Author: David J. Shakow, Professor Emeritus, University of Pennsylvania School of Law1
The discussion in this document reflects legal principles as of January 20, 2020.
In 2014, in its first decision relating to cryptocurrencies, the IRS held that a cryptocurrency, such as Bitcoin, is not a currency for tax purposes. Why was that important? The Internal Revenue Code contains special provisions relating to currencies. Treating a medium of exchange as a currency provides some special rules relating to the character and timing of any gain or loss on that item. It also allows individuals, who may be traveling in a foreign country, to ignore small amounts of gains and losses that result from changes in exchange rates between the time a unit of currency is purchased and the time it is spent.
However, the most important advantage in treating a medium of exchange as a currency is that it allows a business to conduct its operations in that medium of exchange without having to treat every transaction in the medium of exchange as a taxable event. If we use the case of Bitcoin, for example, if bitcoins were treated as a currency for tax purposes, a business that conducts many of its transactions using bitcoins could keep its books in bitcoins, figure its income or loss at the end of the year in bitcoins, and only then translate its profit or loss into dollars for purposes of paying its United States tax liability. The alternative is to calculate gain and loss on every receipt and disposition of a bitcoin. As a practical matter, this is not possible for a company that has many Bitcoin transactions. The only practical alternative for such a business is to exchange any bitcoin immediately for cash upon receipt.
Why did the IRS rule that cryptocurrency is not a currency? The IRS was interpreting a statute that was drafted long before cryptocurrencies were a practical alternative to fiat currencies. Apparently, the IRS thought it would be difficult to interpret the term “currency” in the Internal Revenue Code to encompass a type of currency unknown when the statute was passed.
Could this result change? To the extent the IRS’s 2014 notice gave any reason for its conclusion, it stated that virtual currency does not have “legal tender” status in any jurisdiction. In other words, in no jurisdiction are persons required to accept any cryptocurrency in payment of an obligation.
At the moment, this conclusion still holds. There is an exception for a cryptocurrency issued in Venezuela, but even if that cryptocurrency is actually treated as legal tender in Venezuela, it is not a very significant item of cryptocurrency even within the country.
However, this situation could change. If any country were to designate Bitcoin, for example, as legal tender, it would seem that the IRS would change its conclusion and treat Bitcoin as a currency for purposes of the Internal Revenue Code. However, this result is not strictly compelled, since the nature of the IRS’s original pronouncement in this area was a “Notice”, a document that does not necessarily reflect the highest level of review at the IRS. The IRS would most likely treat a cryptocurrency like Bitcoin as a currency for tax purposes if the jurisdiction that accepted it as legal tender were a significant jurisdiction. If it were a very small jurisdiction (for example, Bhutan, with a population of less than one million), it is possible that the IRS would withhold its approval. For example, the IRS might distinguish bitcoins from other items treated as legal tender because unlike other items treated as legal tender, bitcoins are not issued by a government. However, without further arguments from the IRS, this would appear to be a distinction without a difference. Accordingly, if a country that was a significant economic player made Bitcoin legal tender, logic dictates that the IRS should change its position and treat it as a currency.
It is not clear currently whether any country will treat a cryptocurrency as a legal tender. China, which is active in the blockchain arena, has announced that it will issue a blockchain version of its currency, the Yuan. This virtual version will be issued by the Chinese government and is intended to be the exact equivalent of its regular currency. As such, it can be treated as a currency for tax purposes and does not raise any new issues in this area.
So-called stablecoins might be viewed as similar to the blockchain Yuan that the Chinese government is implementing. A stablecoin is backed by assets and its value is pegged to the assets that back it. So, in particular, a stablecoin could be backed by a fiat currency and its value would generally equal the currency that backs it. However, if the stablecoin is not issued by a government and is not accepted by a government as legal tender, its position for tax purposes would be no different than any other cryptocurrency.
An intermediate situation might raise an interesting problem for tax authorities. What if Bitcoin truly became generally accepted as a form of payment although no jurisdiction officially designated it as legal tender? There would certainly be a reasonable argument that the IRS’s conclusion should change under those facts. However, if that were to happen, and Bitcoin became generally accepted, it seems more likely that any change would be made at the legislative level rather than administratively.
1The statements in this paper represent the views of the author only and should not be attributed to the University of Pennslvania School of Law. Further, this document should not be treated as legal advice to any reader or to Lukka.
