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The Internal Revenue Service has joined several other jurisdictions in publishing guidance regarding the income tax consequences of certain convertible virtual currency transactions. Classification as property may affect the timing and character of income, gain or loss.
While the immediate implications of the Notice are apparent, the mid-term and long-term consequences are still being considered. The IRS has indicated that penalties may apply to taxpayers that have taken return positions that are inconsistent with its position in the Notice or that have failed to file the appropriate information returns.
Virtual currency, such as bitcoin, that is "convertible" i. In addition, such tax consequences may be immediate or deferred, and any tax imposed may be at varying rates , depending on the nature of the transaction and the type of person disposing of or receiving such virtual currency.
In the following paragraphs, we discuss the Notice and its immediate implications, and we point out some legal, factual and practical issues that the Notice raises. As a preliminary matter, it is important to note that the Notice only addresses the US federal income tax consequences of convertible virtual currency transactions and not any other types of virtual currency transactions. Whether the IRS will release further guidance with respect to virtual currencies that fall outside the scope of what it has defined as convertible virtual currencies is unclear at this time.
While the Notice does invite public comment, it only does so with respect to "other types or aspects of virtual currency transactions that should be addressed in future guidance" and that are "not addressed in this 3798otice. The Notice clarifies that the IRS will treat bitcoin and other convertible virtual currencies like property, such as stocks and securities, and not as currency. This means that a taxpayer who receives virtual currency as payment for goods or services must include in gross income the fair market value of the virtual currency, measured in US dollars , as of the date that the virtual currency was received.
The taxpayer will have a tax basis in such currency equal to the fair market value of the virtual currency in US dollars as of the date of receipt. According to the notice, the fair market value of a convertible virtual currency, if such currency is listed on an "exchange" and the exchange rate is established by "market supply and demand," is determined by converting the virtual currency into US dollars or into another real currency which in turn can be converted into US dollars at the exchange rate, in a "reasonable manner" that is "consistently applied.
Arbitrage opportunities may exist if virtual currencies are first converted into non-US currencies and then to the US dollar.
If the fair market value of the property received is less than the adjusted basis of the virtual currency, the taxpayer has a taxable loss.
The character of any gain or loss as ordinary or capital generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. Income characterization of sales and exchanges of virtual currency transactions. As referenced above, the character of a taxable sale or exchange deferred exchanges are mentioned briefly below of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
Generally, this is good news for a taxpayer that sells virtual currency, held for investment purposes, at a gain and held such currency for more than one year. A capital asset generally is an asset held for investment purposes, like stocks or bonds or other investment property. Conversely, property held as inventory or other property mainly for sale to customers in a trade or business is not considered a capital asset.
The sale or exchange of a capital asset generates capital gain or loss while the sale or exchange of an asset other than a capital asset generates ordinary income or loss. Currently, long-term capital gains i. Short-term capital gains i.
Unused capital losses can be carried forward or backward, subject to limitations, to offset future or past capital gains. A non-corporate taxpayer holding positions in appreciated virtual currencies for more than one year may be able to take advantage of these lower marginal tax rates. Before the Notice, there was a danger that the IRS could have been whipsawed, with investors taking inconsistent positions with respect to virtual currency as a foreign currency for purposes of claiming ordinary losses and as a capital asset for purposes of including capital gains.
Notwithstanding the generally taxpayer friendly position that the IRS has staked out in the Notice, merchants and dealers who accept virtual currencies as a form of payment and who do not immediately convert such currencies into US dollars may themselves be whipsawed. If the merchant cannot use the capital loss to offset other capital gain in the same year, such loss will be suspended and the merchant will suffer a character mismatch.
If the merchant has entered into some form of hedging agreement whereby it has downside protection against declines in the value of bitcoin, it is not exactly clear whether such transactions would be treated as ordinary or capital transactions for US federal income tax purposes — thus, a second potential for mismatch occurs see "Hedging and notional principal contract considerations" below.
Individuals using virtual currencies who are neither dealers nor investors may have an economic loss with no accompanying tax loss upon disposition of virtual currency that has depreciated in value since its acquisition; personal losses are generally non-deductible. Lastly, any taxable sale or exchange of a virtual currency likely will be subject to the 3. NII includes net gain to the extent taken into account in computing taxable income attributable to the disposition of property, other than property held in a trade or business to which the NIIT does not apply, ix minus the deductions that are properly allocable to that net gain.
Generally, property held for investment would include virtual currencies. Mining virtual currency is a taxable event. A taxpayer who mines virtual currency is subject to tax on receipt based on the fair market value of the virtual currency at such time. The Notice presumes that the income from mining would be ordinary, and if mining constitutes a trade or business and is not undertaken as an employee, any net earnings generally, gross income less allowable deductions constitute self-employment income and are subject to the self-employment tax i.
All taxpayers who receive virtual currency as compensation for services, whether as an employee or an independent contractor, are taxed in the same manner as if the amounts paid were US dollars. Employees who receive virtual currency will be subject to wage withholding and employment taxes.
All payment of US taxes must be in US dollars, even if the compensation for services was paid in virtual currency; this can present timing of income issues as well as character mismatch issues if the recipient taxpayer does not immediately convert the virtual currency into US dollars upon receipt. A payment made using virtual currency is subject to the same information reporting and backup withholding requirements as payments made in US dollars.
