Bitcoin enthusiasts have recently been roiled by claims that an Australian named Craig Wright and his deceased partner are the mysterious founders behind the cryptocurrency.
Of course, we’ve been down this path before. The New York Times, Fast Company, The New Yorker and Newsweek have all made similar claims about different people, only to be proved wrong. And last month, Wired—the magazine behind the most recent claim—said there are reasons to believe Wright is actually a hoaxer and not “Satoshi Nakamoto,” as the currency’s creator is known.
Regardless of whether the new claims are correct, it has resurrected a worry that has long plagued bitcoin users. Around one million bitcoins were mined early in the currency’s history and have never been transferred. Were they to be sold en masse, bitcoin’s value could drop precipitously, wiping out a lot of wealth and threatening its status as a reliable alternate currency, independent of banks and governments.
However, the reporting about Wright and the bitcoin businesses and trusts he has established—presumably for tax and secrecy purposes—reveals an even bigger threat to bitcoin users and other supporters of virtual currency: how will such currencies be treated for tax purposes?
This is a question I have been exploring for the last decade, both with regard to virtual currencies designed to be used solely online, such as for World of Warcraft, and those designed for use in the real world, such as bitcoin.
Currency or Investment?
Bitcoins are created by a computer algorithm and are initially allocated through a process colloquially referred to as “mining.” Miners collect bitcoins by solving complex mathematical equations used to authenticate transfers and in so doing both bring more of the currency into the world and maintain the system.
Bitcoin users have a public key and a private key associated with the bitcoins they own. To effect a transfer, one must use the private key. However, transfers are recorded on a public “block chain,” which uses the associated public key.
This secure public record-keeping obviates the need for third-party intermediaries, like banks. While the world can see the public key and how many bitcoins are associated with it, the owner of the bitcoin can remain anonymous if he keeps his association with that key secret.
Approximately 15 million bitcoins have been issued to date, and they are currently valued at about US$430 each, for a total of approximately $6.5 billion. The algorithm is designed to generate 21 million bitcoins, and experts anticipate that the last bitcoin will be issued sometime between 2110 and 2140.
Bitcoin is designed to be used as a currency, though some hold it as an investment. The difficulty is that governments have taken a variety of positions on the nature of bitcoin for tax purposes.
For instance, some countries, including those in Europe, have classified bitcoin as a currency for consumption tax purposes, meaning that the various value-added taxes do not apply to bitcoin exchanges, while others, such as Australia, have not. Similarly, the U.K. treats bitcoin as foreign currency for income tax purposes, while the U.S. regards it as property.
Those who “mine” bitcoins will likely be subject to income tax on the value they receive under the theory that they are being compensated for validating bitcoin transactions and maintaining the block chain that records all transfers. But this is true regardless of whether bitcoin is recognized as a currency. In other words, they are not really mining and not subject to the complex rules governing mining operations. Instead, they are being compensated for services.
The difficulty arises when people try to spend their bitcoins, however acquired.
How Cash Transactions Are Taxed
Those who spend local currency, such as dollars (U.S. or Australian) or euros, do not report a gain or loss when they do so. For instance, if I buy a hamburger, I don’t have a gain or loss on the currency used, regardless of whether it has changed value relative to other currencies.
As the baseline currency, a dollar is worth a dollar, even though it may fluctuate against other currencies or be affected by inflation.
Foreign currency is different. If I buy a euro for $1 and spend it later, when it is worth $1.10, theoretically I have a $0.10 gain that I should be taxed on. Different countries have different rules, but in the U.S., taxpayers need not pay taxes on such gains if they are under $200 in a given year.
