Crypto Assets & Tax: Current Tax Issues

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Crypto Assets & Tax: Current Tax Issues

• 21 June 2022
• Individuals Tax
• Chris Herbst

Most global tax authorities have stated that their respective income tax acts cater to crypto assets. They argue that crypto is an asset. The income tax act caters to the taxation of assets, and no further guidance is required. I disagree with this; the nuances of the crypto asset space require special consideration.

Mining and staking taxation

Definition of Crypto mining:

The competitive process that verifies and adds new transactions to the blockchain for a cryptocurrency that uses the proof-of-work (PoW) method. The miner that wins the competition is rewarded with some amount of the currency and/or transaction fees. PCMag.

Definition of Crypto staking:

Loaning ("locking up") cryptocurrency to earn interest (see yield farming). Crypto is also staked to win block rewards as a crypto miner. For example, proof-of-stake (PoS) is a consensus algorithm that rewards miners who initially stake their crypto and then win the competition to add the next block of transactions to the blockchain. PCMag.

The non-technical definition is that you mine when you expend resources to perform specific tasks and are rewarded for that. When you stake, you lock up resources to perform particular tasks and are rewarded for that.

The general stance of most global tax authorities is that both mining and staking rewards are taxed as income. You perform some service and pay tax on that reward. However, this is not as simple as it may appear.

Say you are an author. You write a new book and print 1 000 books. Should you be taxed on the selling price of the 1 000 books immediately after it has been printed? Certainly not. You will be taxed when you sell the relevant books. This is precisely the point of several stakers. When staking, you lock up resources to produce future value. However, the future value is only realised when you sell the created assets.

Joshua and Jessica Jarrett, better known as the Tezos validator who took the Internal Revenue Service (IRS) to court, are creating big waves in the crypto industry, setting a possible precedent for how authorities will tax staking rewards.

The court case of Joshua Jarrett, Jessica Jarrett (plaintiffs) v. the US (defendant) is one worth following, especially in the crypto space.

The couple received a staking reward in 2019 and relying on the conservative approach, the couple declared the reward and paid the tax owed to the IRS on the income. However, they then decided to amend their tax return on July 31, 2020, arguing that the staking reward was not income, and thus, the tax amount on the income was invalid. Instead, they wanted to be paid back for the taxes they had previously paid the IRS.

They argued that newly created property is only taxed at the time of sale, not at the receipt of such property.

The complaint by the Jarrett’s to the IRS has resulted in the Tax division of the US Department of Justice ordering the IRS to issue a refund. The unexpected part is the couple refused to accept the refund.

Joshua Jarrett made the following statement explaining his reasoning behind their refusal:

Fast forward to late December 2021, when I received a letter saying the government wanted to grant me a refund—in other words, a year and a half into this process, the government didn’t want to defend the position that the tokens I created through staking were taxable income. At first glance, this seemed like great news. But until the case receives an official ruling from a court, there will be nothing to prevent the IRS from rechallenging me on this issue. I need a better answer. So I refused the government’s offer to pay me a refund.

The issuing of a refund is a possible signal by the IRS that rewards derived from staking should not constitute taxable income at the time of receipt. However, the taxpayer cannot safely rely on this tax treatment; only when a formal court ruling is issued can a taxpayer depend on such treatment.

If the judgment favours the plaintiff, it could set a clear precedent for the taxation of staking rewards in the future.

The court case is still ongoing, but resistance against unclear policy and the feeling of a ripple effect in the industry are signs of growth. Changes that it will bring are a step in the right direction. In addition, the outcome of Jarrett’s case will clarify to the US public how staking rewards will be taxed in the future, which will be a big win for the US digital assets industry.

It is an exciting time, and we can speculate that other countries, for example, South Africa, may follow suit depending on the outcome of the court case.

The taxation of Airdrops

Definition of an Airdrop:

A reward in tokens is given to people interested in a new cryptocurrency. Delivered to users who have crypto wallets, airdropped tokens are a way of spreading the word about a new coin. Users may have to post information about the crypto, mention it in some blog or article or simply show curiosity. Often, airdropped tokens are part of an overall scam to make money and run for the hills. PCMag.

