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In the aftermath of Satoshi Nakamoto’s groundbreaking paper in 2009, money began travelling via a new financial route - virtual currencies. The first Bitcoin exchange was established on February 6, 2010 where Bitcoin traded for the first time for 0.3 cents.
Last June, the American Institute of Certified Public Accountants (AICPA) asked the Internal Revenue Service (IRS) for more guidance on virtual currency beyond Notice 2014-21 to provide clarification to taxpayers and practitioners and to boost compliance with federal tax laws. At that time, Bitcoin’s value was a mere $600, less than a tenth of its current price.
In response, last November 2016, the Treasury Inspector General for Tax Administration (TIGTA) published a paper titled “As the Use of Virtual Currencies in Taxable Transactions Becomes More Common, Additional Actions Are Needed to Ensure Taxpayer Compliance” which addressed the deficiencies in taxpayer noncompliance issues for transactions involving virtual currencies.
Following TIGTA’s report, on November 30, 2016, the IRS began issuing broad based "John Doe Summonses" seeking information on the US headquartered $10 billion Bitcoin exchange Coinbase’s US customers. The summons’ sought to track unreported virtual currency gains allegedly transmitted between the years 2013 and 2015, since trading in Bitcoin is a taxable event. Jonathan Levin, co-founder of Chainalysis, explained that his company:
“Provides software to IRS, DOJ, DEA, FBI, Europol and several other law enforcement officials and government agencies around the world to help identify the owners of virtual currency.”
Findings from multi-jurisdictional Bitcoin exchange and market investigations showed millions of Bitcoin transactions belonging to US taxpayers. However, the IRS stated that, “only 800 US taxpayers had reported their Bitcoin gains from 2013 through 2015.”
With the US as one of the world’s major financial hubs and a hotspot for Bitcoin activity, the IRS may have their hands full scrutinizing $150 billion in virtual currency transactions for US tax evasion purposes. This is because a federal judge, US Magistrate Judge Jacqueline Scott Corley in San Francisco, is poised to allow an IRS audit of Coinbase Inc. to proceed over the company’s objection.
Here are some of the US tax reporting requirements applicable to US taxpayers involved in virtual currency transactions:
1. U.S customers who traded virtual currencies should report capital gains to IRS
Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. A virtual currency, such as Bitcoin, that has an equivalent value in real currency or that acts as a substitute for real currency is called “convertible” virtual currency. Convertible virtual currency is treated as property for tax purposes.
A US taxpayer who successfully “mines” convertible virtual currency realizes gross income in the amount of the fair market value (FMV) as of the date of receipt of the virtual currency. This would apply, for example, to a taxpayer who uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger.
Gain or loss on the sale of virtual currency is gain or loss from the sale or exchange of property, treated in a manner similar to the sale or exchange of securities. If held as investment property, the gain or loss on sale will be capital gain or capital loss.
Form 8949 Individual taxpayers report Bitcoin capital losses and capital gains.
Penalties: Failure to timely file or correctly report virtual currency transactions, may be subject taxpayer to information reporting penalties under Code Sec. 6721, 6722 and tax underpayments attributable to virtual currency transactions, may be subject to accuracy-related penalties under Code Sec. 6662.
2. Foreign Financial Accounts (FBAR) Reporting
FinCEN Form 114: A US person that has a financial interest in or signature authority over foreign financial accounts must file a Report of Foreign Bank and Financial Accounts (FBAR) if the aggregate value of the foreign financial accounts exceeds $10,000 at any time during the calendar year. FBAR requires reporting of all foreign financial accounts. The types of “accounts” which must be reported are defined very broadly and include traditional checking, savings, money market funds, CDs, life insurance plans, and even online Bitcoin based poker accounts. A US taxpayer’s Bitcoin denominated foreign bank account or an account in a foreign virtual currency exchange, which convert Bitcoins in and out of other fiat currencies, that function similarly to brokerages, and offer a variety of financial services similar to banks or other financial institutions in exchange for fees would be reportable on an FBAR as a foreign financial account.
