Moderator Paul D Carman Chapman and Cutler LLP Lead Presenter John T Lutz McDermott Will amp Emery LLP Panelists Michael Shulman Shearman amp Sterling LLP Lawrence Zlatkin Vice President Tax Coinbase ID: 911904
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What Happened to the Realization Principle: A Critical Analysis of the Recent IRS Guidance Involving the Bitcoin Hard Fork
Moderator:
Paul D. Carman, Chapman and Cutler LLP Lead
Presenter:
John T. Lutz, McDermott Will & Emery LLP
Panelists:
Michael Shulman, Shearman & Sterling LLP
Lawrence Zlatkin, Vice President, Tax, Coinbase
Slide2Bitcoin
Bitcoin is software that tracks and validates the transfer of digital assets called “bitcoins”
Each bitcoin transaction (from bitcoin’s inception) is encrypted and recorded in a public ledger (see,
e.g., https://blockchain.info/)Transactions are added to the ledger in “blocks,” each of which is cryptographically-linked to the prior block in the chain (hence, the moniker, “blockchain”) The cryptography used in bitcoin ensures that each block can be linked to only one particular “parent” block, which permanently fixes the order of transactions and prevents “double spending” of bitcoins
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Slide3Mining
Users, or “nodes,” broadcast transactions to the network
Each miner (a specialized node) collects such transactions into a candidate block and then attempts to validate its candidate by solving a complex cryptographic problem
The first miner to solve the problem and validate its candidate broadcasts its validated block to the network, which adds it to the ledger as the next block in the chain
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Slide4Mining (cont.)
The “winning” miner automatically receives a “block reward” (newly-issued bitcoins) and transaction fees as payment for expending the significant energy required
to update the blockchain
Block rewards are the only source of “new” bitcoinsAfter 21 million bitcoins have been mined, no new bitcoins will be issued
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Slide5The Blockchain Ledger and Consensus
The ledger, or blockchain, is not centrally maintained
Instead, each node downloads and updates its own local copy with new blocks as miners broadcast them
Occasionally, two miners broadcast valid blocks for the same parent, which causes the blockchain to become inconsistent across nodes (i.e., each node updates its copy of the blockchain with the first block it receives)
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Slide6The Blockchain Ledger and Consensus (cont.)
Such inconsistencies are resolved by consensus, which is determined based on which of the two versions of the blockchain is extended by the next valid block
All nodes will always consider the longest blockchain the authoritative blockchain and work to lengthen it
The tremendous energy required to create a chain longer than the “honest” chain limits both its feasibility and its appeal, diminishing the risk that the blockchain will be hacked
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Slide7Development
Rules governing creation of transactions and blocks are programmed into the bitcoin software
Because the bitcoin software is open-source, no single constituency has control over its development
Literally anyone can download the underlying code and develop and release a new version of the softwareThus, development occurs by consensusEach node that implements the new version of the software is “voting” in favor of the rules it imposes, while each node that fails to implement the new version of the software is voting against the rules it imposes
Typically, consensus emerges when one version of the software or the other becomes dominant
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Slide8Forks
A “fork” is a new version of the bitcoin software
A “soft fork” is more restrictive regarding validity requirements for transactions and blocks
A “hard fork” is less restrictive regarding validity requirements for transactions and blocksA fork of the bitcoin software may or may not cause the blockchain to permanently diverge, or split, into separate chains depending on the compatibility of the fork with the existing software andthe consensus of nodes (or lack thereof)
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Slide9Forks (cont.)
