from an existing digital asset), the newly created digital asset may not generate one at the time the asset is created taxable income issue. A basis for this position would be that the digital asset may not have current value at the time of its creation, especially the early digital assets such as bitcoin that entered the market at a time when the concept of digital assets was new and the value of such assets was highly uncertain. Accordingly, at least in the case of Bitcoin, even assuming that the entire issue of Bitcoin was owned by the creator at the time of issue, nothing of value was created at that point, and therefore there would be none at the time of issue taxable income.

The next topic is how to treat the creator / owner when paying this digital asset to others. The IRS has made its position that bitcoin and similar digital assets should be properly treated as property, not currency, for income tax purposes. Therefore, if the creator of a digital asset were to use a digital asset in an exchange for other real estate or services, the exchange would in principle be a taxable operation for the creator / payer. This would result in Bitcoin being distributed to a miner in exchange for its services related to validating transactions on the blockchain.

The creator would recognize a profit equal to the fair market value of the received services or property, minus any basis it would have in the digital asset (this value is likely zero since nothing valuable was created at the beginning or very low since the Creator) / Payer could add costs incurred in generating the digital asset in its base). When income or profits are recorded, the valuation of the services or property received would need to be determined. In tax law, it is assumed that the amount of two items that are exchanged in a transaction under normal market conditions have the same value. Thus, the value of the services provided to the creator / payer of the bitcoin would correspond to the value of the bitcoin paid for. If the digital asset paid or distributed is already widespread, the valuation is equal to the commercial value. However, a new or recently issued digital asset would require the taxpayer to determine its fair value to calculate its tax liability while the government could contest that determination.

However, the above analysis assumes that it is a sale or an exchange. At first glance, it is not initially clear what the creator / payer of the virtual currency will receive in return for his payment to a miner. However, one could argue that the creator / payer received a valuable service in exchange for every block reward distribution. In particular, the IRS has made it clear that the digital asset reward received by the miner on this exchange will be considered taxable income for the miner. However, the IRS did not elaborate on how it would handle the same distribution that applies to the creator / payer. The creator / payer may compensate the miner for his work related to validating transactions. It appears that the creator / payer is making the payment to the miner to increase the value of their own product – e.g. B. the blockchain and the total value of the digital assets issued. Validating transactions on the blockchain adds value to all holders of the digital asset, including the issuer. Thus, on payment, the creator / payer would arguably have a taxable gain equal to the value of the asset paid to the miner over the base of the creator / payer of the digital asset, if any.

Insofar as the payment to the miner is treated as consideration for services and therefore triggers a profit for the payer, there is a further level of analysis, namely whether there is a compensation deduction for the payer. For the purposes of this article, we assume that the issuer / payer carries out a "commercial or business activity" for tax purposes and that any expenses incurred are currently deductible as ordinary business expenses, compared to the expenses to be capitalized, which are allocated to the base of the taxpayer's base value become an asset.

Thus, while the issuer might see a gain for exchanging the digital assets for the services provided (i.e. validating transactions), such payment would be in exchange for services. If the actual payment is for services rendered, the payer should be able to deduct the amount of the compensation paid to the service provider. This deduction would not only make up for the profit, it could perhaps more than make up for that profit. The gain captured from the payment would be equal to the fair market value of the digital asset paid, less the basis that the payer would have in the digital asset issued. As mentioned above, to the extent that the payer incurs costs that were properly attributable to the creation of the digital asset, this would increase the foundation of the digital asset in the hands of the payer and therefore reduce any capital gain. However, the offset deduction would be the full market value of the transferred digital asset, with no reduction in the base. So if the digital asset being paid is worth $ 100 and the base is $ 10, the profit is $ 90 while the deduction would be $ 100.

