This article is about the regulations that the USA started to implement on crypto. Also, it´s about how other countries are considering legislation to regulate the crypto environment, making this a natural worldwide tendency.

In this article, we are not offering legal advice, but we are describing the current situation of the crypto environment in the US and the world. If you want a detailed consultation on the best crypto jurisdiction and most convenient crypto businesses, you can read our articles on Malta, Montenegro, and Estonia, where we can offer a variety of services. Since each case is different, we recommend asking for a consultation with our experts as soon as possible.

Before the famous Foreign Account Tax Compliance Act or FATCA saw the light of day in the 2000s, the IRS conducted many fishing expeditions in order to understand how the taxpayers were managing to keep their funds outside the US, and, in some cases, using these strategies to avoid taxation.

It´s important to keep in mind that the money placed abroad is not always used to avoid taxes, and also the US has an option that’s even recognized by the Supreme Court that states that it is legal for the citizens to optimize their tax burden, allowing the establishment of family offices abroad, or accepting in the US the establishment of foreign family offices.

As a result of the aforementioned fishing expeditions, the government of the US, through the Department of Justice and the IRS, managed to understand the cash flows in foreign countries and created the now famous FATCA in 2010. Nowadays, with the cryptocurrency boom, the IRS is focused on understanding this new monster, that exists outside of its radar and it´s depleting the IRS´s income. Keep your enemies close, they say. For this reason, in order to understand this new enemy, the IRS must adapt to the crypto ecosystem and determine the variation in income of the taxpayers, so that the crocodile can close its mouth and finally swallow its prey and the IRS can tax for the crypto income.

The US is not the only one trying to research, analyze and study the uses and applicable taxes of these technology-based financial instruments. From 21 to 22 of July, 2018, the Minister of Finance of the G-20 and the governors of national banks of several countries got together in Buenos Aires, Argentina, in order to discuss a series of international tax matters, including the crypto boom and the need of government regulation. This approach was similar to other countries´ approaches towards the regulation of crypto, such as New Zealand, the United Kingdom, Israel and many others.

The OCDE, for example, has started a work group in order to assess the cryptocurrencies and their impact in today´s financial world. In a similar way, companies are increasing the use of cryptocurrencies. For example, Facebook planned to issue their own payment system based on cryptocurrency, this project was called “project Libra”. However, the fact that the environment was not yet ready for a cryptocurrency without banking regulation, put this project on hold. This makes us think about the future of this virtual currency, when the traditional banks manage to understand how to take advantage of this tendency and what would happen then. Will, somehow, the decentralized nature of the crypto philosophy suffer?

Thus, the “call” that the United States has made through the IRS after having understood the crypto-related activities is similar to the times when the offshore banking research gave birth to the famous FATCA.

On July 2nd, 2018, the IRS announced a campaign with the objective of understanding the cryptocurrencies and then enforcing the correspondent tax obligations on the citizens. A year after that, on July 26, 2019, in order to educate and encourage the taxpayers to comply with their obligations on crypto-earned money, the IRS issued the following press release:

Report on virtual money transactions

The press release gives three examples of letters (letter from the IRS 6173, letter from IRS 6174, letter from IRS 6174-A), that are known by many as “the IRS letters”. These letters are intended for taxpayers to understand their tax obligations and federal reports. The initial sentence of the letters alone reminds us to the similar one about FATCA:

“(we have) information that you have or have had an account or more accounts holding cryptocurrency and it´s possible that you haven´t complied with the tax return requirements of the US for transactions that involve cryptocurrencies and non-crypto virtual currencies”.

According to this press release issued by the end of August 2019, the IRS sent more than 10,000 letters to taxpayers who were suspected of obtaining income from cryptocurrencies without reporting them during the fiscal years from 2013 to 2017. The warning came from a passive taxation that encouraged individuals to amend their reports, otherwise they know what´s coming. If it´s proven that the individual has not reported something, they can be prosecuted under federal charges.

Such a warning would probably have driven any sane person to amend the reports as fast as possible, in case they have crypto-generated income still not disclosed.