Compatibility determines whether nodes using one version of the software will accept transactions and blocks created using the other version of the software
In the case of a soft fork, a node that does not upgrade will accept transactions and blocks created using the new version of the software, but not vice versa
In the case of a “compatible” hard fork, a node that does upgrade will accept transactions and blocks created using the existing version of the software, but not vice versaIn the case of a “bilateral” hard fork, nodes using one version of the software will not accept transactions and blocks created using the other version of the software
Consensus generally determines whether one version of the software prevails as preferred over the other
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Slide10Chain Splits
If, upon a fork, there is consensus such that all nodes upgrade or no nodes upgrade, there will be no chain split
A soft fork causes a chain split if and for as long as
there is no consensus and the blockchain created using the existing software has more support (i.e., is longer)A compatible hard fork will cause a chain split if and for as long as there is no consensus and the blockchain created using the new software has more support
(i.e., is longer)A bilateral hard fork will always cause a permanent chain split ― developers of a bilateral hard fork generally lack sufficient support to gain consensusBitcoin Cash and Bitcoin Gold are bilateral hard forks
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Slide11Forks
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Soft Fork
Existing
Software
New
Software
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Compatible
Hard Fork
Existing
Software
New
Software
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109
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109
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Bilateral
Hard Fork
Existing
Software
New
Software
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107
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104
101
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Slide12Consequences of a Chain Split
Immediately after a chain split, a user that upgrades will automatically own (and can spend) the same number of “coins” on the new chain as on the old chain because the two chains have an identical transaction history through the point of the split
The existing ledger is, in effect, “copied” into the new chain and the record of the user’s existing coins is reflected on both the old ledger and the new
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User A 80
User B 30
User C 70
User D 100
User A 80
User B 30
User C 70
User D 100
User A 80
User B 30
User C 70
User D 100
User A 100
User B 40
User C 50
User D 90
Slide132017 Bitcoin Hard Folk
On August 1, 2017, Bitcoin experienced a hard fork with the result that each investor in Bitcoin automatically received one unit of Bitcoin Cash for each unit of Bitcoin owned prior to the hard fork (which it continued to own).
Earlier this year, the IRS issued a Chief Counsel Memorandum that concluded (1) a taxpayer who received Bitcoin Cash as a result of the hard fork had to recognize gross income; and (2) the amount and timing of such income depended on the fair market value of the Bitcoin Cash on the date the taxpayer obtained dominion and control over the Bitcoin Cash.
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Slide14Cited IRS Authorities
Glenshaw Glass
Section 61(a)(3)
Rev. Rul. 2109-24
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Slide15How Should We Analyze a Hard Fork?
Airdrop
Section 1001 Exchange
Distribution With Respect To Property Division of Property
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Slide16How Should We Analyze an airdrop?
An “airdrop” is a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers.
An airdrop is often used to distribute free samples of a new or developing cryptocurrency.
Rev. Rul. 2019-24 concludes that the taxpayer has income from an airdrop at the time the taxpayer acquires the ability to transfer, sell, exchange or otherwise dispose of the airdropped cryptocurrency.
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Slide17How Should We Analyze an airdrop?
Windfalls are includable in gross income.
Glenshaw Glass
Free samples distributed to promote a product are not gifts. Rev. Rul. 70-330 concluded that free samples were taxable on receipt.Rev. Rul. 70-498 concluded that free samples were taxable on sale or disposition.
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Slide18Is there a 1001 exchange?
Treas. Reg. § 1.1001-1 requires recognition of the gain or loss from the exchange of property for other property differing materially in kind or extent.
Treas. Reg. § 1.1001-3 provides that there is a deemed exchange if there is a significant modification to a debt instrument.
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Slide19Is there a distribution in respect of property?
Macomber ruled that income was
not
a gain accruing to capital; not a growth or increment of value in the investment; but a gain, a profit, something of exchangeable value, proceeding from the property, severed from the capital, however invested or employed, and
coming in, being "derived" —that is, received or drawn by the recipient (the taxpayer) for his separate use, benefit and disposal—that is income derived from property.
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Slide20Is there a division of property?
Does a cryptocurrency represent an interest in a pool of capital?
Is the pool of capital divided pursuant to a hard fork?
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Slide21Where Is the Realization Event?
