On Bitcoin: Voices from the cutting edge

Friday, July 17, 2015 - 12:43
MCC’s contributing firms weigh in on the bitcoin phenomena – how it works, legal and privacy implications, and the broader impact of this disruptive technology as non-monetary currency gains acceptance and popularity.
Bitcoin: An Important Disruptive Technology?

Bitcoin has been identified as a new and disruptive technology platform with application well beyond its intended purpose, “bitcoin as money.” Well-known technology investor Marc Andreesen in 2014 compared the development of bitcoin to the arrival of personal computers in 1975 or the Internet in 1993. Are those statements “hype” by a venture capitalist with a vested interest, or is bitcoin that important a technology? Steve Gold of McGuireWoods LLP addresses this question and comments on some of the non-monetary uses of bitcoin technology that will have an impact on the legal system and the legal landscape for businesses. 

According to many observers, the blockchain technology that underlies bitcoin represents both an important advance in computer science and a disruptive innovation that has a wide variety of applications well beyond its application to bitcoin itself as a currency. The blockchain is the online, decentralized and programmable shared ledger of bitcoin transactions. The cryptography and the clever incentive structure of bitcoin mining that underlies the blockchain are what make it possible for there to be an agreed ledger that everyone participating in bitcoin can trust as providing the definitive description of everyone’s accounts and balances, without a single party, such as a government or a bank, managing the whole bitcoin system.

A host of other applications can be built on a single, decentralized but still definitive mechanism to account for all the rights of all the participants in an activity. What’s more, because the system is digital and was designed to be programmable, the decentralized blockchain ledger can respond automatically to other digital events.

While some of the blockchain applications under development are technological in nature (a way, for example, to manage large quantities of disk storage over a network), there are other possible applications that will directly impact lawyers and legal practice. For example, the NASDAQ recently announced an experiment to use blockchain technology to track the trades of privately held securities. Other possible applications, some of which are already under development, include using blockchain technology to manage records of ownership of other financial assets or of physical assets, such as real estate or vehicles.

Once assets are digitally represented, additional applications are possible. Startups today are working on “smart contracts” by which assets represented on the blockchain could become programmable – automatically, without human or central intervention, providing for future transactions. Smart blockchain contracts, for example, could process ongoing payments of a digital financial asset, automating a payment stream. Smart blockchain contracts might also automate future transfers of a digitally represented physical asset, creating a complete, virtually managed, complex relationship, such as an escrow or a repurchase arrangement. Just as bitcoin (as money) would reduce the need for services of financial institutions, these blockchain structures with digitized assets would be designed to reduce costs by eliminating some of the legal services that would otherwise be required for these transactions.

Of course other legal services would be engendered. As bitcoin and blockchain technologies are applied, there will be few direct precedents to establish the basic parameters of accountability and trust. Contractual, industry or legislative steps will be needed to establish appropriate allocation of liability for transactions that go wrong, particularly if circumstances arise in which the distributed blockchain itself is at fault (or is alleged to be at fault) for a party’s losses. Beyond that, difficult questions of attribution will arise if automated transaction steps (repetitive withdrawals of consideration over time, for example) are carried out without human intervention and without a single entity being responsible, but rather distributed responsibility occurring over the blockchain. 

IRS Treatment of Virtual Currencies

Federal and state authorities have been considering a number of tax issues involving the treatment of certain virtual currencies. While virtual currencies act like real currency, there is no physical counterpart. Therefore, the authorities have had to address the fact that virtual currencies are essentially intangible assets. Addressing some of the tax implications of transactions made with bitcoin, Michael F. D'Addio of Marcum LLP looks at the question of how this intangible asset can be taxed.

The Internal Revenue Service clarified a number of issues concerning the taxation of bitcoin and other “cryptocurrency” last year in Notice 2014-21. However, the guidance also created a number of complexities while imposing significant additional accounting responsibilities.

The IRS has taken the position that bitcoin and other forms of cryptocurrency are not currency (like dollars or euros) and therefore should be treated as personal property. This conclusion produces both positive and negative tax consequences. On the positive side, income earned by investors when they dispose of the virtual currency can produce capital gains treatment depending on how long the investor held the currency. When the coins are held for less than 12 months, regular tax rates will apply to any gain on disposition. However, when the coins are held for more than 12 months, they qualify as capital assets. As capital assets, any gain earned upon a disposition is subject to the preferred (lower) long-term capital gains rates (0 percent, 15 percent and 20 percent) instead of the higher ordinary income rates.

