Taxing Blockchain Forks
Suppose a group of countries decides to require its domain name servers to work according to modified rules, so that its domain name registry begins to diverge from the “original” Internet. Further, each network claims to be “the” Internet and sees the other as noncompliant. As existing names are carried over to both Internets, existing owners come into possession of two distinct assets—a domain name on each network.
While this scenario is rather far-fetched, blockchain forks and the resulting splits are common in the cryptocurrency world. Upon a split, the owner of a blockchain token becomes the owner of two tokens on as many blockchains, creating all kinds of philosophical and practical quandaries. In our paper (Taxing Blockchain Forks) we look specifically at taxation. Is income realized upon the split? Upon the sale of one of the split tokens, how does one calculate capital gains and losses?
The tax code has dealt with questions like these long before cryptocurrencies: taxpayers acquire new assets without a purchase when they find treasures, when the firms whose stock they own spin off a subsidiary, when their livestock has offspring, et cetera. Cryptocurrencies present unique challenges, however. For instance, consider the recent U.S. Internal Revenue Service ruling that, upon a split, the taxpayer realizes income equal to the fair market value of her “child” token holdings.
First problem: which blockchain is the child? Bitcoin Cash, an updated version of Bitcoin, is deemed to be its child. In contrast, Ethereum Classic is considered a child of Ethereum because it is not updated (“a continuation of the original Ethereum blockchain—the classic version preserving untampered history”). Although informal agreement among market participants is common, there are no formal criteria, and “I know it when I see it” is usually a nonstarter for compliance and enforcement purposes.
Second problem: unlike events in traditional securities markets, most blockchain forks are nuisances. Many announced forks never result in a split (i.e., in an actively trading blockchain), or do so with substantial delay. In one case we document a 530-day gap from fork to split. It does not seem appropriate, therefore, to assume that a taxpayer is aware that a split happened.
Third problem: what is the fair market value of the new token? Circumstantial evidence suggests that around the split the prices of “child” tokens (as conventionally identified ex-post) are severely overvalued, possibly due to manipulation, resulting in large negative average returns (-64% at the 90-day mark). It does not seem appropriate, therefore, to assume that a taxpayer is able and willing to take the steps necessary to claim newly forked currency that may become worthless after a few months.
Unsurprisingly, therefore, other countries are not following the USA in assuming that income is realized upon the split. However, there is no silver-bullet approach. For instance, Japan attributes the entire original cost to the parent token, so that upon the sale of the child the entire proceeds are treated as a gain. While this approach is our favorite because of its simplicity, it still requires identification of the child, which is potentially controversial or even subject to manipulation. The United Kingdom sidesteps this problem by requiring that the original acquisition cost be apportioned based on fair market value. However, apportionment requires not just values for both tokens, but – fourth problem – comparable values.
Although the taxation of cryptocurrency forks may seem a niche technical topic, the rise of distributed protocols means that digital assets such as Internet domain names and blockchain tokens are increasingly commonplace, and therefore it is crucial to get the taxation framework right.
Mattia Landoni - Cox School of Business, Southern Methodist University
Gina Pieters - Department of Economics, University of Chicago