In October 2019, the IRS issued a new Revenue Ruling – 2019-24 which deals with virtual currencies/cryptocurrencies and provides much needed guidance on the treatment of specific taxable events associated with cryptocurrencies. The virtual world is similar to a web (which is where the “world wide web” derived its name from) or akin to a hydra headed alien for those trying to investigate transactions on it. Cryptocurrencies are and have been a favorite project of revenue departments the world over. Some jurisdictions have come up with regulations while some are still studying its intricacies. This holds true not just for the tax departments but also for all Central Banks across the world.
Today we will look at two cryptocurrency transactional events that may or may not generate a taxable event. The two events are a hard fork and an airdrop. A cryptocurrency transaction is usually recorded digitally in a distributed ledger (block chain). Units may be coins or tokens. There is no central data admin function. Block chain technology records and synchronized transactions in multiple places at the same time. A hard fork is said to occur when a cryptocurrency undergoes a change in protocol and is diverted permanently from existing ledger. It results in the creation of a new cryptocurrency on a new ledger. Any transactions with the new crypto are then recorded on the new ledger. Any transactions involving the older crypto will continue to be recorded in the old ledger as before. An airdrop on the other hand is a way to distribute the units of a currency to the ledgers of multiple individuals.
Cryptocurrency works through a cryptocurrency exchange. When a hard fork results in the creation of a new crypto, the new currency must be distributed to the individual’s ledger address so that he has control over it and can use it. Let us assume the taxpayer has a Crypto K account with 50 units. A hard fork occurs creating a new currency Crypto S. During a hard fork two possible events may take place:
- Post experiencing a hard fork a new currency Crypto S is created but it is not airdropped or transferred to the owner’s ledger address/account.
- Post a hard fork, 25 units of the new currency Crypto S is distributed/airdropped into the owner’s ledger address and the owner has the ability to use the currency. Now, in this case the new currency will be recorded on new ledger address while the old one (Crypto K) will continue to be recorded on the legacy address.
So what are the tax implications of these two events? Per Sec 61 of the IRC, “all gains or access to wealth over which a taxpayer has complete dominion, are included in gross income”. Based on this definition, the two events above may be categorized as taxable or non-taxable events. In the first situation, the taxpayer did not receive dominion over the currency. Therefore, he does not have accession to wealth and this does not qualify as gross income. In the second situation the airdrop ensures that the new currency is in the distributed ledger address of the taxpayer and he has the ability to use it as well as complete dominion over the currency. Originally, taxpayer held 50 units of Crypto K and post the hard fork he also has control over 25 units of Crypto S. In this case, he has an addition to gross income in the form of the value of new currency (25 units of Crypto S) credited to his ledger post the hard fork.