Penalties: US Bitcoin denominated foreign account holders who did not file FinCEN Form 114 could face steep civil and criminal penalties. Each non-willful failure to file violation can carry a civil penalty of $10,000, while penalties for willful violations could be the greater of $100,000 or 50 percent of the amount in the account for each violation.
3. Foreign Account Tax Compliance Act (FATCA) Reporting
Enacted as part of the HIRE Act of 2010, FATCA imposes extensive reporting obligations on US taxpayers, foreign entities and withholding agents. FATCA imposes a 30% US withholding tax to payments of certain US source income (e.g., dividends, interest, insurance premiums) made to non-US financial institutions (FFIs).
Foreign assets that are subject to FATCA reporting requirements include accounts with any FFI. For these purposes, virtual currency denominated foreign bank accounts, deposit accounts at foreign Bitcoin exchanges may be considered FFI, although the law on this subject is undeveloped at this time. It should be noted that interest from an interest bearing Internet based foreign Bitcoin account could be 50% US sourced under international communications income sourcing rules and subject to 30% U.S WHT.
Form 8938: US individual taxpayers report foreign financial assets valued at $50,000 or more.
Penalties: Noncompliance with FATCA subject’s taxpayer to, taxes, severe penalties in excess of the unreported foreign assets and exclusion from access to US markets.
4. Country-by-Country Report (CbCR)
This year for the first time, US headquartered Bitcoin exchanges like Coinbase, Inc., with annual revenues of at least $850 million (Multinational Enterprises or MNE) were obligated to file US CbCR on form 8975 on Oct 16, 2017.
Form 8975: MNE disclosed to tax authorities information regarding Bitcoin transactions, on a country-by-country basis as follows:
Tax jurisdiction and residence of the entity;
The main business activity or activities of entity;
Financial and employee information for each tax jurisdiction in which the US MNE does business (including revenues, profits, income taxes paid and accrued, stated capital, accumulated earnings);
Total net book value of tangible assets, which may include virtual currencies because they are classified as property and not a currency for US tax purposes (cash or cash equivalents, intangibles, or financial assets were not declared).
The IRS will automatically exchange filed CbCR with other governments via tax treaties and Tax Information Exchange Agreements. On July 4, 2017 the EU parliament approved making CbCRs publicly available.
Penalties: MNEs that failed to file a CbCR could be subject to penalties under US federal tax rules, and to penalties under rules imposed by the 57 other countries that have agreed to exchange CbCR. The US Supreme Court said in Pasquantino v. US (No. 03-725, 4/26/05) that federal wire fraud charges could be brought against violators of foreign tax laws.
Conclusion
Bitcoins, with their unprecedented investment returns, are attracting the IRS’s attention. Given recent actions by US law enforcement, government agencies, and regulators, holders and dealers in virtual currencies should beware that:
The IRS appears determined to audit virtual currency businesses — whether it be virtual currency exchanges, wallets, hedge funds, asset management companies, or binary Bitcoin markets;
The IRS, by using the long arm of US law, may claim jurisdiction over foreign virtual currency businesses that lack any physical presence in the United States, so long as they do substantial business in the United States based on a facts-and-circumstances-driven analysis.
The many taxpayers who neglected to report their Bitcoin related taxable gains, or withholding taxes to the IRS and Treasury - under the erroneous assumption that virtual currencies are independent from any government or regulation - are advised to report them, as the IRS has indicated that these transactions give rise to US tax obligations and US tax reporting requirements.
Disclaimer: this article is reproduced with permission from Tax Analysts. Virtual Currency: US Tax Considerations and Fraudulent Activity Amid a Growing Global Market, by Selva Ozelli, reprinted from Tax Notes Int’l, October 16, 2017, p. 257
Bio: Selva Ozelli, Esq., CPA is an international tax attorney and CPA who frequently writes about tax, legal and accounting issues.