Tax treatment of digital asset protocol upgrades

Editor: Mark G. Cook, CPA, CGMA

The IRS, through Chief Counsel Advice memorandum (CCA) 202316008, has clarified the reporting for taxpayers holding certain digital assets that undergo certain protocol upgrades. In cases in which the protocol upgrade for the blockchain undergoes a change to the consensus mechanism by which future transactions are validated, the IRS concluded that no gain or loss is realized, and the taxpayer has no items of income because of the protocol upgrade.

In the CCA, a taxpayer held units of a specific cryptocurrency (C) that is native to a specific blockchain (K) and stored the private keys for these units in an unhosted wallet. Blockchain K uses distributed ledger technology to record cryptocurrency transactions based on a certain protocol. The protocol included a consensus mechanism, known as proof of work, for adding new blocks of transactions to the blockchain. Later, the protocol for blockchain K upgraded so that now the consensus mechanism used to add new blocks to the blockchain was exclusively proof of stake, as opposed to proof of work. No additional units of cryptocurrency C were created, and the taxpayer did not receive any cash, services, or property as a result of the protocol upgrade.

Because of the protocol upgrade, all future transactions and blocks are added to blockchain K using the new consensus mechanism proof of stake. But this does not alter the past transactions posted to the distributed ledger using the consensus mechanism of proof of work. The taxpayer’s units of cryptocurrency C remain validated and unchanged in the history records found on blockchain K.

Per Notice 2014-21 issued by the IRS, cryptocurrency is treated as property, and general tax principles applicable to property transactions also apply to cryptocurrency. Under Regs. Sec. 1.1001-1(a), the realized gain or loss from the sale or exchange of property for other property differing materially either in kind or in extent is treated as income or loss. Therefore, an exchange of property is realized only if the exchange results in the receipt of property that is materially different from the original property transferred. Once the protocol upgrade was complete, the taxpayer still had the same existing units of cryptocurrency C, so no materially different property was received in exchange. Therefore, per Regs. Sec. 1.1001-1(a), no sale or exchange could have occurred, which means no gain or loss could be realized.

Sec. 61(a) outlines all items of income that need to be included in gross income on a taxpayer’s tax return. Included in this list under Sec. 61(a)(3) are gains derived from dealings in property. As mentioned previously, under Regs. Sec. 1.1001-1(a), there was no gain or loss to realize from the sale or exchange of property here, so there could be no gain derived from dealings in property. Furthermore, the taxpayer’s units of cryptocurrency C remained unchanged after the protocol upgrade, so the taxpayer did not derive any economic benefit in the form of cash, services, or property. Accordingly, under Sec. 61(a), the OCC advised, there was no gross income to be included by the taxpayer in their respective tax return.

The key to determining that the protocol upgrade, which switched the change-in-consensus mechanism from proof of work to proof of stake, did not result in income lies in the fact that the original units of cryptocurrency C remained validated and unchanged. In contrast, where a protocol upgrade such as a hard fork occurs, per Rev. Rul. 2019-24, there is a permanent diversion from the legacy or existing distributed ledger. A new cryptocurrency is created on a new distributed ledger in addition to the existing cryptocurrency on the original distributed ledger. Following this hard fork, transactions involving the new cryptocurrency are recorded on the new distributed ledger, and transactions involving the existing cryptocurrency are recorded on the original distributed ledger. It is common when a hard fork occurs for there to be an airdrop of the new cryptocurrency to addresses containing the existing cryptocurrency. As determined by Rev. Rul. 2019-24, a taxpayer has gross income under Sec. 61(a) if the taxpayer receives new units of new cryptocurrency. As one can see, there are examples of protocol changes in which gross income does need to be reported. However, in a case in which the only change is that the consensus mechanism is upgraded from proof of work to proof of stake, there are no additional units of existing or new cryptocurrency, and no gross income needs to be reported.

For a taxpayer holding a specific cryptocurrency native to a specific blockchain, the type of protocol upgrade is essential in determining the tax treatment and whether any income needs to be reported. As concluded by the IRS, a protocol upgrade to a blockchain, in which the consensus mechanism changes, does not result in a gain or loss under Regs. Sec. 1.1001-1(a) and does not result in gross income under Sec. 61(a).

Editor Notes

Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Cook at mcook@singerlewak.com.

Contributors are members of or associated with SingerLewak LLP.