Taxation of Virtual Currency

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The electronic form of currency used in real-world transactions is also frequently referred to as "virtual" or "digital" currency. There are many types of those currencies, the most popular of which is the Bitcoin. As of October, the Bitcoin had a circulation of close to 12 million, up from around 3 million in August 2010. n3 The term "virtual currency" may be a misnomer when used to describe the Bitcoin and similar electronic currencies used in real-world transactions, because there is no virtual economy using the Bitcoin as functional currency. Unlike World of Warcraft's "Gold Coins" or Second Life's (another MMORPG) "Linden Dollars," the Bitcoin exists only in the real world, albeit a digital one.

Bitcoins enter circulation through a process called mining, whereby members solve complex mathematical equations that further secure the Bitcoin system. By successfully solving an equation, a miner is awarded Bitcoins. Bitcoins have some characteristics of conventional currency; they can be used to pay for goods and services, and purchased for other currencies via online exchanges. However, unlike conventional currencies, the Bitcoin is not backed by any central government and until recently has not been subject to regulatory authority. n4 Also, because it lacks formal government backing and its circulation is still in a developmental stage, the value of a Bitcoin can fluctuate sharply.

Despite the risk associated with its value, the Bitcoin is gaining popularity among both investors and end-users. Investors have begun trading on the price fluctuations using online exchanges such as Mt. Gox, the largest Bitcoin trading platform. Private equity and venture capitalists see that increased activity as an investment opportunity, and funds are considering strategies that include investments in virtual currencies. One of the first funds to take that step is SecondMarket, a platform focusing on alternative investments. It is raising cash for the Bitcoin Investment Trust, a private investment vehicle that will trade solely in Bitcoins and is open only to accredited investors. Also, the Winklevoss brothers intend to launch the Winklevoss Bitcoin Trust, an exchange-traded fund (which will be subject to tighter regulation) open to a wider pool of investors. End-users, such as small business owners, have increased their use of Bitcoins as a form of payment to save on credit card processing fees, because transaction fees for its use are minimal to zero. n5 Also, some international users have opted to use the Bitcoin as a form of payment to avoid the scrutiny that cash transfers might bring.

The increased activity has subjected virtual currencies to more publicity. But that publicity is not necessarily always positive. Bitcoin and virtual currencies are often in the news through reports about the growing risk associated with their use for illegal activity and tax evasion. n6 More importantly for promoters of the currency, however, is the increased scrutiny by regulatory and taxing authorities. Virtual currencies have historically not been subject to much regulation. That has given its originators a relative amount of freedom, but that may be coming to an end.

B. Technical Analysis

There is limited guidance governing the tax treatment of digital currency. n7 In fact, the Government Accountability Office issued a report to Treasury in May recommending that the IRS develop guidance on the topic. The taxpayer must determine not only the proper character of the income but also when a recognition event occurs for tax purposes, and the related tax reporting requirements.

1. Character. The tax character of a transaction is important to the taxpayer because it governs the tax rate applied to any gain or loss generated from the transaction. For example, foreign currency gain is taxed at the federal ordinary income rate of up to 39.6 percent for individuals. Alternatively, capital gain from an asset that is held over a one-year period is taxed at a maximum rate of 20 percent for individuals. n8 Taxpayers have taken different approaches regarding the character of the income associated with digital currency activity and have considered treating that income as transactions involving currency, capital assets, or other financial instruments.

a. Currency treatment. The code provides ordinary tax treatment for foreign currency transactions in the absence of specific elections. n9 However, it does not define currency. Rather, it defines functional currency as "the currency of the economic environment in which a significant portion of such unit's activities is conducted and which is used by such unit in keeping its books and records." n10 The Bitcoin is not likely the currency of choice for a significant portion of a taxpayer's activity and therefore generally would not be considered the functional currency of a taxpayer. However, the question remains: Is the Bitcoin considered currency under the code, even if it is not the functional currency of any economy?

Although the definition of currency is ambiguous under the code, the courts have weighed in on the subject. In 1998 the Court of Federal Claims addressed the definition of currency for purposes of federal foreign tax credits in AMP Inc. v. United States, with the holding later reversed by the Federal Circuit. n11 The case involved the use and implementation of Brazil's Readjustable Obligation of the National Treasury (ORTN). The ORTN was introduced when Brazil was operating under a hyperinflationary economy that significantly decreased the purchasing power of its official currency at the time, the Brazilian cruzeiro. In an attempt to secure the value of the income tax it was expected to receive, the government adopted a decree law in 1982 establishing an indexing system for the payment of Brazilian income taxes. n12 The index was based on the value of the ORTN and required all taxpayers to state their tax liability in units of ORTN. The ultimate tax payment was made in cruzeiros, based on the cruzeiro-to-ORTN rate that was determined monthly by the Brazilian government (according to official inflation indices). n13

AMP Inc. owned 100 percent of its Brazilian subsidiary, AMP Brasil. AMP claimed an FTC under sections 901 and 902 for the deemed-paid Brazilian taxes attributable to the tax years in question. n14 However, after the introduction of the ORTN system, AMP amended its earlier returns to capture the increased amount of Brazilian cruzeiros paid to satisfy their new liability under the ORTN system and thus requested a refund on the amended tax returns. n15

The IRS rejected the refund request under the premise that the tax liability did not change and