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.