However, in order to comply with what the IRS is asking many doubts arise, and some tax loopholes start to appear.

1. Key aspects of cryptocurrencies and background

Cryptocurrencies, also known as virtual currencies have been subject to an increasing interest by the government regulators, among them we can count different countries like Spain, Argentina, Ukraine, South Korea, Portugal, Mexico, Canada and, of course, the start of this article, the United States.

The dynamics of the market, the absence of taxes, and their easy transfer has attracted the attention of many investors, who have seen many opportunities opening in front of them but at the same time have been targets of tax authorities, due to the management of the money through channels different than the usual (banks, stock exchange, etc.).

Many say that the cryptocurrency market is not growing due to the banks´ pressure, while others more conservative believe that there are many grey areas in these types of investments that call for immediate regulation. No matter your opinion, the fact is that the IRS believes that is imperative to tax cryptocurrencies.

When we talk about cryptocurrencies (Bitcoin, Ethereum, LiteCoin), we are talking about an e-payment system based on cryptographic proof, that allows the parts to exchange information using the blockchain technology. This doesn´t require a third party to validate the transaction (a bank, for example). A blockchain, from an accountant´s point of view, is similar to a ledger account of all the transactions happening on the net, but it´s decentralized, meaning the ledger is not kept in only one place but distributed all over the blockchain. Anyone has access to this information.

Blockchain technology allows participants to confirm transactions without the need of a third party, thus eliminating commissions.

This ledger account is distributed throughout the blockchain and each participant can simultaneously have access to the information, in real time and without possible alteration. Cryptography allows integrity and security as the information cannot be altered. The participants then become autonomous entities and the third party becomes obsolete, and we can kiss commissions goodbye.

The users that supply crypto information to a network for the creation of new currency are called “miners”. And the mining process is conducted with state-of-the-art technology capable of designing algorithms that allow for the insertion of new blocks to the chain, this is why it´s called a blockchain.

It´s worth mentioning that Bitcoin is an e-payment system between pairs. It was introduced for the first time in 2008 by an unknown person or group of persons under the pseudonym Satoshi Nakamoto. What motivated this group of people was the frustration they felt with the inadequate response of the central banks upon the market collapse and the global recession. For this reason, many innovative minds decided to create Bitcoin as an alternative way of money that could solve the problem of the lack of trust in the central banks.

In order to better understand the taxation of cryptocurrencies, it´s imperative to firstly revise the concepts. For example: the terms “cryptocurrency, “virtual currency” and “digital currency” are usually used as synonyms. These terms shouldn’t be mixed with “digital money”, which are a platforms authorized by a regulatory entity where transactions are conducted in fiat money.

A “digital currency” is an exchange based on the internet but with similar characteristics to the physical money. The “virtual currency” is a subcategory of the digital currency and the banking authority of Europe defines it:

“Virtual currency”: a digital representation of value that is not used by a central bank or a public authority nor is necessarily linked to fiat money, but it´s accepted by individuals or legal entities.

Cryptocurrency is a subcategory of virtual currency in which crypto technics are used to regulate the generation of units of currency and verify the transparency of the funds. A wallet or e-wallet is a platform where cryptocurrencies are acquired, can be exchanged, and stored. Once an e-wallet is created, the owner can access, use, or transfer the currencies. In a way, an e-wallet is like a bank account, but it exists only on the blockchain.

The most common virtual currency is Bitcoin. However, there are many others, called altcoins, that include Ethereum, Ripple, Litecoin, Dash, etc. There is also Bitcoin Future, which are similar to a forward or a swap where you set a date to acquire a future for a price fixed today. On the other hand, we have “hard forks”, which is only a change in protocol dividing the crypto in 2 (for example, where Bitcoin is divided into Bitcoin Cash).

A “hard fork” results in two currencies based on the blockchain. It is also important to understand: what is an airdrop of cryptocurrency? This means when a blockchain distributes tokens or currencies into the community as a protocol. In general, in order to receive this currency, the taxpayer must already own relevant cryptocurrency from the blockchain (Bitcoins or Ethereum).

