IRS Says Crypto Protocol Changes Are Not Taxable

• Jurisdiction: United States,Federal
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Subject Matter: Technology, Fin Tech
• Author: Mr Cadwalader, Wickersham & Taft LLP
• Published date: 25 May 2023

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 (...