These are turbulent times for cryptocurrencies. The crypto market soared in the first half of 2019, with the total market cap peaking at $352 billion, but subsequently did a nose-dive in the latter half of the year, falling by $88 billion from July to October. In 2020, crypto has again been on the rise, from $186 billion at the start of the year to $302 billion in mid-February before faltering again. With so much volatility in profits and losses — and questions about where all that cyber money is going — can talk of crypto regulation and taxation be far behind? 

From banning it altogether to creating tax-free havens for it, governments around the world have shown dramatically different attitudes towards cryptocurrency. Economies like Japan and the European Union have a rather pragmatic approach — Japan treats crypto like any other financial instrument, while the E.U. treats it like fiat currency. Germany and France, while less categorically welcoming, have regulations that are becoming increasingly progressive and crypto-friendly. Likewise, mere days ago, New Zealand’s Inland Revenue Department considered doing away with their goods and services tax (GST) on crypto. Moving in the opposite direction, emerging economies like China and India have been more hostile toward crypto, even as they look to promote state-sponsored digital currencies; India has banned banks from dealing with virtual currencies, while China has cracked down on exchanges and put many out of business.

The U.S. strikes a balance between the two extremes. While such agencies as the SEC, CFTC, and FTC have demonstrated an interest in the industry, few formal rules and regulations have been set, with lawmakers caught between the need to regulate a growing, volatile market while also fearing to drive investment overseas. 

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The IRS has released guidelines on how to file taxes on their cryptocurrency assets. Photo: Saturnism

Hesitation in putting forward definitive regulations of cryptocurrency is understandable, experts say. It would be a mistake to sit back and do nothing. Alternatively, it would also be a mistake to have regulatory hammers come down too fast, too hard and kill innovation.

“A hasty attempt to rein in every potential for security would likely fail and cause more damage than good to the technology,” Braden Perry, a regulatory attorney and former chief compliance officer at Mariner Holdings, told Forkast.News. 

Yet it would also be irresponsible to leave the market to its own devices, with consumers neither well-enough informed nor protected and hence at risk of falling prey to crypto scams. Crypto is also increasingly regarded not only as an alternative to fiat money but investment, which normally would be subject to taxation. These are the regulatory dilemmas that U.S. tax authorities are currently grappling with.

See related article: How Cryptocurrencies are Becoming an Asset Class: Marc P. Bernegger, Crypto Finance

What’s going on with the IRS? 

As tax season approaches in America, how crypto will be regulated and regarded for tax purposes is preoccupying many minds. In the last few years, the United States’ tax authority — the Internal Revenue Service — has issued some guidelines for crypto taxation. The most recent, and the first since 2014, came in October last year. These guidelines clarified some long-standing issues but also raised others.

Specific Identification is now okay

Taxpayers can finally use “specific identification,” an accounting method, to calculate their cost basis while figuring out their capital gains. With specific identification, a taxpayer can now identify the specific coin that they are selling or exchanging, and use the actual acquisition cost of that particular coin to determine their cost basis. Not only that, but taxpayers can use either first-in, first-out (FIFO) or specific identification — whichever works better for them.

How does this really work?

Let’s say Person A buys 1 unit of Crypto X for $2,000 in February 2019 and another unit of Crypto X for $2,500 in June 2019. They then sell the unit they purchased in June for $3,000 in October 2019. 

With the new guidelines, they can now calculate their capital gains in one of two ways. they can use the FIFO method, in which case their cost of acquisition will become $2,000, and their total capital gains will be $1,000. But with the new guidelines, crypto holders can also use specific identification. In this case, their acquisition cost would be $2,500, and their capital gains would come to only $500. This flexibility means that crypto owners will now be able to plan their taxes better for tax savings.

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The IRS’ understanding of cryptocurrency may not reflect the reality of how it is used. Photo: Joshua Doubek

Hard fork guidelines will lead to more chaos

This is one area where many crypto experts feel that the IRS has disappointed in a big way. “The fundamental problem arises from the way the IRS understands cryptocurrency transactions,” wrote Robin Singh, co-founder and CEO of the crypto tax software company Koinly. The IRS has built its entire guideline based on the understanding that after a hard fork takes place, the newly forked currency is airdropped into a customer’s wallet. 

In reality, however, there is no such airdrop — the ledger is simply copied. This means users might end up receiving coins that they have no intention of ever using. Under the new IRS rules, crypto owners still need to pay tax on receipt of these coins. “One unfortunate consequence of this guidance is that third parties can now create tax reporting obligations for you by simply forking a network whose coins you own, or foisting on you an unwanted airdrop,” Jerry Brito, executive director at Coin Center, told CoinDesk.

What this means

The IRS would be treating hard forks like an event where a corporation distributes shares of another corporation to its shareholders, which would constitute a taxable event. Experts like Singh believe, however, that a hard fork is more comparable to a stock split, and this doesn’t count as a taxable event.

