The IRS determined that holding units of a cryptocurrency that undergoes a change from using a proof of work consensus mechanism to a proof of stake consensus mechanism does not create a sale or exchange nor any other sort of income recognition event under IRC §61 in Chief Counsel Advice 202316008.[1]

Proof of Work vs. Proof of Stake

In response to the question “what is proof of work,” ChaptGPT 3.5[2] provides the following explanation:

Proof of Work (PoW) is a consensus mechanism used by blockchain networks to validate transactions and add new blocks to the blockchain. It is a cryptographic puzzle that miners compete to solve, which requires a significant amount of computational power.

In the PoW process, miners use their computing power to solve complex mathematical problems that are associated with the transactions. The first miner to solve the problem broadcasts the solution to the network, and if the solution is correct, the miner is rewarded with new cryptocurrency coins or tokens. The solved block is then added to the blockchain, and the process repeats for the next block.

The difficulty of the PoW puzzle is set by the network, and it increases or decreases based on the total computing power of the network. This ensures that the rate at which new blocks are added to the blockchain remains stable over time.

The fact that PoW puzzles have had to become more difficult over time for popular cryptocurrencies has led to miners acquiring more and more powerful and power-hungry computing rigs, which has raised concerns over the amount of electricity used in the process.

This is one key reason why certain cryptocurrencies are changing their protocol to a “proof of stake” system. Again, ChatGPT 3.5 provides the following general explanation in response to “What is proof of stake?”:

Proof of Stake (PoS) is a consensus mechanism used by blockchain networks to validate transactions and add new blocks to the blockchain. Unlike Proof of Work, PoS does not require miners to solve complex mathematical problems to add new blocks to the blockchain. Instead, the validator nodes are selected to create the next block based on their ownership of the network’s cryptocurrency tokens.

In a PoS system, validator nodes are chosen to create the next block based on the amount of cryptocurrency tokens they hold and have “staked” or locked up in the network. Validators are chosen randomly, but the probability of being chosen is proportional to the amount of tokens they have staked in the network. This process is called “forging” or “minting” instead of “mining.”

Validators are incentivized to act in the best interest of the network, as they can lose their staked tokens if they try to cheat or validate fraudulent transactions. This is because other validators can “slash” their staked tokens if they detect any malicious behavior.

PoS is generally considered to be more energy-efficient and environmentally friendly than PoW, as it does not require the significant amount of computational power used in PoW systems.

Of course, this article’s focus isn’t so much on the mechanics of the blockchain, but rather the tax implications that might arise from changing the underlying protocol from proof of work to proof of stake. Does that fundamental change in the protocol mean that the taxpayer has effectively exchanged one digital asset for another leading to either a taxable gain/loss transaction or some other sort of income recognition event?

Questions the IRS Memorandum Addresses

The IRS specifically looks to address the following two questions:

1. Does an individual taxpayer (“T”), who holds 10 units of C, a cryptocurrency native to a distributed ledger that undergoes a protocol upgrade (as defined below) that changes the consensus mechanism by which transactions are validated, realize gain or loss on those units under section 1001 of the Internal Revenue Code (“Code”) as a result of the protocol upgrade?

2. Does T have an item of gross income under section 61(a) of the Code as a result of the protocol upgrade?[3]

The IRS concludes that the answer is no in both cases.

Facts Presented

The memorandum addresses the following fact pattern:

K is a blockchain that uses distributed ledger technology to record transactions involving cryptocurrency pursuant to K’s underlying protocol. The K blockchain protocol is a set of rules that includes a consensus mechanism for adding new blocks of transactions to K, including those involving units of C. Participants that successfully add new blocks of transactions to K receive a block reward in accordance with K’s underlying protocol.

On Date 1, T purchases 10 units of C and stores the private keys in an unhosted wallet. On Date 2, K changes its consensus mechanism used to select who may validate transactions and add blocks of transactions to the K blockchain from proof-of-work (“PoW”) to proof-of-stake (“PoS”) (the “protocol upgrade”).

After the protocol upgrade on Date 2, K’s protocol requires that transactions be validated and that new blocks be added to K’s blockchain exclusively through the PoS consensus mechanism. The protocol upgrade does not affect or otherwise change the transaction history of any blocks prior to Date 2, and new blocks will be added to K pursuant to the changed protocol. Units of C remain unchanged following the protocol upgrade, and T continues to hold the same 10 units of C. T does not receive any cash, services, or property (including additional units of C) as a result of the protocol upgrade.[4]

The Law

The memorandum analyzes the IRC and related regulations, rulings and cases to determine the tax treatment of the protocol change. The analysis begins by discussing the nature of digital assets for tax purposes:

Digital assets are defined under section 6045(g)(3)(D) as digital representations of value that are recorded on a cryptographically secured distributed ledger.1 Digital assets do not exist in physical form and include, but are not limited to, property the Service has previously referred to as convertible virtual currency and cryptocurrency. See Notice 2014-21, 2014-16 I.R.B. 938; Rev. Rul. 2019-24, 2019-44 I.R.B. 1004. Notice 2014-21 provides that convertible virtual currency is treated as property and that general tax principles applicable to property transactions apply to convertible virtual currency.

