IRS Releases Memorandum on Tax Consequences of a Blockchain Protocol Upgrade | McDermott Will & Emery

On April 21, 2023, the Internal Revenue Service (IRS) issued a Chief Counsel Advice Memorandum (ILM 202316008), which concluded that a protocol upgrade to the consensus mechanism of a cryptocurrency blockchain that did not result in the issuance of new tokens (or coins). ) did not result in gain, loss or other income to a taxpayer that had cryptocurrency native to the blockchain.

IN DEPTH

IRS GUIDANCE ON PROTOCOL UPGRADES

On September 15, 2022, Ethereum implemented a protocol upgrade known as “The Merge” where Ethereum upgraded from the original proof-of-work (PoW) consensus mechanism to proof-of-stake (PoS). The merger was one step in Ethereum’s roadmap to better scale itself and adapt to the latest technologies emerging from research and development. This did not result in any change in ownership for holders of Ether (ETH) tokens, unlike a hard fork, another type of protocol update that may involve issuing new tokens (or coins) to pre-existing token holders. Ethereum has further upgrades on its roadmap and recently completed another protocol update known as the “Shanghai Upgrade”, which marked the final step for Ethereum to move from a PoW to a PoS consensus mechanism.

Ethereum is not the only blockchain to undergo a protocol upgrade. In the same month as The Merge, Algorand announced the implementation of a major protocol upgrade as well. As blockchain technology continues to evolve, and as new technologies are created and released, further protocol updates are expected with evolving blockchains (such as Ethereum).

The IRS’s memorandum addressed the federal income tax consequences of a blockchain undergoing a protocol upgrade. Although it is not explicitly referenced which blockchain is being referred to, based on the facts provided in the memo, it can be inferred that such guidance likely applies to The Merge.

The memorandum considered a simple fact pattern where a specific blockchain (K) used distributed ledger technology to record transactions involving cryptocurrency based on a specific protocol. The protocol included a consensus mechanism for adding new blocks of transactions to the blockchain, including those involving a particular cryptocurrency (C). A taxpayer purchased 10 units of C and stored the private keys of those units. Later, K changed its consensus mechanism used to choose who can validate transactions and add blocks of transactions to the K blockchain from PoW to PoS. The memorandum labeled this change the “protocol upgrade.” After the protocol upgrade, the K blockchain required transactions to be validated and new blocks added to the K blockchain exclusively through the new PoS consensus mechanism. The protocol upgrade did not affect or change the existing transaction history on the K blockchain, and new blocks were added to the K blockchain according to the new protocol. The units of cryptocurrency C remain unchanged, including the 10 units held by the taxpayer. The taxpayer did not receive any cash, services or property as a result of the protocol upgrade.

GAIN, LOSS AND INCOME TAX GENERALLY

Code Section 1001 provides rules for calculating and recognizing gains and losses related to the sale or other disposition of property. Gains and losses generally arise from the difference between the amount of money (as well as the value of any property) received by selling or otherwise disposing of property and the taxpayer’s tax basis in that property. The Treasury Regulations further provide that when property is exchanged for other property of a substantially different nature or extent, a gain or loss may be realized and treated as income or as a loss. However, an exchange of property is only a realization event if the exchange results in the receipt of property that is significantly different from the transferred property. Properties must contain legally distinct rights to be substantially different. Otherwise, the transfer will not result in the realization of a gain or loss.

Section 61 of the Code provides the rules for gross income. Gross income means all income from any source, including gains from trading in real estate. In general, all gains that are clearly realized by the taxpayer are included in the gross income. This includes when a taxpayer receives property or services that have a greater market value than what the taxpayer pays for it. Because this calculation is concerned with the value received, income can be realized in many forms, including money, property or services.

TAX CONSEQUENCES OF A PROTOCOL UPDATE

The note’s conclusions about profit or loss treatment and income as a result of the protocol upgrade are simple. First, the note concluded that the protocol upgrade did not result in a realization event where the taxpayer realized gain or loss on the existing 10 units of cryptocurrency C. This is because the existing units of cryptocurrency C were not changed by the protocol upgrade and there was no taxable exchange of shares .

Secondly, the memo concluded that the protocol upgrade did not result in income being recognized for the taxpayer. This is because there was no accession to wealth as a result of the upgrade; The taxpayer’s 10 units of cryptocurrency C remain unchanged and the taxpayer did not otherwise obtain any separable financial benefit from the protocol upgrade, such as cash, services or other property (including other cryptocurrencies).

CONCLUSION

Although the note deals with a fact pattern that involves a protocol upgrade that does not directly result in a hard fork, the note’s guidance is consistent with Situation 1 by pastor Rul. 2019-24 and Question 22 of the IRS Virtual Currency Transactions FAQ, both of which state that if a cryptocurrency went through a hard fork but a taxpayer did not receive any new cryptocurrency (either through an airdrop or some other form of transfer), the taxpayer has no taxable income. Unlike Situation 2 by pastor Rul. 2019-24 and question 23 in the tax authorities’ frequently asked questions where the tax authorities determined that a taxpayer has taxable income if an air drop was followed by a hard fork, Situation 1 by pastor Rul. 2019-24 and question 22 of the IRS FAQ have not been viewed as controversial guidance requiring further clarification, and such guidance can reasonably be extrapolated to a fact pattern involving a protocol upgrade that is not a hard fork.

Notwithstanding the above, the IRS’s supplemental guidance regarding a protocol upgrade (without a hard fork) continues to support the fact that absent (1) a change in an existing property, (2) an exchange of property, or (3) receipt of property (or other economic benefit that can be separated) to a taxpayer, a taxpayer may be able to expect that a protocol update (whether in the form of a non-airdrop hard fork, an update to a consensus mechanism, or otherwise) will not result in gain, loss or other income for himself.

The note shows the tax authorities’ view that guidance related to the taxation of cryptocurrency (and related technologies) is important and is given priority.

[View source.]