Mattia Landoni* and Gina C. Pieters**
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TAXING BLOCKCHAIN FORKS Mattia Landoni* and Gina C. Pieters** ABSTRACT The tax treatment of cryptocurrency forks presents four unique challenges: (1) parent/child designation, (2) new token access, (3) assessment of fair market value, and (4) assessment of comparable contemporaneous fair market values. We provide evidence that each issue complicates the determination of income realization, or basis apportionment. We compare three existing approaches for assets acquired without a purchase. We conclude that the least problematic approach (adopted by Japan) assigns zero tax basis to the new coin and taxes the proceeds upon sale. Treating the new coins as realized income (as recently ruled in the US) is the most problematic approach. 1. INTRODUCTION The last few years have seen an explosion of interest in, and activity around, distributed ledger technologies. Since the introduction of Bitcoin, many other cryptocurrencies have been launched, 1 and businesses have raced to find ways to incorporate blockchain technology in their operations. Tradable and storable tokens associated with blockchains are just one * Federal Reserve Bank of Boston; Assistant Professor, Southern Methodist University, Cox School of Business. ** Assistant Instructional Professor, University of Chicago, Department of Economics; Research Fellow, University of Cambridge, Cambridge Center for Alternative Finance (CCAF). 1 Some cryptocurrencies have been introduced to address some of Bitcoin’s perceived limitations. For instance, the Ethereum blockchain is a distributed computing platform that is able to execute ―smart contracts,‖ and Zcash attempts to provide truly private transactions. Other cryptocurrencies, however, have been introduced as hobby projects (Dogecoin), and many others which we will not name are copycats trying to capitalize on the popularity of the blockchain phenomenon. 197 198 STANFORD JOURNAL OF BLOCKCHAIN LAW & POLICY [Vol. 3.2 example of a growing class of digital assets that exist within and depend on community-wide protocols.2 A well-known example of such a protocol is the World Wide Web, whose domain names are regularly bought, traded, and commonly understood as ―property.‖ The rise of digital assets creates interesting tax issues. The most visible and vibrantly debated tax issue specific to blockchain-based currencies is whether they should be treated as currency or property. The first published Internal Revenue Service (―IRS‖) guidance on the topic maintains the position that they should be taxed as property,3 while in other jurisdictions (e.g., Germany) cryptocurrency can be used as normal currency, i.e., spent to purchase goods without incurring gains and losses. The focus of this paper is a less-obvious but equally important issue: the tax implications of token issuances after chain splits, one of the most unique technological aspects of a purely digital asset class. Chain splits are also the subject of Revenue Ruling 19-24 of 9 October 2019,4 the second and latest installment of IRS guidance on cryptocurrencies. These events consist of a duplication of the ledger (the blockchain) on which token transactions are recorded following a so-called fork. Chain splits, whose full implications are discussed in Section 2, result in the allocation of additional tokens to existing (and possibly unwitting) token holders. The tax treatment of such a token acquisition and of a potential subsequent sale poses important questions for a regulator. Chain splits are frequent. Some, like the fork that created Bitcoin Cash, are of significant economic importance. Others, like the fork that created Bitcoin Pizza, are at best highly speculative.5 Prior to Revenue Ruling 19- 24, the lack of guidelines had caused uncertainty for taxpayers.6 The new ruling does answer some of the taxpayers’ most frequent questions, but it appears to apply only to those taxpayers who hold cryptocurrencies indirectly via an exchange, and not those who hold them directly. 2 We will use ―token‖ to refer to any tradable unit tracked by an underlying blockchain. We do not intend to delve into the distinctions between the different types of tradable units such as currency tokens (i.e., cryptocurrencies), utility tokens, or asset/investment tokens. 3 INTERNAL REVENUE SERVICE, Rev. Rul. 2014-21 (2014), https://www.irs.gov/pub/irs- drop/rr-14-21.pdf. 4 INTERNAL REVENUE SERVICE, Rev. Rul. 2019-24 (2019), https://www.irs.gov/pub/irs- drop/rr-19-24.pdf. 5 BITCOIN PIZZA (Sep. 17, 2019), http://bpa.p.top/en/index.html [https://web.archive.org/web/20190917044125/http://bpa.p.top/en/index.html]. 6 Mordecai Lerer, The Taxation of Cryptocurrency: Virtual Transactions Bring Real-Life Tax Implications, CPA J. (2019), https://www.cpajournal.com/2019/01/24/the-taxation-of- cryptocurrency. 