Keyword: Internal Revenue Service (IRS)

HMRC’s New Approach to Cryptoassets – Tax First, Define Later

The UK tax authority, Her Majesty’s Revenue & Customs (HMRC), has taken a further step towards tackling perceived tax avoidance in transactions involving cryptoassets. Specifically, according to press reports, exchanges such as eToro, Coinbase and CEX.IO have received letters from HMRC requesting customer and transaction data.

The move follows HMRC’s most recent policy paper, “Cryptoassets for Individuals,” published in December 2018, which in turn built on the brief general guidance published by HMRC four years earlier in 2014. The 2018 policy contains the statement that HMRC will apply the relevant income or capital gains tax provisions by looking at the factual details of each circumstance rather than by reference to terminology.

While the policy paper does distinguish between exchange tokens, utility tokens and security tokens, in practice we expect HMRC to focus on a transaction’s factual elements, rather than the description of the cryptoassets.

In contrast to HMRC’s approach, the UK financial regulator, the FCA, has recently revamped its classification of cryptoassets, clearly defining which ones among them would not fall within the scope of its regulatory regime, the Financial Services and Markets Act 2000. HMRC is yet to comment publicly on this development, but it is hoped that HMRC will follow suit and provide taxpayers with more certainty in determining their tax obligations in relation to cryptoassets.

Interestingly, on the other side of the Atlantic, the U.S. Internal Revenue Service (IRS) was also reported to have sent compliance letters to holders of cryptocurrency, warning them of the consequences of their potential non-compliance with relevant tax obligations. It is not clear whether the letters are limited to those taxpayers identified in the Coinbase Summons in 2016. The IRS believes that in 2017 up to $90 billon in cryptocurrency gains went unreported. On the Chain authors have written on the topic previously here, here and here.

While the IRS confirmed in 2014 that virtual currency ought to be treated as property for tax purposes, HMRC has, so far, used the word “property” only to describe cryptoassets for inheritance tax (IHT) purposes. Whether a similar approach will be taken for other UK taxes is yet to be confirmed and cannot be assumed.

The Financial Committee of the City of London Law Society published a paper that provided a potential framework for legal classification of cryptoassets. According to the Committee, exchange tokens could constitute a new category of personal property that is neither a “chose in possession” nor a “chose in action,” subject to the Supreme Court extending the notion of personal property to such assets.

In order to tap into the value generated by cryptoassets, HMRC’s approach has been to treat cryptoassets as property in relation to IHT and as “assets” in relation to other taxes. This approach is potentially quite unclear for taxpayers if we consider that, at the time of writing, there is no legislative basis (judicial or statutory) for the classification of cryptoassets as property. The fact that HMRC has recognized cryptoassets as property only in relation to IHT, and not for other UK taxes, adds to the uncertainty.

This uncertainty, coupled with the fact that most taxing legislation was drafted before digital assets even existed, means there is an urgent need for clarification on their legal status.

This is relevant to all value-generating actions involving cryptocurrencies, including the UK tax treatment of:

  1. options on tokens – will this mirror the taxation of options over shares?
  2. ICOs – will these be taxed in the same way as IPOs? and
  3. the transfer of tokenized shares – will these fall within the scope of stamp duty?

At the moment, there is no clear answer.

One thing does seem certain, however – blockchain is a harbinger of a new way of generating value and its potential will be fully leveraged only when the tax and legal frameworks around it have reached a serviceable level of cohesion. How and when this will be achieved is difficult to say.

IRS Advisory Committee Identifies the Need to Enforce Compliance on Cryptocurrency Transactions

A recent report (the “Report”) of the IRS Commissioner’s Information Reporting Advisory Committee (“IRPAC”) has identified the need for additional guidance on cryptocurrency transactions to enforce compliance on cryptocurrency transactions. The Report heavily relies on the recent experience the IRS had in enforcing the Coinbase summons, as recently reported in On the Chain. The IRS explained the problem earlier this year: because transactions in virtual currencies can be difficult to trace and have an inherently “pseudo-anonymous” aspect, some taxpayers may be tempted to hide taxable income from the IRS. IRS News Release, IR-2018-71, March 23, 2018. Taxpayers in this situation are at risk, given that, as recently reported in On the Chain, there is no voluntary disclosure program for taxpayers that have failed to report crypto related income.

In the Report, the IRS estimates that potentially unreported cryptocurrency tax liabilities represent approximately 2.5% of the estimated $458 billion tax gap. The calculation relies upon a recent article by Fundstrat Global Advisers, which sets cryptocurrency-related labilities at $25 billion, based on taxable gains of approximately $92 billon and a noncompliance rate of 50%. The Fundstrat Report estimates that approximately 30% of the investors in cryptocurrency are in the U.S., which is more than $500 billion at the end of December 2017 (up from about $19 billion at the start of January 2017!), according to data from CoinMarketCap.

While the IRS previously addressed certain issues in Notice 2014-21, there remain significant open issues that will need additional analysis and further guidance to refine the reporting of these transactions.  For example, the reports cites the following:

  1. whether virtual currency held for investment is a capital asset;
  2. whether the virtual currency ought to be treated as a security, subject or not subject to the wash sale rules, or affected by mark-to-market implications under section 475 of the Code;
  3. whether a taxpayer may use LIFO or FIFO to determine the basis of virtual currency sold;
  4. how to track basis through activities in the blockchain;
  5. whether broker reporting is required under section 6045 of the Code for transactions using virtual currency;
  6. whether a taxpayer may contribute virtual currency to an IRA; and
  7. whether virtual currency is a commodity.

