A recent Chief Counsel Advice Memorandum (“CCA”) discusses certain tax consequences pertaining to a taxpayer owning cryptocurrency native to a blockchain that undergoes a protocol upgrade. CCA 202316008. In the hypothetical scenario discussed in the CCA, a hypothetical blockchain, very similar to Ethereum, underwent a change in the method in which it approved and processed transactions. The CCA provided valuable guidance to taxpayers that the hypothetical protocol upgrade would not cause a realization event, triggering gain or loss, or income to the taxpayer.
An individual taxpayer (“T”) owns 10 units of a certain cryptocurrency (“C”), native to a specific distributed ledger that undergoes a protocol upgrade that changes the consensus mechanism by which transactions are validated (think Ethereum moving from proof of work to proof of stake).
The hypothetical blockchain (“K”) is a blockchain utilizing a distributed ledger to record transactions, including those involving C. K blockchain protocol is a set of rules utilizing a consensus mechanism for adding new blocks of transactions to K. Those participating in the consensus process that successfully add new blocks of transactions to K receive a block reward in accordance with K’s underlying protocol.
In the CCA, the hypothetical assumed that on Date 1 T purchased 10 units of C, storing T’s private wallet keys in an unhosted cold storage wallet. Subsequently on Date 2, K changed its consensus mechanism to select who may validate transactions and add blocks to K from proof of work (computational algorithms requiring miners to solve cryptographic puzzles) to proof of stake (validation by participating in the staking progress – i.e. ownership of C and participation as a validator).
Following the protocol upgrade, K’s transactions must be validated through the proof of stake consensus method. For all other purposes, the K and C remain virtually the same, with the only substantial change being the consensus method. Additionally, the ledger itself and historical transactions relating to pre-proof of stake consensus remain unchanged. C units remain unchanged and T does not receive any cash, services, or property (including additional C units) as result of the upgrade.
The issues concerning this scenario and for which guidance was given were as follows:
- Whether T should realize gain or loss pursuant to Section 1001 as a result of the upgrade, and
- Whether T has gross income under Section 61(a) of the Code as a result of the upgrade.
The Code defines digital assets under Section 6045(g)(3)(D) as digital representations of value that are recorded on a cryptographically secured distributed ledger. The assets do not exist in physical form and include property the Service previously referred to as convertible virtual currency and cryptocurrency in Notice 2014-21, specifically identifying such as property and informing taxpayers that general tax principals applicable to property transactions would be applicable to cryptocurrency.
Under Section 1001, gain or loss is recognized upon the sale or other disposition of property. Treas. Reg. Section 1.1001-1(a) provides that gain or loss realized from an exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained. Furthermore, an exchange of property is a realization even under Section 1001 only if the exchange results in the receipt of property that is materially different from property transferred. For properties to be “Different in the sense of being ’material’ for the purposes of Section 1001, they must embody legally distinct entitlements.” Cottage Savings Assn. v. Comm’r, 499 U.S. 554, 564-565 (1991). It is worth noting that Section 1031 does not apply to cryptocurrency as Section 1031 relates specifically to real property.
Looking to Section 61(a), the general rule is that, except as otherwise provided by subtitle A of the Code, gross income means all income from whatever source derived, including gains from dealings in property. Section 61 also provides that all gains or undeniable accessions to wealth, clearly realized, over which the taxpayer has complete dominion are included in gross income. Comm’r v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).
This CCA mirrors closely the events relating to the change of the Ethereum blockchain from proof of work to proof of stake, which occurred on September 15, 2022. In both the case of Ethereum and the hypothetical provided in the CCA, the protocol upgrade affects the consensus mechanism by which future transactions would be validated and blocks added to the blockchain after Date 2. The CCA noted that prior transactions would not be altered and that T’s units would remain unchanged.
It appears that, based on the Service’s position with respect to the hypothetical blockchain, discussed in the CCA, that the Service’s position with respect to the Ethereum consensus change on September 15, 2022, will not result in any realization event as T derives no accession to wealth from the upgrade as T’s units were unchanged and T did not derive any separate economic benefits in the form of cash, services, or other property (including other cryptocurrencies) from the change.
Specifically, the CCA held that, as to the two issues presented, that the upgrade neither results in gain or loss under Section 1001, nor does such constitute an item of gross income under Section 61(a).