Digital Currency: A New Worry for Tax Administrators?

By David D. Stewart and Stephanie Soong Johnston
TaxAnalysts
Monday, October 29, 2012

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Controversies surrounding presidential candidates are old hat in any given election year, but 2012 could very well be the first time that hackers, presidential tax returns, and a mysterious digital currency called bitcoin all had starring roles in one of the oddest politically motivated tax capers in recent memory.

In early September it was reported that a group of hackers claimed to have broken into PricewaterhouseCoopers's Franklin, Tennessee, office in late August and copied Republican presidential candidate Mitt Romney's sought-after tax returns to thumb drives.

The hackers then said they had sent the thumb drives to local Democratic and Republican offices, along with ransom notes demanding that $1 million -- all in bitcoins -- be paid by September 28 to one of two accounts to destroy or release the cyberkey required to access the files contained on the thumb drives. (For prior coverage of the hacker incident, see Tax Notes, Sept. 10, 2012, p. 1253, Doc 2012-18670, or 2012 TNT 174-2.)

That deadline has since come and gone, and the incident was declared a hoax by many. But the news certainly accomplished one thing: shining the spotlight on bitcoin, a decentralized, peer-to-peer Internet currency that has been growing in popularity and prominence in the digital age -- and in doing so has raised a series of legal questions, especially in the area of taxation.

A 'Bit' of History

The currency was created in 2009 by Satoshi Nakamoto -- likely a pseudonym for the programmer or programmers responsible for developing the system. It is distinct from virtual currencies used in online gaming communities. Virtual currencies, such as World of Warcraft gold, function within the universe of the game but may be bought and sold using real-world currency. The function of virtual currencies is limited by their utility to other game players. (For discussions of the tax implications of virtual economies, see Tax Notes Int'l, Jan. 15, 2007, p. 149, Doc 2007-997, or 2007 WTD 10-8; and Tax Notes Int'l, Nov. 21, 2011, p. 579, Doc 2011-22984, or 2011 WTD 224-18.)

Bitcoins function as a unique currency with its own free-floating exchange. It has no government and no central bank and is intended to be used worldwide. Think of it as the Esperanto of currency.

Coffees from San Antonio-based BitBrew can be purchased
only by using the bitcoin system.

Users can also send and receive bitcoins using unique Internet addresses and store their bitcoins -- each of which is broken down into 100 million units known as satoshis -- in a virtual wallet. The stored bitcoins, which offer some degree of anonymity to users, can then be used to buy everything from coffee and T-shirts to LSD tablets and drug-fueled energy drinks.

Tax Analysts sought out members of the bitcoin community as well as tax experts to identify what the implications are for tax administrators. Some believe that the system could be used to facilitate tax evasion, while others contend that the open nature of the transactions would deter such evasion. All believe, however, that bitcoins raise significant questions. For tax administrators, the challenge is how to approach a system that is outside the traditional streams of commerce and finance. For users, the challenge is how to navigate an ambiguous regulatory climate in which guidance is difficult to come by.

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