Journal of Taxation of Financial Products, IRS GUIDANCE—CCA 202114020 Clarifies the Tax Treatment of Hard Forks of Virtual Currencies, (Jul. 19, 2021)

As published in Wolters Kluwer’s Journal of Taxation of Financial Products, July 19, 2021. 

Stevie D. Conlon is a Vice President and tax and regulatory counsel for Wolters Kluwer and coauthor of PRINCIPLES OF FINANCIAL DERIVATIVES: U.S. & INTERNATIONAL TAXATION (1999). Anna Vayser is a Senior Product Manager, and Robert Schwaba is a is a Manager, Specialized Consulting, with Wolters Kluwer.

Introduction

On April 9, 2021, the IRS released Chief Counsel Advice 202114020 (dated March 22, 2021, the “CCA”) addressing the tax consequences for an individual who received Bitcoin Cash (BCH) as a result of the Bitcoin (BTC) hard fork on August 1, 2017. Although tax guidance relating to virtual currencies remains spotty and incomplete, the taxation of virtual currency forks had previously been addressed in Rev. Rul. 2019-24 (the “Rev. Rul.”). Many taxpayers and commentators had criticized the conclusions and technical discussion of the Rev. Rul.¹ As discussed below, the technical discussion set forth in the CCA is better than that contained in the Rev. Rul. In certain respects, it could be viewed as a “do-over” or attempt to rehabilitate the Rev. Rul. given issues raised regarding its technical correctness. However, many taxpayers and commentators are likely to be unhappy with the CCA because, like the Rev. Rul., it also concludes that the taxpayer had taxable ordinary income at the time of dominion and control over a new forked virtual currency. It is important to note the explosive growth in the valuation of virtual currencies in the past five years. During that period the price of a single BTC skyrocketed from $500 to almost $60,000.² 

Summary of the Rev. Rul.

Although the IRS had initially provided limited tax guidance on virtual currency in the form of Notice 2014-21, the publication of the Rev. Rul. five years later was the first release of authoritative tax guidance relating to virtual currency.³ The Rev. Rul. highlighted two integrally related issues: first, does a hard fork result in gross income to a taxpayer when the taxpayer does not receive units of a new virtual currency; and, second, does a similar hard fork result in gross income “as result of an airdrop of a new cryptocurrency following a hard fork,” if the taxpayer receives units of the new virtual currency?⁴ It opens with a general discussion of the technological substrate upon which virtual currencies are built before moving on to the virtual currency specific terms “hard fork” and “airdrop.”⁵ A “hard fork” is defined in the Rev. Rul. as “when a cryptocurrency on a distributed ledger undergoes a protocol change resulting in a permanent diversion from the legacy or existing distributed ledger,” which “may result in the creation of a new cryptocurrency on a new distributed ledger….”⁶ The Rev. Rul. defines airdrop as “a means of distributing units of a cryptocurrency to the distributed ledger addresses of multiple taxpayers,” while also noting that while “[a] hard fork followed by an airdrop results in the distribution of units of the new cryptocurrency … a hard fork is not always followed by an airdrop.”⁷ 

These general terms and discussion are then applied to the two fact patterns outlined above. The Rev. Rul. clarifies that in the fact pattern, the new virtual currency “is not airdropped or otherwise transferred to an account owned” by the taxpayer, while in the second example new virtual currency is “airdropped to [the taxpayer]’s distributed ledger address and [the taxpayer] has the ability to dispose” of the virtual currency immediately.⁸ As the taxpayer did not receive anything in the first example, there is no income. In the second example, the taxpayer received new property over which the taxpayer had immediate dominion and control, an accession to wealth resulting in income.⁹ 

Criticism of the Rev. Rul.

There was notable criticism of the Rev. Rul. after its release.¹⁰ Commenters noted that the definitions provided of hard forks and airdrops didn’t match the way the terms are commonly used.¹¹ Hard forks are generally understood to mean a software change that renders newly added data unintelligible to old versions of the software; essentially, a drastic rule change. Users can choose which path to follow, like a fork in the road. Where developers anticipate the entire community will follow the new rules, the hard fork is generally considered to be a mere technological upgrade. Where the community splits, the hard fork is considered divisive; the Rev. Rul. does not mention this crucial distinction.

In addition to declining to distinguish between the two broad categories of hard forks, the Rev. Rul. also neglected to consider the impact of a hard fork upon the development, mining, and investment communities surrounding the forked asset. In a corporate spin-off or division, a discrete set of assets is divided. When a virtual currency goes through a fork, each community member must choose where to allocate their resources, and thereby metaphorically choose which forked path to follow. The result may be determinative of both paths’ futures. Furthermore, in some situations it may not be clear which virtual currency is “new” and which is “legacy,” while in others some participants may simply not upgrade, creating the appearance of a “legacy” chain where developers didn’t intend for one to exist.¹² It is unclear how or if the Rev. Rul. guidance would apply to the situation of a “legacy” chain maintained by a single user.

