IRS Says Crypto Protocol Changes Are Not Taxable – Fin Tech

On April 21, 2023, the IRS released Chief Counsel Advice Memorandum 202316008 (the
“CCA”), which provides that cryptocurrency protocol
changes are not treated as realization events and do not give rise
to gross income for cryptocurrency holders, provided that the
holder does not receive property, including additional units of
cryptocurrency, as a result. A protocol change occurs when a
particular cryptocurrency changes its method of validating
transactions such as when a cryptocurrency utilizing proof-of-work
(“POW”) validation shifts to proof-of-stake
(“POS”) validation. The CCA was likely prompted by
Ether’s transition from POW to POS validation in 2022 (the
“Merge”, as discussed further here).

Ultimately, the CCA provides welcome clarification on the tax
treatment of protocol changes and is generally taxpayer favorable,
but it continues the IRS’s inclination to analyze unique crypto
tax issues in terms of conventional tax concepts. Specifically, the
CCA reasons that a protocol change is not a realization event
because the property received is not materially different under
Section 1001 as the holder does not enjoy different legal
entitlements before and after the protocol change (citing the
Supreme Court’s decision in Cottage Savings Association v.
Commissioner, 499 U.S. 554, 565 (1991)). Likewise, the CCA
determines that a protocol change does not result in gross income
under Section 61; there is no accession to wealth because the
holder is in the same economic position before and after the
protocol change (referencing the Supreme Court’s decision in
Commissioner v. Glenshaw Glass, 348 U.S. 426, 431
(1955)).

While the CCA’s conclusion that a taxpayer has no accession
to wealth in a protocol change is understandable since the value of
the cryptocurrency units do not change as a result, the logic
supporting the CCA’s conclusion regarding nonrealization is
less compelling. As noted in the CCA, under Cottage
Savings a realization event occurs whenever the properties
“embody legally distinct entitlements.” While that phrase
has an understandable meaning in the context of a physical asset or
an asset representing legal rights against a particular obligor,
its scope is considerably less clear in the crypto context. In
concluding that no realization event occurred, the CCA focused
exclusively on the facts that the new protocol had no impact on
past blockchain transactions and did not involve any exchange of
existing units for new units within the blockchain (i.e.,
taxpayers continued to hold the same units). Yet there are
objective differences in respect of a holder’s units before and
after a protocol change that could be seen as constituting legally
distinct entitlements, which the CCA does not discuss. For
instance, after a protocol change from POW to POS, holders of the
cryptocurrency have the ability to participate in validation
activities by “staking” their crypto. Since POW
cryptocurrencies do not validate by staking, the pre-protocol units
by definition lack the right to participate in such staking
transactions. Perhaps the new ability to use their existing crypto
in a previously unavailable manner is not a “legally distinct
entitlement” of the crypto itself, but that conclusion is not
obvious. More fundamentally, the validation methodology of a
cryptocurrency is central to the reliability and operation of the
blockchain in ways that could be seen as implicating the legally
distinct entitlement standard. Certain validation methods are more
resistant to hacking and some may provide objectively faster
validation of transactions. Perhaps these are simply changed
aspects of the blockchain itself that are distinguishable from
entitlements inherent in the cryptocurrency units
“tracked” within the blockchain, but given the integrated
nature of digital assets with their associated blockchain, that
conclusion is by no means certain.

Despite these analytical ambiguities, and while Chief Counsel
Advice Memoranda may not be relied upon or cited as precedent, the
CCA does provide comfort to crypto market participants, as well as
blockchains contemplating protocol changes, as it indicates the
IRS’s likely position regarding protocol changes. Holders of
Ether before and after the Merge should particularly take note of
the CCA. At the time of the Merge, taxpayers were left to sort
through the then available IRS guidance in order to determine
whether the Merge resulted in a “hard fork” (and
potentially a taxable event) or “soft fork” (generally
not a taxable event). The IRS has generally defined
“forks” as protocol changes with the distinguishing
feature that “hard forks” are protocol changes that give
rise to a new “ledger” while the legacy ledger continues
in existence (i.e., generally a continuation of the old
cryptocurrency and receipt of a new cryptocurrency tracked on a new
ledger). For example, the IRS previously released guidance
describing Bitcoin’s 2017 “hard fork” as a taxable
event, where holders of Bitcoin received a new cryptocurrency,
Bitcoin Cash, which was validated on a wholly separate ledger (as
discussed here). In contrast to the Bitcoin “hard
fork”, the CCA notes that the holder that is the subject of
the CCA has “the same” units before and after the
protocol change and receives no additional property. The facts of
the CCA are arguably identical to the Merge, where Ether holders
received the same units of Ether; and in line with the CCA the only
apparent change was changing validation methods to POS. As a
result, holders of Ether may want to revisit their 2022 tax
filings, discuss them with their tax advisors and potentially file
any amended returns in light of this new guidance.

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guide to the subject matter. Specialist advice should be sought
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