Subdivision of Property
Software Upgrades
Improvements to PropertySelf-Created Property
Personal-Use Property
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Slide22Hard Fork Most Closely Resembles a Division of Property
Conversion of a Joint Tenancy in Stock
Livestock
Pregnant CowsMare in Foal
Traditional MiningSections 1286 and 305(e)
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Slide23Policy Considerations
Example 1: Taxpayer purchases Crypto #1 for $100. Immediately prior to a hard fork, Crypto #1 is worth $120. As a result of a hard fork, the taxpayer continues to hold Crypto #1 and now also holds Crypto #1B. Crypto #1 and #1B are identical in all legal respects. Both Crypto #1 and Crypto #1B possess the same rights and entitlements. Immediately after the hard fork, the market value of Crypto #1 is $0 and the market value of Crypto #1B is $120.
Example 2: The facts are the same as Example 1 but immediately after the hard fork, the market value of Crypto #1 is $60 and the market value of Crypto #1B is $60.
Example 3: The facts are the same as Example 1 but immediately after the hard fork, the market value of Crypto #1 is $120 and the market value of Crypto #1B is $0.
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Slide24Policy Considerations
Example 4: Taxpayer purchases Crypto #1 for $100. Immediately prior to a hard fork, Crypto #1 is worth $120. As a result of a hard fork ,the taxpayer continues to hold Crypto #1 and Crypto #1B. Crypto #1 and #1B are identical in all legal respects. Both Crypto #1 and Crypto #1B possess the same rights and entitlements. Immediately after the hard fork, the market value of Crypto #1 is $70 and the market value of Crypto #1B is $70.
Example 5: The facts are the same as Example 4 but immediately after the hard fork, the market value of Crypto #1 is $120 and the market value of Crypto #1B is $20.
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Slide25Policy Considerations - Examples
Taxpayer purchases Crypto #1 for $100. Immediately prior to a hard fork, Crypto #1 is worth $120. As a result of a hard fork, the taxpayer receives Crypto #1B and continues to hold Crypto #1. Crypto #1 and #1B are identical in all legal respects.
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Scenario
Crypto #1
Crypto #1A
Total Value
A
0
120
120
B
60
60
120
C
120
0
120
D
70
70
140
E
120
20
140
Slide26Policy Considerations (cont.)
If a hard fork constitutes a realization event, the income inclusion analysis seems incorrect. The trading values of the Bitcoin before the hard fork and the Bitcoin/Bitcoin Cash after the hard fork should dictate the income inclusion analysis.
Cryptocurrency Exchange Issues.
Valuation Challenges (Volatility)Illiquidity
Taxpayer Expectations
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Slide27Lightning round
Staking Income
Transition to Ethereum 2.0
Crypto LendingWrapped Bitcoin/Ethereum
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Slide28Appendix
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Fork Name
Fork Date and Crypto Name
Value Day -1
Value Day 0
Value Day +1
Bitcoin Gold
October 23 2017
Bitcoin
$5,930.32
$5,526.64
$5,750.80
Bitcoin Gold
--
$142.96
$137.09
Bitcoin Cash
July 23 2017
Bitcoin
$2,730.40
$2,754.86
$2,576.48
Bitcoin Cash
--
$440.70
$406.90
Ethereum DAO
July 24 2016
Ethereum
$12.75
$13.84
$11.99
Ethereum Classic
--
$0.60
$2.55
Slide29Appendix
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Bitcoin/Zcash
October 29 2016
Bitcoin
$714.48
$701.86
$700.97
Zcash
--
$574.82
$1,624.58
Bitcoin/Qtum
May 24 2017
Bitcoin
$2,443.64
$2,304.98
$2,202.42
Qtum
--
$4.66
$4.10
Bitcoin/Dash
Febuary 14 2014
Bitcoin
$661.99
$650.92
$616.63
Dash
--
$0.31
$0.41
(Note, very small relative fork value distorts results)
Bitcoin Cash/ SV
November 9 2018
Bitcoin Cash
$544.42
$556.60
$533.34
Bitcoin SV
--
$87.06
$113.47
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