Crypto mainstreaming takes a hit

Along with these guidelines, the IRS has refused to exempt crypto transactions below a certain threshold from taxation. While this pretty much confirms the status quo, it’s still a let-down for many crypto enthusiasts. What this basically means is that every single crypto transaction is subject to tax under whatever category that transaction falls under — if you’re just using bitcoin to buy your morning coffee, that payment counts just like regular money. If you’re exchanging crypto assets, that is a taxable transaction. According to the IRS, capital gains or losses are taxable as “the difference between the fair market value of the services you received and your adjusted basis in the virtual currency exchanged.” 

These rules can be difficult to keep track of. In July of last year, the IRS sent cautionary letters to over 10,000 Americans who it believed had failed to accurately report the crypto taxes they owed. Tax dodgers can, in extreme cases, face criminal prosecution and fines of up to $250,000. It is therefore crucial to keep track of and report all transactions of any kind. 

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Tax evaders can face criminal prosecution and fines. Photo: Unsplash

The cumulative effect of such tax policies could have severe implications for the future of crypto as a mainstream currency. Even if people are not discouraged by the complexity and ambiguity of crypto taxation, if every single transaction is going to be taxed, anybody would hesitate before using crypto for everyday transactions because of the additional tax burden. Plus, businesses might find it too burdensome to accept crypto in exchange for low-cost goods and services. In the long run, this could really limit the usability of cryptocurrencies as a whole.

In addition to moving toward stricter crypto reporting requirements, the most recent IRS guidelines also raised other questions. The Government Accountability Office declared in a recent report that parts of the tax authority’s guidelines were not authoritative “because [the guideline] was not published in the Internal Revenue Bulletin (IRB).”

“IRS has stated that only guidance published in the IRB should be considered authoritative interpretation of the law,” the GAO asserted. “IRS did not make clear to taxpayers that this part of the guidance is not authoritative and is subject to change.”

The GAO also chided the IRS and the Financial Crimes Enforcement Network (FinCEN) for not having “clearly and publicly explained when, if at all, requirements for reporting financial assets held in foreign countries apply to virtual currencies.” 

The IRS has yet to publicly comment on the issues brought to light. At a March 3 summit that the IRS hosted for crypto groups in Washington D.C., industry representatives asked questions or raised concerns such as those brought forth here. But agency officials mostly listened and remained silent.

Implications for the rest of the world

The IRS, as the taxation overseer for the world’s largest economy, wields considerable global influence. While other countries might not be tracing its footsteps exactly, its judgments and guidelines often cause ripple effects. Britain’s HMRC (Her Majesty’s Revenue and Customs), for instance, has followed the IRS’s example and asked crypto exchanges like Coinbase for information on customer names and transaction histories. 

This monitoring of crypto investors and the categorization of crypto assets as falling under capital gains, income or even inheritance tax seem not only stringent, but also potentially confusing and discouraging to the average investor, industry experts say. Danish tax authorities are behaving similarly, obtaining information from three local exchanges and sending more than 20,000 letters to crypto holders, after declaring that “losses on sales of bitcoins purchased as an investment are tax deductible [and] profits are subject to income taxation.” 

As a whole, ambiguous regulation by any state authority, but particularly those key players such as the IRS, is unsettling for cryptocurrency globally, and only serves to confuse and intimidate potential investors. Similar to the IRS, the guidelines that HMRC released last year are also vague and ambiguous. 

See related article: Gibraltar is pioneering creation of blockchain ecosystems, says FM

So what is it about cryptocurrencies that makes them so difficult to tax and to regulate? Crypto transactions are proving too complex to fit neatly within existing tax and regulatory frameworks. Some government agencies may also still be struggling to understand the very nature of cryptocurrencies and how they differ from fiat money.

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The IRS’ guidelines may affect how other countries deal with similar scenarios. Photo: Unsplash

Where do we go from here?

Here’s what we know about crypto regulations as a whole today:

  • Cryptocurrency represents a huge regulatory problem for tax authorities. It’s relatively easy to shift crypto income to offshore exchanges with no reporting requirements, so governments want to really double down on tax avoidance. As a result, some are issuing strict rules and guidelines on taxation.
  • At the same time, the conflicted policymaking and unclear administrative guidance seen in the recent issuance by the IRS show a fundamental lack of understanding about the technology. There is always some amount of reduction that happens when a new, complex technology like crypto is being fitted into the existing regulatory framework. Perhaps that is why even the strictest guidelines have ambiguous, confusing language. 

So what happens next? The IRS summit on crypto regulation, attended by invite-only crypto companies and industry groups, was held for the purpose of “balanc[ing] taxpayer service with regulatory enforcement” that was supposed to include “technology updates, issues for cryptocurrency exchanges, tax return preparation, and regulatory guidance and compliance.” 

If the IRS doesn’t take major steps after this summit to resolve ambiguities, the lack of clarity could create legal challenges over time and ripple effects in crypto regulation all over the world, experts say. In the meanwhile, if the IRS continues ramping up the strictness of its tax rules, crackdowns on individuals over crypto tax evasion, whether deliberate or unwitting, also seem likely to increase.

“A well-designed regulatory scheme that aims to affect the bad actors and not overregulate the technology would likely be a positive for crypto, and this would require a collaborative effort between Congress, regulators, and big players in the industry, including Ripple and Coinbase,” said Perry, the regulatory attorney. “I suspect broad industry-wide policies and procedures on crypto will be forthcoming.”