Also, while an initial reading would suggest that virtual currency would not be considered a financial account for FATCA purposes, various guidance notes issued by foreign jurisdictions for purposes of implementing the Common Reporting Standard (CRS) have indicated virtual currency does represent a financial account.  This inconsistency, the Report notes, between regimes that purportedly try to maintain a high level of consistency will be confusing to withholding agents and subject to inherent error.

Citing the recent Coinbase summons and the failures to report income identified in that case, the Report opines that many, if not most, taxpayers will report their virtual currency activities correctly if they are able to determine their tax implications.  Some taxpayers will be tempted to do otherwise, however, because anonymity is inherent in the structure of the block chain activities.  In light of Coinbase, these taxpayers are likely to use exchanges outside the jurisdiction of the U.S.  The Report notes that it is unclear at present whether the U.S. may obtain information from foreign exchange activities (determining the exact nature of residence of the virtual activities of an exchange is itself vexing under existing source and jurisdiction rules, and leads to issues of whether the activities are sourced to any jurisdiction or are stateless income).

The Report concludes with IRPAC stating that it would be very interested in helping develop information reporting and withholding guidance on these important issues.

https://www.irs.gov/pub/irs-pdf/p5315.pdf

IRS to Virtual Currency Traders: No Formal Voluntary Disclosure Program

The IRS recently announced that it is not planning to establish a formal voluntary disclosure program for taxpayers who have unreported income derived from virtual currencies. Specifically, Daniel N. Price of the IRS’s Office of Chief Counsel stated on November 8, 2018 that he needed to dispel the rumor that had been circulating since last year that the IRS intended to establish a separate voluntary disclosure program for unreported income related to offshore virtual currencies. This is in contrast to the voluntary program that the IRS established for unreported income from offshore financial accounts.

Under IRS guidance from 2014, the IRS classified Bitcoin and other virtual currencies as property (rather than foreign currency). Accordingly, any income from virtual currency transactions is treated as either ordinary income or capital gains, whichever is applicable based on the activity that gave rise to the income (e.g. investment or mining). Because the IRS requires a U.S. taxpayer to report its worldwide income regardless of where that income was generated or where the taxpayer lives, a U.S. taxpayer could have significant income tax liability for its cryptocurrency activities that were conducted and remain offshore. In spite of this substantial U.S. taxpayer exposure, and despite the potentially enormous amount of unreported income from virtual currency activities, the IRS has provided relatively little guidance to taxpayers and tax professionals, given the complexity of the tax issues and reporting requirements triggered by virtual currencies. At the same time, as discussed previously in On the Chain, the IRS is preparing to collect the massive amount of tax from unreported income from Bitcoin-related trades.

The IRS is Closing in on Cases Regarding Bitcoin Income Reporting

Following a several-year court fight, the Internal Revenue Service (the IRS) appears to have obtained a substantial amount of information regarding individuals’ transactions in cryptocurrency, and the agency might be in a position to make criminal referrals of failures to report income from such transactions. In December 2016, the IRS, believing that virtual currency gains have been widely underreported, issued a summons demanding that Coinbase, the largest U.S. cryptocurrency exchange, produce a wide range of records relating to approximately 500,000 Coinbase customers who transferred Bitcoin, a virtual currency, from 2013 to 2015. Formed in 2012, Coinbase has served at least 5.9 million customers and handled $6 billion in transactions. Coinbase did not comply with the summons.

In seeking to enforce the summons in the Northern District of California, the IRS cited the fact that while approximately 83 percent or 84 percent of taxpayers filed returns electronically, only between 800 and 900 persons electronically filed a Form 8949, Sales and Other Dispositions of Capital Assets, that included a property description that was “likely related to bitcoin” in each of the years 2013 through 2015. Presumably, the IRS believes that more than 900 people made gains on bitcoin trading during that period.

On November 28, 2017, the court enforced but modified the summons by requiring Coinbase to provide documents for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send or receive) in any one year from 2013 to 2015. The order required Coinbase to provide: (1) the taxpayer’s ID number, name, birth date and address; (2) records of account activity, including transaction logs or other records identifying the date, amount and type of transaction, i.e., purchase/sale/exchange, the post-transaction balance and the names of counterparties to the transaction; and (3) all periodic statements of account or invoices (or the equivalent).

The IRS appears to be getting closer to the prospect of criminal cases:

  • In March 2018, Coinbase informed 13,000 of its customers that it would be giving information on their accounts to the IRS.
  • At the recent Tax Controversy Institute in Beverly Hills, Darren Guillot, Director (Field Collection), IRS Small Business/Self-Employed Division, said that “[he] has had access to the response to the John Doe summons served on Coinbase, Inc. for two months and has shared that information with revenue officers across the country.”
  • Bryant Jackson, Assistant Special Agent in Charge (Los Angeles), IRS Criminal Investigation Division, recently said that CI has been expecting fraud referrals from the Coinbase summons response.
  • CI and the Justice Department Tax Division have been discussing those anticipated cases and issues that may arise in them, such as proof of willfulness.

It is noteworthy that in Notice 2014-21, the IRS answered a series of questions related to the taxation of cryptocurrency (which it refers to as “virtual currency”). In the Notice, the IRS indicated that penalties would apply for failures related to the reporting of gains under section 6662 and failure to file information returns under sections 6721 and 6722. While the Notice specifically provided that penalty relief may be available to taxpayers and persons required to file an information return who are able to establish reasonable cause, it did not provide any indication as to whether reasonable cause relief would be available for taxpayers who failed to report cryptocurrency-related gains. More recently, on July 14, the Large Business and International division of the IRS initiated a Virtual Currency Compliance Campaign to address noncompliance issues.

While there may be valid reasons for failure to report cryptocurrency-related gains, taxpayers who are among the 13,000 Coinbase customers should be particularly concerned about the penalties that might apply due to the failure to report their gains.