Commenters also generally seemed dissatisfied with both the central outcome of the Rev. Rul., that virtual currency received is taxable as income upon receipt of dominion and control, and with the Rev. Rul.’s implied retroactive effective date.¹³ 

The CCA

The CCA provides taxpayers and commentators with additional insights into the IRS’s analysis of the taxation of hard forks. It focuses on perhaps the most famous hard fork event in virtual currency’s brief history, the event leading to the creation of BCH. The central issue is simple; did a taxpayer who received BCH in the hard fork event have income under Code Sec. 61 as a result? In short, yes, because under longstanding tax law guidance, the receipt of the new property (due to the hard fork, in this case) represented an accession to wealth. Specifically, based on Glenshaw Glass, the CCA concludes that the taxpayer recognized taxable income from the receipt of virtual currency in a hard fork at the time the taxpayer obtained complete dominion over the currency received.¹⁴ 

The CCA states that a taxpayer “has received gross income under § 61 if the hard fork results in a new cryptocurrency and the taxpayer actually or constructively receives the new cryptocurrency.”¹⁵ The discussion in the CCA references the Rev. Rul., demonstrating that the IRS intends to apply the principles articulated in the Rev. Rul. regardless of any imperfections in its explication of technology. Although the Rev. Rul. emphasizes airdrops, the CCA’s discussion is much broader; receipt of new virtual currency in a hard fork event is income, regardless of whether the facts of the specific event perfectly align with the Rev. Rul. or what terms are used to describe the event.¹⁶ 

In the first example presented in the CCA, a taxpayer holds private keys to BTC in their own wallet. Immediately following the hard fork event, according to the CCA, the taxpayer’s “distributed ledger address continued to hold 1 unit of Bitcoin while also holding 1 unit of Bitcoin Cash.”¹⁷ As the taxpayer can sell, give away, or otherwise dispose of the BCH, the taxpayer now has dominion and control and thus has acceded to wealth, triggering income under Code Sec. 61.

The second example involves a taxpayer who holds BTC through an exchange. The exchange holds the private keys to the virtual currency and delays support of the new virtual currency resulting from the fork. The taxpayer in that example is unable to sell, give away, or otherwise dispose of the BCH until the exchange provides access to it. Without clear dominion and control, the taxpayer in this example does not have an accession to wealth and the attendant triggering of income until such access is granted.

This delay in recognition of income means that the two taxpayers can have markedly different tax outcomes depending on when they are granted dominion and control over the forked virtual currency. Virtual currencies tend to be wildly volatile; the second example posits that the fork event happened on August 1, 2017 and that the taxpayer received access to the BCH on January 1, 2018. The “close” price of one unit of BCH on August 1, 2017 was $380.01. The “close” price of one unit of BCH on January 1, 2018 was $2,432.54, a spread of $2,052.53.¹⁸ This means that the average individual taxpayer holding one unit of BTC directly would have had $380.01 of ordinary income in 2017 resulting from the receipt of the BCH, while a taxpayer holding one unit of BTC on the exchange in the CCA would have had $2,432.54 of ordinary income in 2018.¹⁹ 

The taxpayer in the first situation is free to use any reasonable method to determine the value of the virtual currency, although the CCA recommends using published data from exchanges or data aggregation services. The taxpayer in the second situation can first consult the exchange for valuation; if the exchange cannot provide the information, this taxpayer is also free to use any reasonable method.

Challenges with Applying the Principles of the CCA

Because the tax law guidance focuses on when the taxpayer obtains dominion and control of the virtual currency, the CCA concludes, in part, that different taxpayers can receive entitlement to virtual currency from the same hard fork at different times; entitlement occurs when each taxpayer obtains dominion and control over the virtual currency received. Accordingly, different holders might include this income in different amounts and on different dates if they acceded to dominion and control over the new asset at different times. Although individuals holding their BTC directly all received dominion and control over the new BCH at the same time, virtual currency exchanges did not immediately support the new asset. As exchanges rolled out support, holders of BTC received dominion and control over the BCH on different dates. The CCA makes it clear that the ability to dispose of the BCH is the strongest indicator of dominion and control; holders of BTC through exchanges did not obtain such dominion and control until and unless the exchange on which they held their BTC made the BCH available.

A practical challenge of recognizing taxable income related to a hard fork at different times is that the valuation of the virtual currency can change between the different dates when dominion and control arises. This is a particular concern because virtual currency valuations can vary widely depending on the exact time and the data source used to determine valuation. This has been a historically challenging issue in the mainstream securities markets, and additional guidance specific to virtual currencies would be helpful.²⁰ Another practical challenge is that software systems used to track tax lots of virtual currency will need to distinguish subgroups of the same virtual currency held via different exchanges because the timing of income recognition and the valuation of forked currency received will differ depending on when dominion and control is obtained with respect to virtual currencies held with each exchange.

Conclusion: The CCA Is Unlikely to Satisfy Many Taxpayers

The CCA’s conclusion that hard forks give rise to taxable ordinary income at the time dominion and control is obtained over a forked virtual currency seems unlikely to satisfy the industry. Some continue to advocate for treatment that would value any new virtual currency at the time of distribution as zero or that the fork event should be nontaxable, effectively deferring any gain until sale or other disposal of the virtual currency. As many active virtual currency traders tend to trade between different coins more than they trade to fiat, arguments along this line may have a practical basis but seem unlikely to sway the IRS. Given the valuation volatility of many virtual currencies and the likely risk profile of individuals investing in the virtual currency markets, continued litigation and controversy regarding the proper tax treatment seems inevitable. Increased information reporting requirements and further efforts to enhance the IRS’s ability to trace transactions will likely be necessary to reduce litigation and disparate tax treatment by various taxpayers and to increase tax collection in various virtual currency transactions, including hard forks.

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Footnotes