Bitcoins have suddenly been the subject of flurry of articles in places like the New Scientist (probably because a Swedish IT entrepreneur, Rickard Falkvinge, has announced that he’s putting his money into Bitcoins), with some more hysterical commentators declaring that Bitcoins are a danger to governments because they “can’t be taxed”. I thought I’d add this article to the flurry, to examine that hypothesis.
In summary, governments don’t generally care what format your wealth change is in; they will want the tax paid in their local currency, but are quite happy to let you earn it in anything you like – including Linden dollars, for example (to take a mild blast from the past). You need to declare it on your tax return (translated to local currency) when it increases your wealth; whether or not the Government can easily find out about it is irrelevant to a taxpayer’s obligations under law. To be pedantic (no doubt a first for a tax lawyer), the hysteria also misses the point that currency itself is not generally taxed (except in the case of collectible coins, for example) – tax is based on changes in wealth, which are usually measurable in currency of one format or another.
The main tax question is: when does a virtual currency increase your wealth for tax purposes?
What are Bitcoins?
Bitcoins are part of a peer-to-peer currency, created in 2009, with no centralised authority or issuer. The currency is controlled by software distributed across the network of users, with reasonably strong security to reduce the risk of money being spent twice etc. Bitcoins are generated by the system slowly, and will be limited to 21 million; the rate of increase reduces over time so that it is estimated that the full 21 million will not be in circulation in the system until around 2033 (see http://en.wikipedia.org/wiki/Bitcoin for more details). Bitcoins are, effectively, a user’s reward for the service of running the software. (Edited to add: there is an argument that these Bitcoins acquired by running the software should not be subject to tax unless they are sold – ie: that this is a latent gain, rather than earnings. Given how few Bitcoins a user will acquire through this method, I doubt it’s something that the authorities will get particularly excited about. If anyone breaks the system to generate their own Bitcoins at will, the currency will become valueless**.)
Bitcoins can also be bought and sold by users; the limited number and declining generation of new Bitcoins means that the price is steadily increasing as more users enter the system and more goods and services can be acquired with Bitcoins. Initially traded at 6¢ each, they are now trading at more than $6 each.
There have been various attempts to produce online currencies before, not least because of the cost issues around micropayments – the fees charged by credit card companies mean that the cards are not appropriate for very small payments. Offline, people use cash for such payments, and the online community has been searching for a version of cash for use online ever since the internet became popular (I seem to recall attending a conference sponsored by one such, somewhere around 2001 – I don’t remember which currency it was, and it has long since disappeared!). Previous attempts have relied on a central issuing entity, however.
Other virtual currencies derive from online games – Linden dollars, earned in Second Life, being the classic example. Linden dollars are accumulated by players each week that they log onto Second Life; they can also be earned by selling virtual goods and services in the game. ‘Gold’ obtained in World of Warcraft is another although, under the game’s terms and conditions, the currency is not supposed to be tradeable outside the game. This hasn’t prevented a gold-farming industry developing, principally in China and the Far East, earning gold ingame for sale offline.
Tax free?
As I said in the summary above, most tax authorities’ rules are set up so that they tax measurable increases in wealth, whether income or gains; in general, tax authorities will try and calculate the value of such increase, no matter how difficult. The authorities generally shy away from trying to tax latent increases in wealth – for example, a person who knits as a hobby arguably increases their wealth by turning yarn into a sweater (the sweater will have a higher fair market value than the yarn it was made from), but there is no tax on that increase unless the person later sells the sweater as part of a trade.
Some may see Bitcoins and other online currencies as an opportunity to evade taxes, because the currencies are hard to trace. Without a central authority, Bitcoins in particular are fairly invisible unless specifically declared by the user. As such, they will undoubtedly facilitate the black economy, but so does any form of barter – and tax authorities have managed to track down and enforce tax rules on businesses providing goods and services for barter before. None of this means that income or gains measured in Bitcoins can’t be taxed in law, it just means that the taxpayer who doesn’t declare the income or gains in Bitcoins is breaking the law.
But when to tax?
The interesting question to date has been: when should earnings in a virtual currency be taxed?
There has been some debate over the years on this with regard to Second Life earnings. Tax authorities appear not to be interested in people earning Linden dollars unless/until they exchange those Linden dollars for real dollars. This is perhaps similar to the approach taken over airline miles; the IRS in the US has specifically stated that they don’t tax airline miles unless they are exchanged for cash (Announcement 2002-18, 2002-1 C.B. 621) – the fuss over airline miles about ten years ago related to miles earned by employees travelling on business paid or reimbursed by their employer. There was an argument at the time that such employees should be taxed on airline miles earned through business which were then used for personal travel, on the basis that the miles were a benefit of the employment. In the end, the difficulty of working out when the tax point would be meant that the simplest route was to tax only if turned into cash.
The difference between Linden dollars and Bitcoins, however, is that Linden dollars can’t be used for offline transactions (certainly not with any particular ease) unless/until they are converted into US dollars. They can only be used to buy virtual services and virtual goods. In general, a tax authority isn’t likely to be interested in a virtual currency until you can use the currency to buy a pint of beer (or milk, if you prefer) that you can drink.
However, Bitcoins can be used, as such, to pay for goods and services where they are accepted (there are only a limited number of businesses accepting them, including a number of gambling sites, a software developer and an eBay bookshop; a number of blogs are accepting Bitcoins as donations). The financial side of the transaction needs to be completed online, but smartphones could make that relatively straightforward if Bitcoins were to make the transition to offline retail sales.
As a result, Bitcoins are likely to be viewed by tax authorities (when they finally catch up with the point!) as a form of currency like any other, to be declared (translated at the fair market value – on which will turn a lot more questions and enquiries, of course) on tax returns when earned as income or gains. The question will be when, not if, provided that Bitcoins become something more than a minor curiosity.
*”Plus ça change” – I first wrote about the tax implications of electronic cash in 1998. Nothing much has changed since then, except the names of the currencies!
** Edited 22/6/11 – the link between security and value for bitcoins was demonstrated when hackers broke security and stole bitcoins (http://www.bbc.co.uk/news/technology-13857192). The value tanked to near zero for a while, and this wasn’t even a “print your own” security breach).
Thanks to @tpittpayne for suggesting this article.
Tags: bitcoins, internet, second life, virtual currency, world of warcraft