On April 21, 2023, the IRS issued 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 a gross income for cryptocurrency holders, provided that the holder will not receive any property, including additional units of cryptocurrency, as a result. A protocol change occurs when a particular cryptocurrency changes its transaction validation method, such as when a cryptocurrency using proof of work (“POW”) validation switches to proof of Stake (“POS”). The CCA was likely driven by Ether’s transition from POW validation to POS validation in 2022 (the “merger”, as discussed later here).
Ultimately, the CCA provides welcome clarification on the tax treatment of protocol changes and is generally taxpayer-friendly, but it continues the IRS’ tendency to analyze unique crypto tax issues in terms of conventional tax concepts. Specifically, the CCA finds that a change in protocol is not a realization event because the property received is not materially different under Section 1001, as the holder does not enjoy different legal rights before and after the protocol change (citing the Supreme Court decision in Cottage Savings Association v. Commissioner, 499 U.S. 554, 565 (1991)). Similarly, the CCA determines that a change in protocol does not result in gross income under Section 61; there is no access to wealth because the holder is in the same economic position before and after the protocol change (referring to the Supreme Court decision in Commissioner c. Glenshaw Glass348 US 426, 431 (1955)).
While the CCA’s conclusion that a taxpayer does not have access to wealth in a protocol change is understandable since the value of cryptocurrency units does not change as a result, the logic supporting the CCA’s conclusion regarding non-realization is less convincing. As stated in the CCA, under Savings on the chalet a realization event occurs whenever the properties “embody legally separate rights”. Although this phrase has an understandable meaning in the context of a physical asset or an asset representing legal rights against a particular debtor, its scope is considerably less clear in the context of cryptography. In concluding that no realization event occurred, the CCA focused exclusively on the fact that the new protocol had no impact on past transactions on the blockchain and did not involve any exchange of existing units. against new units within the blockchain (that’s to say., the taxpayers continued to hold the same shares). Yet there are objective differences between a holder’s units before and after a protocol change that could be considered to constitute legally distinct rights, which the ACC does not address. For example, after a protocol change from POW to POS, cryptocurrency holders have the opportunity to participate in validation activities by “staking” their crypto. Since POW cryptocurrencies do not validate through staking, pre-protocol units are by definition not entitled to participate in such staking transactions. Perhaps the new ability to use their existing crypto in ways previously unavailable is not a “legally separate right” from the crypto itself, but that conclusion is not obvious. More fundamentally, the validation methodology of a cryptocurrency is essential to the reliability and functioning of the blockchain in a way that could be considered to involve the legally distinct standard of law. Some validation methods are more resistant to hacking and some can provide objectively faster validation of transactions. These may simply be altered aspects of the blockchain itself that are distinct from the inherent rights of “tracked” cryptocurrency units in the blockchain, but given the integrated nature of digital assets with their associated blockchain , this conclusion is by no means certain.
Despite these analytical ambiguities, and although the Chief Counsel’s Opinion Memoranda cannot be relied upon or cited as precedent, the CCA provides reassurance to crypto market participants, as well as blockchains considering changes in protocol, as it indicates the likely position of the IRS regarding protocol changes. Ether holders before and after the Merger should take special note of the CCA. At the time of the merger, taxpayers had to sort through the IRS guidance then available to determine whether the merger resulted in a “hard fork” (and potentially a taxable event) or a “soft fork” (generally not a taxable event) . ). The IRS has generally defined “forks” as protocol changes with the distinguishing characteristic that “hard forks” are protocol changes that result in a new “book” while the legacy registry continues to exist (that’s to say, usually a continuation of the old cryptocurrency and the receipt of a new cryptocurrency followed on a new ledger). For example, the IRS previously issued guidance describing the 2017 Bitcoin “hard fork” as a taxable event, where Bitcoin holders received a new cryptocurrency, Bitcoin Cash, which was validated on a fully-fledged ledger. separated (as discussed here). Unlike the Bitcoin “hard fork”, the CCA notes that the holder who is subject to the CCA has “the same” units before and after the protocol change and does not receive any additional ownership. The facts of the CCA are arguably identical to the merger, where Ether holders received the same Ether units; and in accordance with the CCA, the only apparent change was to change the validation methods to POS. Therefore, Ether holders may want to review their 2022 tax returns, discuss them with their tax advisors, and possibly file any amended returns in light of these new guidelines.
