The Internal Revenue Service (IRS) and other global taxing authorities are continuing to focus on bringing taxpayers who hold cryptocurrencies into compliance.
As cryptocurrencies have made some investors very wealthy, concern has arisen that investors are not reporting gains to taxing authorities. Internationally, governments are committed to bringing these investors into compliance. The most important compliance-related variables are how to characterize gains and losses, and at what point a reporting obligation arises. While many questions remain to be answered, taxing authorities have issued initial guidance on the treatment of cryptocurrencies, and have scored important victories in obtaining access to information necessary to bring taxpayers into compliance.
IRS Notice 2014-2 makes it clear that "convertible virtual currency" will be treated as a capital asset, i.e. property, not as currency. Thus, capital gains rules apply to gains or losses from sale or exchange of virtual currencies. Like rules governing taxation of property, realization occurs when cryptocurrency is traded for cash or other cryptocurrency, or when it is used to purchase goods or services. The IRS also stated that it would not require the virtual currency accounts to be reported on Reports of Foreign Bank Financial Accounts (FBARs).
In 2019, the IRS looks to leverage its important victories related to cryptocurrencies. In late 2017, a U.S. judge ruled to enforce an IRS summons issued to Coinbase seeking identifying information and all records of activity for all users on accounts with at least $20,000. In March 2018, the IRS reminded taxpayers to report virtual currency transactions in order to avoid audits and potential criminal prosecution. Consequences to taxpayers include penalties, interest, fines and potential incarceration.
Throughout 2018, including at year-end, Don Fort, Chief of IRS Criminal Investigation Division, made clear that the IRS would heighten its efforts to enforce taxation on unreported gains generated by cryptocurrency. Fort put together a team of ten cryptocurrency experts to identify scofflaws.
The IRS has formed a global tax coalition to combat non-compliance, known as the Joint Chiefs of Global Tax Enforcement (J5). This coalition includes government agencies from Australia, Canada, the Netherlands, the United Kingdom, and the United States. The IRS's efforts are consistent with the global trend toward tightening up cryptocurrency regulations. On January 14, 2019, Denmark's Tax Agency announced that a Danish court had given it authority to obtain information from 2016, 2017 and 2018 from three undisclosed virtual exchanges.
As taxing authorities look to increase cryptocurrency compliance, many outstanding questions remain that make compliance difficult for taxpayers. For example, what is convertible virtual currency, and exactly what kind of property is it? How should hard forks be treated, and is the receipt of the new cryptocurrency a taxable event? (Hard forks occur when a different software validates a transaction and thereby creates a new blockchain. As a result, a person who owns the original strain of cryptocurrency also owns the subsequently created one).
Effective regulation and appropriate compliance will bring legitimacy and should add value to cryptocurrency as an asset class, increasing the prevalence of cryptocurrency. Internationally, regulators have been publishing guidance on virtual currency, including most recently by the UK Financial Conduct Authority in January 2019. As the IRS and virtual currency investors grapple with challenging tax issues, the role of legal counsel is more critical than ever.
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