Cryptocurrency is a type of virtual currency that utilizes cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. Units of cryptocurrency are generally referred to as coins or tokens. Distributed ledger technology uses independent digital systems to record, share, and synchronize transactions, the details of which are recorded in multiple places at the same time with no central data store or administration functionality. See Rev. Rul. 2019-24.[5]

One possible result is that this transaction might be viewed as an exchange of the PoW protocol digital asset to a new PoS protocal digital asset. So, the memorandum looks at the law defining a taxable sale or exchange of an asset:

Section 1001 provides rules for the computation and recognition of gain or loss related to the sale or other disposition of property. Treas. Reg. §1.1001-1(a) provides that the gain or loss realized from the exchange of property for other property differing materially either in kind or in extent is treated as income or as loss sustained.

An exchange of property is a realization event under §1001 only if the exchange results in the receipt of property that is materially different from the property transferred. For properties to be “different” in the sense of being “material” for purposes of section 1001, they must embody legally distinct entitlements. See Cottage Savings Assn. v. Commissioner, 499 U.S. 554, 564-565 (1991).[6]

As well, it’s possible this might be viewed as some other type of income generation event, so the memorandum looks at the definition of income under the IRC:

Section 61(a) provides the general rule that, except as otherwise provided by subtitle A of the Code, gross income means all income from whatever source derived, including gains from dealings in property. Under section 61, all gains or undeniable accessions to wealth, clearly realized, over which a taxpayer has complete dominion, are included in gross income. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). As stated by the Supreme Court in discussing an earlier version of this section, “[t]he income taxed is described in sweeping terms and should be broadly construed in accordance with an obvious purpose to tax income comprehensively.” Commissioner v. Jacobson, 336 U.S. 28, 49 (1949).

In general, the excess of the fair market value of property or services over which the taxpayer has dominion and control reduced by the amount, if any, paid by the taxpayer shall be includible in gross income.

Gross income includes income realized in any form, whether in money, property, or services. Income may be realized, therefore, in the form of services, meals, accommodations, stock, or other property, as well as in cash. Treas. Reg. §1.61-1(a).[7]

IRS Analysis

Having set forth both the facts and the relevant authorities, the memorandum now analyzes the application of the law to the facts to answer the questions presented.

The memorandum first concludes that the change in protocol does not create a sale or exchange of the underlying digital asset:

The protocol upgrade affects the consensus mechanism by which future transactions are validated and blocks are added to K after Date 2. The protocol upgrade does not alter past transactions or blocks previously validated and added to K, including T’s 10 units of C. Furthermore, the existing units of C remain unchanged by the protocol change and there is not an exchange of the units of C under section 1001. Accordingly, T continues to own the same 10 units of C before and after the upgrade and the protocol upgrade does not result in a realization event from which T realizes gain or loss on T’s existing 10 units of C.[8]

The memorandum continues, concluding there is also no other type of income generated by the change in the protocol:

Similarly, T derives no accession to wealth from the upgrade. T’s 10 units of C remain unchanged after the upgrade, and T does not derive any separable economic benefits, in the form of cash, services, or other property (including other cryptocurrencies) from it. In the absence of an accession to wealth to T, the protocol upgrade does not result in T having an income inclusion within the meaning of section 61(a).[9]

[1] Chief Counsel Advice 202316008, April 21, 2023, https://www.taxnotes.com/research/federal/irs-private-rulings/legal-memorandums/no-gain-or-loss-realized-in-crypto-protocol-upgrade/7gkk2 (retrieved April 22, 2023)

[2] https://chat.openai.com/

[3] Chief Counsel Advice 202316008, April 21, 2023

[4] Chief Counsel Advice 202316008, April 21, 2023

[5] Chief Counsel Advice 202316008, April 21, 2023

[6] Chief Counsel Advice 202316008, April 21, 2023

[7] Chief Counsel Advice 202316008, April 21, 2023

[8] Chief Counsel Advice 202316008, April 21, 2023

[9] Chief Counsel Advice 202316008, April 21, 2023