Plodding Mediocrity (Part V)

There series are from April 2018

Bitcoin taxed as property - hurdle to medium of exchange

If previously I wanted to dive into the topic why classifying bitcoin as a commodity will hurdle its adoption as medium of exchange, here I would like to briefly cover bitcoin’s current taxation nature - that of a property. I am in no position to give any tax advice to anyone, but the mere outlines from IRS already show some hurdles to bitcoin’s adoption as medium of exchange and I would like to address those. This issue is not out-of-sight, many people discuss it now seen that it’s a tax season. People are questioning their choices and are in position where they need to decide to realize losses, which as well can reflect itself in crypto-to-fiat sell-off on the market.

I will give myself the joy of describing taxation from theoretical point of view as well. I need it because whatever hypothesis I want to build around taxation, I first need to have a relevant ground for it. So let's Dig Down.

Theory of taxation

Taxation is the very complex channel of government’s ideology. Tax code is the political tool, a channel if you wish, which is utilized by governments to convey their ideology. Because tax codes are very complex and require legislative bodies or referendums to change them, governments are usually limited in their options if their views differ from what tax code says. A tax code is the expression of rate of equality policy (wealth or opportunity) and encouragement of expenditure, it can explain the course of nation that it has taken. The code is complex, technical and ambiguous and at any given time it must be flexible and cater to all the ideologies that its citizens might have. At the very basic level code translates views on property rights, with extreme views being that property is an absolute right of an individual, or that a state is the guarantor of the wealth accumulation by providing legal framework and justice system to sustain the progress. Most of the codes fall in between these two with varying bias towards one or another. Cryptocurrency viewed as property by IRS should generally be more enraging to the bitcoin anarchists on ideological level. Seen what tax code and property is, deeming cryptocurrencies as property can spark very acute debate between cryptocurrency holders, but it is yet to come. Cryptocurrency and taxation is a very different discussion and implies too many ambiguous thoughts and current policies. My point is simple - in legal parlance no word is a word for sake of being a word, each word carries a philosophy behind it, it might be open and free to be challenged and reversed, or it might be cuffed by legal workings to its originality, whichever it is, you have to understand the context behind it to a) predict its future course and b) to importantly contribute to its development. This is why it is important for fund managers and policy makers to read between the lines of tax code and understand the underlying meaning, policy and philosophy of why your property is being taxed this way and not the other way, or why it is considered as property in the first place. This is daunting thing to do which I’m not in a capacity of doing.

Benjamin Franklin’s famous quote about taxes reads: “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.” Since then, nation has been through a lot of thought about how taxation should work. As I’ve said before it is a burden to choose between equality of wealth or opportunity but this is how it is fundamentally structured. In an enclosed and absolute situation fair distribution can be assigned to effort and luck to first come first serve, but society and population is not enclosed and absolute, it is fluid and generational, due to this fair distribution must account for equality. Equality can be need-driven or outcome-driven. What we think is fair distribution is dependent on our scope of knowledge. We can distribute by need to our friends (because we care for them, we know their story), and we decide to distribute by merit to those we do not know. The difference here is the transparency, with honest, full transparency we can apply need-based distribution for larger circle, but this can result in privacy breach and first of all we can not know everyone who is in need, due to this we transfer the burden of this decision to regulators who set rules. United States and other developed capitalist countries use distribution through equality of opportunity. This policy is tightly connected to the level of solidarity. This is philosophical question, society is not unanimous in understanding equal distribution, but in order for government to function and meet its duties, it has to stick to one policy and not to destabilize government functioning by updating tax codes frequently, which it might desire to do to please its voters. While the issue of distributing services is complicated so is the issue of collecting and we have two different approaches: one where citizens with equal revenues are required to pay same taxes or people consuming equal government services should pay same taxes. Historically it is the former that governments do. It endorses the right of equal opportunity for everyone. This is further complicated now by deciding what tax brackets should look like. This has nothing to do with you doing your taxes now, but this gives pretty good picture to understand that cryptocurrency can benefit in developing fairer tax mechanism in distant future.

Crypto as property tax

IRS has deemed bitcoins as property, not currency. This ruling provides some navigation to any holders of cryptocurrencies who are eager to pay taxes. As a property and if you have been holding your cryptocurrency for over a year you will be taxed at your applicable tax bracket rate plus long-term capital gain - which is favorable. In case you are active trader your capital gains will be taxed as short-term capital gains triggering higher rates.

IRS requires that you report fair market value of your crypto assets on the date you received these assets. You need to resort to a system where you state fair market value of your transactions and keep them consistent within your filing. You must not abuse the market quotes in your filing, like stating the higher price for an asset when you purchased it and stating a lower price when you sold it. You must be consistent within the fair market value.

Another risk viewed from the taxation perspective is the improper registration of exchange of crypto assets between each other. Most of the assets qualified as like-kind can be argued seen that they widely differ in nature and are not all currency related (bitcoin to ethereum). But IRS is not in power to invent new asset classes. Difference between registering as donation or income have different consequences as well.