2020] TAXING BLOCKCHAIN FORKS 199 Regardless of applicability, we also argue that the approach chosen by the ruling is not sustainable. In Section 3, we identify four key issues for taxation authorities when dealing with chain splits: (1) parent/child designation, (2) the assumption that the taxpayer has access to the new token, (3) assessment of fair market value, and (4) assessment of comparable contemporaneous fair market values. We provide empirical evidence that each of these issues is a hurdle in determining whether income has been realized, or in apportioning the basis between the two split tokens, or both. In Section 4, we then examine the shortcomings and benefits of three existing tax treatments that could be applied to cryptocurrency splits: (i) treating the new coin as an independent accession to wealth by the taxpayer (a ―treasure trove,‖ the approach adopted by Revenue Ruling 19-24 in the USA); (ii) considering the chain split as a stock spinoff or similar event (an ―asset split,‖ the approach adopted by the UK); and (iii) treating the new coin as the offspring of the existing coin (―calving,‖ the approach adopted by Japan). In light of the four issues we identified above and our empirical evidence, we conclude that the third approach is the least problematic, and the first approach the most problematic. Section 5 concludes with this and a few additional suggestions. 2. WHAT IS A CHAIN SPLIT? A NON-TECHNICAL INTRODUCTION For the purpose of this paper, the reader can simply consider a blockchain to be a history of transactions and a software program (i.e., a set of rules) to process and verify these transactions shared across multiple individuals, or more specifically, nodes.7 A cryptocurrency is a distinct form of digital token whose ownership history is recorded in a blockchain. As a purely digital asset, a cryptocurrency is defined by the transaction history recorded on its associated blockchain. Each blockchain can be associated with one or more tokens. For example, the Bitcoin blockchain records Bitcoin (BTC) transactions, the NEO blockchain records both NEO and NeoGAS (GAS), and so on. Tokens can be traded directly between users, or can be traded 7 For a taxonomy of the different types of blockchain, and a deeper description of their operation, see Michel Rauchs et al., Distributed Ledger Technology Systems: A Conceptual Framework, UNIVERSITY OF CAMBRIDGE, CAMBRIDGE CENTER FOR ALTERNATIVE FINANCE (Aug. 2018), https://www.jbs.cam.ac.uk/fileadmin/user_upload/research/centres/alternative- finance/downloads/2018-10-26-conceptualising-dlt-systems.pdf. 200 STANFORD JOURNAL OF BLOCKCHAIN LAW & POLICY [Vol. 3.2 using an intermediary, like a cryptocurrency exchange. Most trades occur via cryptocurrency exchanges. As with all software programs, the software code of a blockchain can fork, i.e., be updated. In practice, the term ―fork‖ is used to indicate both the block number (the height) at which the updated software is allowed to operate and the time at which that block is mined. A fork can be successful, if all nodes update, and unsuccessful, if all nodes reject it. Such successful and unsuccessful forks do not cause the creation of any new asset. There is, however, a third possibility. If the blockchain is not centrally managed, each node must independently decide whether to update their version of the code. It is therefore possible that some nodes incorporate the update, and others do not. A chain split occurs when both the original and the updated software are used simultaneously by a sufficient number of nodes. Even though all nodes recognize a common transaction history up to the fork block, updated and non-updated nodes can create mutually incompatible blocks of transaction records. The addition of incompatible blocks to the original blockchain results in divergent histories and, therefore, non-identical blockchains. Given that the token is inherently defined by its blockchain, this means that the token itself splits into multiple instances as well. It is only when the fork results in a chain split that owners of a token on the parent chain effectively acquire a new asset. Perhaps because a chain split can only happen after a fork, this scenario is often referred to informally as a ―hard fork.‖ 8 In this paper we use the terms ―fork‖ and ―split‖ in a strict sense, as defined above. For clarity and simplicity, in the remainder of the paper we will also assume that a chain split results in exactly two blockchains, and a user that owned one 8 I.R.S., Rev. Rul. 2019-24 uses the terms ―hard fork‖ to indicate a fork, and ―airdrop‖ to indicate the reception of new cryptocurrency. In reality, both hard and soft forks can result in chain splits, even though soft forks are backward-compatible. See John Light, The differences between a hard fork, a soft fork, and a chain split, and what they mean for the future of bitcoin, LIGHTCOIN (Sep. 16, 2019), https://lightco.in/2017/07/30/bitcoin-fork-split. That is, even though nodes using the old code can still process the blocks produced by the updated nodes, mutual incompatibility between the two branches quickly arises as, e.g., the same transaction is included in different blocks.