In addition, there could potentially also be cheap interest rate arbitrage. The gain generated could (depending on the length of the holding period and other factors discussed below) be treated as capital gain currently taxed at a rate of 20%, but the compensatory allowance would be a normal allowance with a peak rate of 37% (although the specific one to apply Rate would depend on a number of factors). However, the analysis on this point of possible interest rate arbitrage is somewhat more nuanced for several reasons and is not the subject of this article.

Handling the issue related to an airdrop

As noted above, in resolving the chargeable event, I suggest that new systems be created when the protocol changes from the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as Airdrops, then when creating a protocol that is not compatible with the original Bitcoin protocol, a chargeable event should be considered to have occurred, creating a current one taxable income arises for the issuer who receives the newly issued digital assets. Accordingly, this section would apply to new protocols such as the current iteration of BTC and BCH, and consequently provide governments with significant sources for closing the tax gap.

The IRS has issued guidance regarding the treatment of the recipient of digital assets in the event of a flight drop, claiming that it is creating ongoing taxable income for the recipient receiving the newly issued digital assets (although it recently changed that view to that extent that the recipient has no dominion or control over the digital assets, he would have no current taxable income until the point in time at which he has control).

Less clear, as noted above, is the question of whether a person / party considered the issuer or creator of the new digital asset created as part of an airdrop should be considered additional property (and therefore currently taxable) .

The analysis of the taxation of digital assets at the issuer not in the context of the stand-alone creation of a digital asset like Bitcoin but in the context of an airdrop shares some points with the previous discussion of the original issuer / creator above. but in many ways it is markedly different.

In the event of a protocol change, holders of outstanding amounts or units of digital asset A will normally automatically receive (subject to a drop) units or coins of digital asset B. In addition, an amount of digital asset B is created and held in reserve to be equal to the Amount of the existing but not outstanding digital asset A. For example, if 100 coins of digital asset A were originally created and 70 of them were paid out to miners, but another 30 are still held in reserve and still need to be distributed to miners, the owners of the outstanding 70 units of digital asset A will become 70 units of digital Asset B thrown out of the air. In addition, another 30 units of the digital asset B held in reserve will be distributed to future miners of the digital asset B.

Neither has the IRS (and by and large the commentators) discussed the tax treatment of any person or party who would or could be treated as the creator or issuer of a new digital asset in connection with an airdrop. As mentioned above, the IRS has taken its position that taxpayers who receive new digital assets from an airdrop will have taxable income. However, there has been no substantial discussion of the treatment of the creators or issuers of the digital asset B. In this article, I argue that just as the IRS ruled that other recipients of the new digital asset from the Airdrop would be currently taxable, so were the creators / Issuers of digital asset B should also be taxable.

As mentioned above, it is questionable whether those who control the protocol or software of the specific digital asset should be viewed as a "reserve" of the digital asset yet to be distributed. For the purposes of this article, we therefore assume that these individuals are being treated as if they owned such a yet-to-be-distributed digital asset B and therefore it would have to be determined whether they are at the time of such airdrop or on a subsequent payment or Distribution to miners.

While the creation of a new digital asset may have little or no immediate value, the digital asset created by an airdrop would likely have significant value since its spread is significant instantly (like all owners of digital asset A now hold units of the digital Asset B and the logs are already in place for future use and trading). Thus, the incorrect value theory discussed above would presumably not apply to any taxation of the Bitcoin creator. Accordingly, in relation to the Airdrop, the issuer would have a profit equal to the difference between the value of the digital asset issued and its base (if any) in that digital asset. Just as the IRS decided that other recipients of the new digital asset from the airdrop would be taxable right now, so the creators / issuers of digital asset B should arguably also be taxable.