Unfortunately, the IRS’ position of treating virtual currency as personal property also creates some disadvantages for investors. This is because, similar to the gain from a disposition of virtual currencies, the losses resulting from the disposition, sale or exchange of bitcoin or other cryptocurrency are also capital in nature. Therefore, the losses can be used to fully offset any capital gain income, but can only offset up to $3,000 of non-capital gain income a year. Any unused losses may be carried over to future years but will be subject to the same annual limitation in those years. As a result, an investor may have to wait to utilize the full tax benefit of the loss. However, if virtual currency were considered to be foreign currency, any losses from their disposition would be deducted as an ordinary loss.

A question still exists as to whether losses relating to bitcoin and cryptocurrency are subject to the wash sale rules, which are intended to limit the use of losses that have not been economically realized. Under the wash sale rule, when stocks or securities are sold at a loss and substantially identical replacement stocks or securities are purchased within the thirty days either before or after the date of sale, the loss is disallowed in the current year for tax purposes. The tax basis of the replacement asset is then adjusted by the amount of the disallowed loss.

It can be argued that bitcoin and other cryptocurrencies are liquid (like marketable stock and securities) and that replacement coins would be substantially identical to exchanged coins so that the wash sale rule should apply. However, the IRS has previously stated that the wash sale rules apply only to stocks and securities and has not yet identified these virtual currencies as being “stocks” or “securities.” It is most likely that the wash sale rules do not apply to losses on the disposition of bitcoin and cryptocurrency. If the IRS or Congress were to change this result, a holder would have to wait 30 days before or after the disposition date before replacing the coins in order to use the loss. This could produce a significant hardship in situations where bitcoins are used as currency to pay for commercial transactions.

There is no income or other gain generated on the purchase of these coins. When they are received in exchange for services performed, there is an immediate tax consequence since the amounts received for services are always subject to tax. Similarly, if the coins are received in exchange for property transferred, the gain or loss must be calculated with respect to the property transferred and treated under normal tax rules.

The IRS states in the Notice that using virtual currency to pay for a commercial transaction results in a sale or exchange for which a taxable gain or loss must be calculated, based on the difference between their values and acquisition costs. Therefore, the holder of bitcoin and other cryptocurrency must maintain adequate records to determine the cost and holding period of the virtual currency being used. This could result in significant record-keeping issues.

Investors should have the option to select the method to determine which bitcoins are sold – i.e., on a first-in-first-out (FIFO) basis, a last-in-last-out (LIFO) method or specific identification method. The method selected would determine the holding period and basis of the coins sold when computing the gain or loss on the transaction. Choosing one method over another could have a significant tax impact. While specific identification might be the best option, this may not be a practical alternative. In order to use this method, the seller must inform the “broker” which particular units are being sold. It is unclear if the current trading platforms maintain sufficient records and have the ability to execute a transfer of specific coins from a particular purchased lot.

Bitcoin and cryptocurrency have raised a number of issues for state governments as well. For states that piggyback their income tax systems on federal rules, the IRS Notice provides the basic taxation structure. Others will need to address taxation issues separately. Bitcoins are creating other state tax questions. New York recently issued guidance stating that the acquisition of bitcoins is generally not subject to sales tax. This is because New York’s sales tax system only applies to tangible personal property, and these virtual currencies are intangible property. However, taxable assets or services purchased with these coins remain subject to sales tax. 

The Bitcoin Exchange System: Do I Own Your Bitcoins or Do You?

It’s almost impossible to discuss the ramifications of bitcoin without a sense of morality coming into play. Edward Turay of Inventus, LLC discusses the ins and outs of the bitcoin exchange system, issues surrounding proof of ownership and the resulting complexity of attributing responsibility for actions within a system that’s designed to provide anonymity.

Bitcoin is a decentralized, open source cryptocurrency “for the people.” This means dealings can be made without a central ledger, accounts cannot be frozen, transaction fees remain relatively low, anyone can purchase anything, giving rise to illegal sites like the Silk Road, and developers can easily edit the software code, making it difficult for governments to regulate. Over a consensus network, monitored by anyone with specialized computer hardware, transactions are processed and verified based on the triple-entry system (bitcoin protocol). After confirmation, records (referred to as blocks) are stored on a transparent public ledger called the block chain. Addresses within a block explain where bitcoins are allocated or sent to. Bitcoins are stored in a personal bitcoin wallet, and addresses are created within a wallet after a public/private key pair is generated. The public key (PubKey) is then hashed, forming the address.

This PubKey is provided to the payer; they decode the sender’s address, create their transaction and digitally sign it to confirm they’re sending the payment. Each transaction contains a scriptPubKey that allows anyone to spend the payment as long as they have the PubKey counterpart (private key). This is where things become complicated. Transactions are irreversible, so lost or deleted private keys prevent owners from spending bitcoins received, and these bitcoins will remain lost forever. Moreover, stolen private keys allow the bearer to spend the bitcoins associated with it.

