European Court Gives Virtual Currency a Boost: How Will This Affect the IRS?

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The European Union’s highest court, the European Court of Justice (ECJ) ruled that virtual currencies (e.g., Bitcoin) are exempted from a value-added tax (VAT) on October 22, 2015. As a consequence, the exemption allows virtual currencies to be treated like traditional cash.

A value-added tax is a type of sales tax that is applied at each exchange of the good or service in transaction chain.

David Hedqvist, a Swedish national, applied for authorization to operate an online Bitcoin exchange.  The Swedish Revenue Law Commission originally told Hedqvist that Bitcoin was exempt from VAT.  As such, Hedqvist believed he was able to operate his online Bitcoin exchange.  However, his belief was met with stark opposition when the Swedish Tax Authority appealed the Swedish Revenue Law Commission.  Swedish authorities argued that because it was not a real currency, Bitcoin did not meet the European Union’s tax-free standard.

After hearing the party’s arguments, the ECJ justified the ruling of the Swedish Revenue Law Commission by referring to the provision in the European Union’s tax code in which transactions relating to currency, bank notes, and coins used as legal tender are exempted from the VAT.  The Court was persuaded that both virtual currency’s nature and increasing use in business transactions justified its exemption from the VAT.

A value-added tax is a type of sales tax that is applied at each exchange of the good or service in transaction chain.  It is applied to each stage of a transaction chain like so: materials to manufacturer, manufacturer to retailer, and retailer to customer.  It is easiest to understand a value-added tax as an elaborate sales tax broken down into several stages, but ultimately the consumer bears the burden of the total tax.

Many have criticized the IRS policy as burdensome, and one that turns a simple transaction into a taxable event requiring detailed records and calculation. 

In March of 2014, the IRS released a notice that it would treat virtual currency as “property“ and not “currency.” As such, income derived by buying and selling Bitcoin is subject to a capital gains tax.

Every time a transaction like this takes place in the United States, the consumer has to keep a record of when they bought the virtual currency, the fair market value of the currency, and the gain if one exists.  Then depending on how long you held the currency, you would have to pay whatever the corresponding tax percentage is.

Many have criticized the IRS policy as burdensome, and one that turns a simple transaction into a taxable event requiring detailed records and calculation.  While other features of virtual currency have made consumers skeptical, like its prevalent use in black markets (e.g. Silk Road), cyber security risks (e.g. Mt. Gox), and volatility, there is no denying that the United States’ tax policy has contributed to the slow implementation of virtual currency in everyday transactions in the States.

If the IRS chose to adopt a tax exemption similar to that of the European Union or re-classify virtual currencies as “currency,” there would be several incentives to engage in dealings involving the medium. 

If the IRS chose to adopt a tax exemption similar to that of the European Union or re-classify virtual currencies as “currency,” there would be several incentives to engage in dealings involving the medium.  Those incentives might include benefits from money transfers sent internationally and grown of our economy.

Individuals working inside the United States who regularly transfer money to family abroad (remittance) would benefit from such a policy.  For instance, the use of virtual currencies, such as Bitcoin, might be beneficial for foreign workers who send money to family and friends in their home country.  Such transfers of funds are commonly known as remittances. According to the World Bank, total annual remittances are $430 billion globally.  This amount in annual remittances is an amount three times greater than the aggregate global aid budget.

In addition to remittance being a common practice across the world, the World Bank has also noted that the costs of these transfers often cost 7.99% of the value sent.  The transfer cost is paid to a third party intermediary like Pay-pal, Western Union, or a bank, and are often accompanied by higher transactional fees.  Promontory Financial has assessed the differences in transactional costs between a wire transfer via bank as compared to a Bitcoin transfer.  The results show that a person using Bitcoin spends fifteen dollars in transactional cost while the individual who uses a third party intermediary averages between forty and eighty dollars in cost for the transfer.

A change in policy would also contribute to the growth within the virtual currency industry and would thus make the United States a more attractive region to improve the virtual currency industry.  The virtual currency industry is already expanding elsewhere in the world, and the opportunity for the United States to capitalize on this expansion would benefit our economy by permitting the flow of more foreign currency.

Since the European Union’s decision, the price of Bitcoin, previously at $274, spiked incredibly and appreciated forty percent in the two weeks following the decision.  Since then, the currency has subsided and returned to $336.  It is believed that the jump was a result of confidence amongst investors of the virtual currency industry.  Mark Williams, a Boston University finance professor, said the IRS policy “reduces the positive economics for Bitcoin owners and miners,” and could reduce liquidity in the Bitcoin market thus pushing related ventures offshore.  It has already been noticed by the technology community that venture capitalist money is finding its way to Europe, and the job opportunities in this sector are growing abroad faster than they are in the United States.

The issue is that virtual currency has features that both resemble currency and a commodity or property. 

Even with all of the potential benefits associated with the IRS changing its policy, the likelihood of a re-classification from property to currency is slim.  There are multiple issues with the idea of re-classifying virtual currency from property to currency, but one in particular is at the forefront of the debate.  The issue is that virtual currency has features that both resemble currency and a commodity or property.

In the United States, virtual currencies are used more for investment purposes than they typically are as a medium for exchange.  The defining feature that justifies a virtual currency as a commodity is its ability to fluctuate in value like a stock.  Given this feature and its potential to create a substantial gain to individuals in possession of virtual currencies, the government feels it is necessary to tax virtual currency like other investment property and treat it like a capital asset.

The European Union ruling will undoubtedly spark a debate as to whether it is in the best interests for countries to scrutinize every virtual currency transaction.   

While virtual currency is not a dominant medium for which individuals conduct transactions in the United States, the fact is more people are using virtual currencies than ever before, and a need for action is obvious.  As the price of Bitcoin surged in earlier weeks it also coincided with an up in Bitcoin usage reaching an all-time high.  For whatever reasons behind individual or business decisions to take advantage of virtual currency, entities are slowing beginning to see the advantages of virtual currency use.

Given the commodity-like features of virtual currency, it is unlikely that a substantial change in virtual currency will occur anytime soon.  The European Union ruling will undoubtedly spark a debate as to whether it is in the best interests for countries to scrutinize every virtual currency transaction.

While the European Union ruling will help bolster the virtual currency industry in Europe, it will likely have no effect on any United States tax policies.  However, if you know somebody that currently resides in the European Union, tell them to go purchase Bitcoin or other virtual currency.  It is tax-free!