At first glance, one might argue that the taxation of airdrops is straightforward. The taxpayer received a reward, which should be taxed as income. This might be where the taxpayer had to perform a specific task and receive the reward. However, there are many cases where the taxpayer did not have control over receiving the airdrop. Remember, a crypto wallet address is public knowledge, and anyone can deposit coins into your wallet.

The airdrops are usually of meagre value since the coin is typically new. There are cases where the value is not small. Let’s look at a scenario:

1. The taxpayer receives an airdrop of 10 token A on 1 December 2021; token A is valued at $10 per token. The total value of the airdrop is $100.
2. The taxpayer is unaware of this airdrop (which can easily happen).
3. The taxpayer’s crypto tax advisor informs the taxpayer in the following year that there is a taxable amount of $100 as the income is calculated at the spot rate of when the tokens were received. At this time, the value of token A is 0 (which can easily happen).
4. The taxpayer now has to pay tax on the $100 worth $0 in terms of fiat currency.

This is another crypto nuance requiring attention from the tax authorities. Canada and Germany see airdrops as tax-free events. USA, Australia, and the UK tax airdrops as income. In South Africa, one can infer that airdrops should be taxed as income.

The Global need for proper guidance by tax authorities

In June of 2022, a proposed US crypto bill, sponsored by US Senators Cynthia Lummis, Republican of Wyoming, and Kirsten Gillibrand, Democrat of New York, has mentioned the following in Section 206 - Implementing effective IRS Guidance:

Not later than one year after the date of the enactment of this Act, the Secretary

of the Treasury (or the Secretary’s delegate) shall adopt guidance relating to the following:

(1) Classification of forks, airdrops, and similar subsidiary value as taxable, contingent upon the affirmative claim and disposition of the subsidiary value by a taxpayer. Such guidance shall also permit a taxpayer to provide notification through an annual return or other appropriate means to the Internal Revenue Service relating to the claim and disposition, or disclaimer of, subsidiary value.

(3) Treatment of digital asset mining and staking, including mining and staking rewards,

in which income is not realised until disposition of the assets produced or received in

connection with such activity, in accordance with section 451(l) of the Internal Revenue

Code of 1986 (as added by this Act).

(1) mentions taxability “upon the affirmative claim and disposition”. This will resolve the issue mentioned earlier in this article with the taxation of airdrops.

(3) mentions “in which income is not realised until disposition of the assets produced” this will resolve the issue with the taxation of staking and mining mentioned earlier in this article.

It is evident with the proposed timeline of “not later than one year” that the Senators infer that this necessary guidance is past due. The global tax authorities are outspoken about enforceability but not about providing proper guidance.

Enforceability by global tax authorities

In South Africa and the US, tax authorities now require taxpayers to indicate on their tax returns if they held any crypto assets during a year of assessment.

In the same two countries, it is a fact that the tax authorities have approached centralised exchanges for details regarding taxpayers. With most centralised exchanges (CEXes) requiring “Know your customer (KYC)”, the identities of traders can be made available to the requesting tax authorities.

With most decentralised exchanges (DEXes), KYC is not a requirement. Some taxpayers are under the impression their identity cannot be revealed and that they are safe in terms of enforcement.

Think again.

The following are possible:

1. The tax authority subpoena the taxpayer for all their wallet addresses. This will lay bare all DEX trades as well. If the taxpayer does not come clean at this stage, they will expose themselves to significant criminal prosecution.
2. The taxpayer's identity is established at the CEX and flows to DEXes, and private wallets are traced from there.

There is a nagging suspicion that SARS and the IRS are partnering with private firms to the like of Chainalysis, which connects real-world activities to blockchain transactions, and will enable them to track taxpayers’ transactions.

The blockchain is wonderfully transparent.

Recently the FBI released their paper of facts regarding their track of the BitFinex hack. Here is a graphic of their trace through the blockchain to the hackers:

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