Because large sums of bitcoins coming in and out of the same address make it vulnerable to an attack, it has been advised that a new address be used each time a payment is sent or received. That way, people who send money cannot see what you are doing with other bitcoin addresses you own. Furthermore, some bitcoin clients can automatically change your address after every transaction, making it difficult to know which bitcoin addresses you own. Despite this, hackers may listen to transaction relays, log people’s IP addresses and link them to certain transactions. As a result, the public are encouraged to use Tor – software that helps hide IP addresses from network traffic surveillance. So the question is, if you are a victim of theft or fraud, how do you prove ownership of bitcoins whilst remaining anonymous and unlinked to specific transactions in the public ledger?

The UK Theft Act 1968 defines theft as “dishonestly appropriating property belonging to another with an intention to permanently deprive them of it.” The Fraud Act 2006 later defined fraud as the “abuse of position, or false representation, or prejudicing someone's rights for personal gain.” If both legislations rely on the defendant having proof of ownership of a tangible or intangible entity and the presence of the mens rea and actus reus to exonerate or incriminate the accused, how can this be resolved if the accused can obtain the victim’s private key and spend their bitcoins in a way that won’t allow an IP/bitcoin address to link back to them? 

Impact of Virtual Currencies on Payments and Transactions

An important topic that is often lost in discussions about virtual currency is the revolutionary nature of the technology underlying the transactions. Coming from a payments perspective, Erin Fonté of Dykema Gossett PLLC is skeptical about bitcoin or virtual currencies for use as a medium of payment. She notes that investors like volatility, but too much volatility is not good for a medium of exchange, and talks further about bitcoin’s potential effect on the financial services industry.

It is unlikely that a ubiquitous payment method can really take off without being paired with government-issued and government-backed currency. "Legal tender" actually means something in terms of settling debts, plus governments are loathe to take monetary policy out of their domestic and foreign policy quivers.

But the technology underlying virtual currencies is another story altogether. Banks and financial institutions are intrigued by the prospect of "self-authenticating" transactions. Many banks are experimenting with using the blockchain framework of virtual currencies to improve the hardest element of payment transactions – authentication.

In physical, online and mobile payments, one of the biggest challenges is authenticating an individual along with the authorization request for a payment transaction. I know Suzie Jones' mobile device was used to initiate a transaction at a gas pump this morning, but how do I know Susie actually had possession of the mobile device? In payments, the law is that certain financial transactions (like online banking) must use "multifactor" authentication. If a transaction has two of the three "factors," then it is multifactor. The three factors are (1) what you have (e.g. a token), (2) what you know (e.g. a PIN or out-of-wallet challenge questions), or (3) who you are (i.e. biometrics like fingerprint, retinal scan or voiceprint).

Authentication is the holy grail of payments transaction legality and security. BNY Mellon created its own digital currency, BK Coins. CBW Bank, a community bank in Weir, Kansas, is building a risk management system incorporating cryptocurrency technology. USAA, based in San Antonio, has a team of researchers looking into the potential of the blockchain. What intrigues these institutions are possibilities for efficiency and security improvements in areas like payments and securities handling by using the self-authenticating technology of the blockchain. Similar to an accounting ledger in which entries can't be edited once created, the original blockchain's distributed ledger is an indelible record of transactions. When kept within a bank, the blockchain becomes an application with multiple nodes, creating robust failover systems for transaction risk.

CBW Bank is working with Ripple Labs, developer of the Ripple protocol, an open-source distributed transaction infrastructure that has its own native digital currency but can be used to transfer ownership of all sorts of assets.

The potential applications are somewhat astounding when you realize that anything that can be defined with a number could be stored and tagged in a blockchain-like facility, giving rise to self-executing escrow or loan tranches automatically disbursed when required conditions are met. If you are a middleman in payments or other transactions, self-authentication could put you out of a job. 

Steve Gold is chair of the cross-departmental technology and outsourcing practice for McGuireWoods LLP and former co-chair of the technology and business department with 25 years of experience as a technology and outsourcing lawyer. He can be reached at sgold@mcguirewoods.com. Michael F. D'Addio is a principal in Marcum's New Haven office. He has more than 35 years as a specialist in compliance and planning in a variety of areas concerning federal and state taxation. He can be reached at  Michael.DAddio@marcumllp.comEdward Turay is a project analyst for Inventus, located in the company's London office. Erin Fonté assists clients with a broad range of matters related to payments/payment systems, digital commerce, banking and financial services (including related legal and regulatory issues), technology/Internet products, privacy and data protection laws, and general corporate matters in Dykema's Austin, Texas office. She can be reached at efonte@dykema.com.