The longer your bitcoin is unrealized, the better rate your are going to get from a long-term perspective. You need to register fair value of the bitcoin same way consistently throughout your reporting. In case you are a business conducting the sales in bitcoin or any other cryptocurrency you need infrastructure that will right away convert them to the USD, you will not hold them short/long term and the instant change in the conversion should importantly reduce the capital gain/loss incurred within the transaction. This is important point to consider if you want to conduct your business in bitcoin, because you do not want to get taxed additionally on the nature of the sale of your product. This is important because internal accounting of a brick-and-mortar business will provide insight into the operating goals of the business where a) you want to expand your customer-base, b) you want to make money on the sides or c) of course the both. With no clear goal and without proper planning running a business will be very hard. If as a consumer you purchase every other product in bitcoin, it might be too hard to differentiate between transactions in order to have short term/long term classification of the coins that you hold and spend - a wallet with built in reporting would help. FIFO and LIFO methods to calculate consumer tax rate is also implemented in some of the exchanges when realizing gains.

Most countries consider Bitcoin and cryptocurrencies as capital assets, and so any gains made are taxed like capital gains. If you make profits from selling your coins, those profits are taxed. If you make losses, you may be able to deduct the losses and reduce your taxes. What is pretty much global, is that buying bitcoin or any other cryptocurrency is not itself taxable. However, you are likely to be taxed when you sell or even spend those coins and make a profit. Earning of cryptocurrencies as a barter transaction or payment-in-kind leads you to being taxed as if you had been given the equivalent amount of your country's own currency (this is where IRS like it as currency of course).

Current taxation approach is not the best one for bitcoin to be stipulated as a medium of exchange. This is why - because IRS sees bitcoin as a property it must be taxed as capital gains. This now leads to creating 2 transactions when you transact in bitcoin, one is selling property (with either capital gain/loss), the other one is purchase transaction. Both are taxable. Capital gain for long term is 15%, although short term gain (below 12mo. period) can be anything up to 39.6%. And these on top of the sales Tax.

Because bitcoin blockchain is a public ledger, IRS might be looking and tracking any large purchases that are not reported to it (FYI only 802 bitcoin reports were made in 2015 within IRS but in 2017 it is estimated that much higher rate will report their taxes). If you are seen as having huge transaction on the bitcoin blockchain network, IRS will come to you. You can still ignore reporting of your transactions for the small purchases, but you must know that most of your crypto events are taxable. IRS demanded from Coinbase to provide them with over 15,000 accounts that they hold, the ones that exceed in $20,000 in any kind of operation (sell, buy). Coinbase shrugged it off, claimed as intrusion into their business but eventually Coinbase lost the appeal. There’s court solicitation for Coinbase to comply (United States VS. Coinbase), Coinbase will now provide its customers with forms to fill in if they fall under the IRS specified category.

This is nothing more than the wrong classification that harms overall adoption of bitcoin, if these approaches are not challenged or reversed then building the decentralized infrastructure as the original papers purports them will risk to be flawed. Incentives within infrastructure itself are not enough, so far bitcoin purchases are disincentivized in real world.

It is definitely hard to keep track of transactional behavior for bitcoin in case you spend it as medium of exchange, while for investment goals taxation seems familiar. Taxing bitcoin transaction as property brings two hurdles to its medium of exchange adoption 1) it is complicated for the consumer to keep track of the double-taxed event transaction and wallet must recognize which coin was acquired and spent when, lets say you might spend $500 from the mixing coins you received both 2 weeks ago and year and a half ago, 2) it does not incentivizes merchants to offer purchases in bitcoin further complicates their tax exposures by offering crypto settlements, taxing cryptocurrency as property means that small businesses will look at crypto settlements from the perspective of capital gain, this is not the best practice to run a business of selling lemonade.

If we take taxation bill in Germany your crypto won’t be taxed when you pay for coffee and this comes from the EU VAT directive. If you purchase goods with bitcoin it is considered that crypto is used as medium of exchange as “legal tender”, but if you are using it for the purposes other than that different rules will apply and will as well take into account whether you do it for yourself or are conducting a business transaction. This is friendlier regulation and it corresponds to what I have mentioned in the previous section - the nature of transaction is of a paramount importance. Of course it might be hard to justify all sorts of transactions we do but simple, smaller consumer transactions that are not taxed as capital gains should pave the way for bitcoin to be used more as medium of exchange (again subject to less volatility, I don’t think you would rush to buy a coffee with an asset as volatile as it is today).

In his 1955 closing remarks Randolph E. Paul said “The perpetually changing economic problems of modern life call for a flexible attitude which looks analytically at the past, realistically at the present, and hopefully toward the future with the knowledge that there must be constant adaptation to the new necessities of an expanding economy.” Nevertheless what Paul’s greater implication and context was, it is a reminder that taxation must not be static, it must be adapting to current needs, we might be applying and trying to look at new assets through the familiar angle but we must also be open to a change. These digital assets do not yet appear worthwhile looking and thinking in the context of proper taxation, but once they start to become stable assets, largely represented in economy, bringing new tax laws and exemptions to help economy flexibly navigate will become harder, and it will become part of the agenda.

finance, law, technologyGiorgi Gurgenidze