Payors making reportable payments using virtual currency must solicit a taxpayer identification number TIN from the payee and must backup withhold from the payment if a TIN is not obtained prior to payment or if the payor receives notification from the IRS that backup withholding is required.
Payors making payments subject to these information reporting and backup withholding rules must ensure proper systems are in place in order to comply with the timing requirements for the issuance of the reports and for the proper translation of exchange rate values in order to withhold the correct amounts from payments.
The information reporting rules currently applicable to third party settlement organizations TPSOs apply to payment processors that settle transactions in virtual currency. In general, a third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a TPSO. The dollar value of payments denominated in virtual currency is based on the fair market value of the currency on the payment date. Taxpayers may be subject to penalties for failure to comply with tax laws for past years.
For example, a taxpayer may be subject to penalties for underpayments attributable to virtual currency transactions if, inter alia , the taxpayer failed to use the appropriate fair market value to translate the virtual currency into US dollars or failed to report gain on the disposition of virtual currency.
Similarly, failure to properly backup withhold may lead to penalties as well. The following are tax issues that have either been raised in the past with respect to virtual currencies or that the Notice has brought to the forefront. We anticipate that the IRS will need to issue additional guidance and perhaps make conforming revisions to existing Treasury Regulations. Based on the rulemaking record and public input, a proposed regulation may be modified or withdrawn, or the agency may proceed with a final rule.
Accrual method taxpayers, generally, are not required to account for an item of income until all the events which determine the fact of the right to income have occurred; this discussion does not focus on the specific impacts of the Notice to accrual taxpayers. All Section references are to the Internal Revenue Code. Section h Thus, if a payor who fails to deduct and withhold the tax can show that the income tax was paid by the payee, the tax won't be collected from the payor.
However, the payor will remain liable for penalties for the failure to deduct and withhold. For more information regarding the US federal income tax treatment of virtual currencies, please contact:.
The transfer of virtual currency as payment for services requires tax reporting Form MISC ordinary income for contractors and Form W-2 wages for employees and wage withholding required for employee wage payments. Gain or loss on the sale of virtual currency is gain or loss from the sale or exchange of property, treated in a manner similar to the sale or exchange of securities.
If held as investment property, the gain or loss on sale will be capital gain or capital loss. This treatment is different from the treatment of currency gains or losses, which are ordinary not capital.
Penalties may be imposed for taxpayers taking positions contrary to those specified in the Notice or failing to comply with applicable reporting obligations. Income characterization of sales and exchanges of virtual currency transactions As referenced above, the character of a taxable sale or exchange deferred exchanges are mentioned briefly below of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
Taxing virtual currency miners "Mining" is the way bitcoin is issued. Information and backup withholding with respect to payments of virtual currency A payment made using virtual currency is subject to the same information reporting and backup withholding requirements as payments made in US dollars.
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. Without further modifications, it is not clear whether virtual currencies should constitute passive assets for purposes of the 50 percent asset test applicable to 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 applicable to PFICs because virtual currencies do not give rise to any income; income from the sale or exchange of virtual currencies should be includable as subpart F income for purposes of the rules applicable to controlled foreign corporations CFCs for the same reason.
Hedging and notional principal contracts considerations: A taxpayer hedging the risk of fluctuation in the value of virtual currency that it holds is not guaranteed ordinary income treatment under the specialized tax rules applicable to hedging transactions. In addition, it is not clear whether the tax rules applicable to "notional principal contracts" would apply to swaps or other derivatives the payments on which are calculated by reference to published virtual currency exchange rates because it is not clear they would be considered a "specified index" under such rules.
The like-kind exchange rules exclude certain property from qualifying for deferral of recognition. This property includes stocks, bonds, notes or other securities or evidences of indebtedness, partnership interests, certificates of trust or beneficial interests, choses in action and foreign currencies; however, it is not clear whether virtual currencies would be excluded from such treatment as well by virtue of inclusion in such list or otherwise.
Mark-to-market rules of Sections and It is not readily apparent whether a taxpayer who deals or trades in virtual currencies would be able to take advantage of the elective mark-to-market rules that exist for dealers in commodities and traders in securities and commodities. In addition, because a derivative contract with respect to a virtual currency would not be considered a "Section 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 US federal tax purposes.
Special tax rules apply to entities, including ongoing reporting obligations. It does not appear that virtual currencies are "financial assets" or virtual currency "wallets" are "financial accounts" for purposes of FATCA.
Similarly, foreign entities holding virtual currencies do not appear to be "financial institutions" for purposes of FATCA. 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, as such, appear outside of the scope of such reporting obligations by US individuals.
Charitable contributions of virtual currencies: Though the Notice indicates virtual currency is property, the IRS should clarify 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 other tax contexts to be tangible personal property and has been treated as such for the charitable tax rules.
Foreign tax credit implications: Constructive sales and straddles: The rules applicable to constructive sales e. In addition, the IRS should clarify whether the rules applicable to straddles apply equally to virtual currencies — it must determine that virtual currency constitutes personal property of a type which is "actively traded.
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