The argument would be based on the IRS's recent assumption that the notion of domination and control is an important factor in its recent judgment. The creators would increase the value of their existing holdings of digital asset B by developing and / or managing the protocol and software of the new digital asset B. The fact that the reserve of the new digital asset B would be available for distribution to the miners (as a result of their efforts), and therefore available to the creators to further increase the value of the existing holdings, reflects their control over the reserve. Therefore, since their actions and continued control over the log have increased the value of their existing assets (i.e. their existing holdings of digital asset B), the IRS could argue that the creation of that digital asset B would result in a taxable event for these creators. While it is not entirely clear what the size or magnitude of such a gain would be, the strongest position seems to be that it should be measured in relation to the new digital asset B, which is being held in reserve to distribute become (i.e. available to be paid to miners). ) as paying to the miners would increase the value of the existing assets of the creators.

The above analysis and discussion relates to the creation of digital asset B in conjunction with an airdrop. If the digital asset B is subsequently distributed or paid out to miners, then the above analysis for recording the profit from the payment of the digital asset for services would probably also be applicable here. To the extent that the issuers of digital asset B are treated as the owners of the digital asset and the payment to the miners is considered consideration for services (as discussed above), the issuers / payers would, but possibly be offset by a deduction, as described above.

There would be a possible difference in the treatment of the payment to a miner. To the extent that the creator / issuer posted income from creating the digital asset at the time of the drop, this income would create a foundation and reduce the amount of profit from the exchange / payment to the miner. This is in contrast to the creator of an entirely new digital asset who probably wouldn't have made a profit at the time of creation and would have little to no foundation at the time.

Conclusion

As mentioned above, governments and regulators need to keep pace with evolving technologies to ensure that blockchain structures and digital assets are not used to facilitate non-compliance with existing laws.

There was no focus on issuers of digital assets, presumably due to issues related to the technology and structure of blockchain systems, such as difficulties in determining the identity of the issuers and clarifying when there is a taxable event in relation to issuers .

I have argued that those who control the protocol or software of a particular digital asset should be viewed as a “reserve” of the digital asset yet to be distributed.

In clarifying what counts as a chargeable event, as implied above, I suggest that new systems be created when the protocol changes from the original Bitcoin protocol, which currently only exists as Bitcoin SV. If a transaction on the original protocol is not compatible with subsequent protocols, which I will refer to as Airdrops, then when creating a protocol that is not compatible with the original Bitcoin protocol, a chargeable event should be considered to have occurred, creating a current one taxable income arises for the issuer who receives the newly issued digital assets.

Accordingly, the analysis in this article is most relevant to new protocols such as the current iteration of BTC and BCH, which would provide governments with significant tax sources to fill the tax gap.

About the author

Johnny Jaswal is the Managing Director and General Counsel of the Jaswal Institute responsible for providing regulatory, legal, government relations, strategic and related investment banking advisory services. He has a wealth of experience advising on regulatory affairs, mergers, acquisitions, divestments and capital raising activities.

Johnny represents global blockchain and digital asset companies and is responsible for leading international advisory services. In addition to advising governments and regulators on digital asset legislation, Johnny has established / executed the global M&A, fundraising, regulatory and tax strategies for multiple companies.

Prior to founding his consulting firm, Johnny served on the executive board of the corporate development and strategy team at TMX Group, which owns a portfolio of financial and technology assets, including the Toronto Stock Exchange, an investment banker at TD Securities, which is one of Canada's premier investment banks, corporate attorney Blake, Cassels & Graydon LLP and Goodmans LLP, two of Canada's premier law firms, and engineer in multiple sectors.

Johnny holds a Master of Business Administration from the Schulich School of Business, a Juris Doctor from Osgoode Hall Law School, a Bachelor of Engineering: Electrical Engineering from Ryerson University and is admitted to the Ontario bar.

This article is provided for informational purposes only and does not constitute and is not intended to be legal advice. No individual or legal entity may rely on this article for legal or other advice from Johnny Jaswal / the Jaswal Institute. The article speaks only on the date written. Future factual changes or developments, as well as future legal proceedings or government guidance, may influence the analysis or conclusions presented in the article. Johnny Jaswal / the Jaswal Institute undertakes no obligation to update the article to reflect future events or actual changes, or for any other reason.

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