Lastly, the ICO (Initial Coin Offering) are developers, companies and individuals that use ICOs or token exchanges to raise capital. The buyers can use fiat money (for example, American dollars) or virtual currency in order to buy currency or virtual tokens.

The bitcoin Exchange allows for users to buy and sale virtual currency for other virtual currencies or fiat money as well. It´s an Exchange platform that facilitates crypto trading with fiat money (e.g. Bitcoins in exchange for dollars, Ethereum in exchange for Bitcoin and so on).

The Exchange connects buyers and sellers. Users deposit fiat money in the process of exchange by sending funds (bank transfer, PayPal, or credit cards) to the Exchange before the operation. The exchange will charge a commission for the transaction.

The appeal of Bitcoin as a virtual currency is derived from the auto verification where users can instantly transfer funds to another person with a bitcoin wallet as if they were paying in cash. There are already many stores that accept bitcoin as a legit payment method.

2. Taxation of cryptocurrency in the USA

IRS guide

In March 2014, the IRS published a guide on taxation of crypto. As an introduction, the IRS analyzes whether a cryptocurrency should be classified as currency or as property for income tax purposes.

In general, virtual currency is defined as “digital representation of value that work as a means of exchange, a unit of measure or value”. Virtual currency is defined as a subcategory of digital currency or one that “has the equivalent value to real currency or acts as substitute for real currency”. Therefore, it´s probable that this announcement doesn’t contemplate tax on other ways of cryptocurrency, like the “smart contract” (Ethereum). A smart contract is a computer protocol that automatically executes the terms in a bilateral or multilateral agreement without an intermediary.

Next, we present a summary of relevant topics for the taxation of cryptocurrency.

Taxation of virtual currency

When it comes to taxes, the IRS has made it clear that, when it comes to federal income tax, cryptos must be considered property. The general fiscal principles applicable to transaction of property must be applied to transaction of cryptocurrency. Therefore, the rules that apply to taxation of currency under the subchapter J of the Tax Code are not applicable. This means that cryptocurrency can´t generate profit or loss when it comes to federal tax in the US.

Thus, let´s suppose that a taxpayer receives one bitcoin as payment for any good or service. This should be included in the gross income with the market value of the bitcoin starting from the date in which the bitcoin was received. The base of bitcoin received by a taxpayer as payment is in American dollars form the receipt date, so this is what will determine the tax base for the federal tax. Meaning all the transactions in cryptocurrency must be reported in American dollars.

Taxation of mining activities

A taxpayer that mines the virtual currency obtains gross income at the market value at the date of receipt. Also, if the “extraction” of the cryptocurrency by a taxpayer constitutes a business, the taxpayer doesn’t conduct the mining activity as an employee. The IRS requires that the net profit for this independent worker is considered and taxed under self-employment category.

Conclusion

To sum up, it is clear that cryptocurrencies are here to stay. Regulations by the IRS to enforce the payment of taxes over these assets have just started and it appears they won´t stop until this area is also another big brother jurisdiction. The same way once the taxpayers didn´t believe that the FATCA could reach their accounts in the safe havens, the current American citizens that hold assets in cryptocurrencies shouldn’t rest so assured. The big fat taxation monster is coming to get you, eventually. For this reason, we recommend having a strategy or plan B to protect your digital assets from the big brother´s reach.

Based on an article by Jorge Garcia 

Disclaimer: The information contained in this article is for informational purposes only and does not constitute financial advice or recommendations. Investing in financial products or cryptocurrencies involves risks, and you should be aware of the potential risks involved before investing. The content on this website is not intended to be a solicitation or offer to buy or sell any financial products or services. The information provided does not take into account your specific investment objectives, financial situation, or needs, and should not be relied upon as a substitute for professional financial advice. You should seek independent advice from a financial advisor or other professionals before making any investment decisions. Please be aware that the legal status of cryptocurrencies and other financial products may vary in different jurisdictions and may be subject to regulation. It is your responsibility to ensure compliance with any relevant laws and regulations governing the sale and marketing of financial products and services in your jurisdiction.