Australian Tax Office Treatment of Bitcoin (etc) Forks: Trouble Ahead

TL:DR; ATO treats forks as creating a “new asset” causing unexpected tax burdens for any Australian taxpayer holding cryptocurrencies in future.

Background

I got a nasty surprise when preparing my 2017/2018 tax return. I had sold my Bitcoin Cash as fast as possible, and gotten around to selling other minor forks just before the close of the financial year. The ATO then decided that those sales were (1) assets under 12 months old, and (2) a cost-basis of 0. The result was that they wanted 48% of the amount in tax; over twice what I was expecting and had set aside!

In Australia, you (generally) pay Capital Gains Tax on the difference between the purchase (“base price”) and sale prices, but you only pay half of the amount if you held it for 12 months or more.

The ATO’s Reasoning

The ATO reasoned that a fork creates a new asset valued at zero and the new asset is the one whose rules have changed. I can see how they arrived at this, and am kicking myself for not getting involved earlier: having a real technical expert involved might have avoided the shallow understanding which lead to this.

A Split is Not a New Asset

The idea that a new asset is created is the base misunderstanding, and to see why, we need to go beyond simplifying nomenclature like “wallets holding bitcoins” and “tokens” and understand what’s actually happening.

Bitcoin is a network of independent nodes, each maintaining its own ledger attaching amounts to keys which can spend them. When I say “I own 1 bitcoin!” what I mean is that all up-to-date nodes on the network have a current entry in their ledger which indicates that 1 bitcoin can be spent using a secret key that I hold. Normally the bitcoin protocol ensure that over time, nodes will come to consensus the contents of their ledgers. This controlling an entry in this consensus of ledgers is what bitcoin actually is, and all bitcoin is: this is what people mean when they say “bitcoin is unbacked”.

Consensus that I control an entry in the ledgers is the asset, because that’s what bitcoin actually is.

Bitcoin has value because people respect these ledger entries as currency, and as long as the network is functioning normally I can use it to send an instruction to update the ledgers which will spread through the network and eventually be entered in all the ledgers (in particular, the one trusted by the “recipient”).

What did change with the Bitcoin Cash fork was not normal though: One (larger) part wanted to update the ledger rules to allow a new appendix with each entry, the other wanted to update the ledger rules to simply expand the allowable number of entries. The network split into two irreconcilable parts which no longer talk.

My key didn’t change, or even gain any additional capabilities. The consensus of ledger entries I controlled split into two groups, but an asset split is not a taxable event. If I own gold and split it into different isotopes, that is not a taxable event, does not change its cost basis, and does not change its acquisition date.

Over time, the market decided that ledger entries of the smaller group (now called Bitcoin Cash) were worth less than those of the larger group (now simply called Bitcoin).

When the ledgers split into two groups, the asset (lines in the ledgers) split. This is not a taxable event.

The ATO’s Workaround I: Asset Valuation

Once they decided to treat it as a newly acquired asset, the ATO instantly had a new problem: how to value the new asset? If you gain an asset, you have to pay income tax on it! Yet clearly the user did nothing, and hitting them with a random tax bill seems unfair (especially if they couldn’t spend it before the price dropped precipitously). To work around this, they chose a value of 0.

The first taxation officer I spoke with declared that they chose a value of 0 as it was the most favorable to the taxpayer, the second insisted that the value of 0 was a “matter of fact”.

You could actually trade Bitcoin Cash before the fork (though you had to send your Bitcoin to an exchange to do so), and there were various other future markets available. I agree that the market was far too easily manipulated and shallow for this price to be a reliable signal, but it’s clearly not zero. Picking 0 is unlikely to draw immediate ire from taxpayers (though see below!), but it’s very hard to defend: as a tax payer I certainly can’t decide to value “hard to assess” assets at 0!

The ATO’s Workaround II: The Technical Test

When deciding which was the new asset, the ATO chose a technical test: the one one whose rules hadn’t changed was the original asset, and the one which had was a New Asset. This often gives the same results as you’d expect if you assumed a “market” test (i.e. biggest market-cap fork is the original, or the one with the original name is the original).

However, it reflects a lack of understanding of how cryptocurrencies work. For all the talk of “immutable ledger”, they change the rules with some regularity. I can think of five bitcoin rule changes, but there were more and we anticipate another one this year (2020).

In particular, while Bitcoin Cash was forked by changing a consensus rule (making it a New Asset according to the ATO), this was a mere technicality: two weeks later Bitcoin also changed, as they locked in the Segregated Witness soft fork. As this change was opposed by Bitcoin Cash proponents, it was necessary they fork first[1]. It could be argued that at the time Segregated Witness activated, the Bitcoin Cash protocol was more similar to the original rules than Bitcoin itself was!

Absurdities That Follow

If you assert 1+1 = 3, things tend to break down badly. The results here are the same: by asserting that a new asset is created, you create a bunch of new problems:

  1. If you held Ethereum across the Ethereum Classic Fork, Your Cost Basis is 0.
    Ethereum became a New Asset on July 20th 2016. This was confirmed verbally by the current chair of cryptocurrencies at the ATO. This means that if you sold Ethereum since then you probably didn’t pay enough tax, and if you sold it before July 20th 2017, you’re not entitled to a capital gains discount. Surprise!
  2. Bitcoin may have become a New Asset at the first halving.
    Greg Maxwell once told me that a number of miners tried to continue to grant themselves 50BTC rewards after the first halving. Their fork quickly petered out, but it’s easy to argue that their fork was following the original rules, and thus Bitcoin is a New Asset. If true, and you held it across November 2012, your cost basis is now 0, and no capital gains discount is available if you sold before November 2013.
  3. Bitcoin may become a New Asset on any Soft Fork.
    Since any rule change can create a fork, you may find yourself holding a New Asset, with cost basis 0 and no CGT discount until 12 months after the fork (unless, of course, it forks again!), should some fool decide to do so. It’s unclear whether you need to be aware of the fork, or how serious it needs to be, but it would be an interesting business model to offer the ATO a contract to create such a fork to create a taxation windfall!
  4. Bitcoin will become a New Asset on any Hard Fork.
    Experience has shown that any Bitcoin hard fork will be controversial; if the original chain is continued (as expected), Bitcoin becomes a New Asset with cost base 0.

In these last cases, you have no control over whether this happens, creating massive taxation risk.

What I’m Doing About It

Clearly, if we want people to actually hold or use cryptocurrencies in Australia, these rules are impractical. Given they’re wrong on a fundamental level, I’ve already spent thousands of dollars on a Private Ruling and objections. At the end of 2019 I engaged a law firm for further research; their professional advice was that it was going to be expensive, and difficult.

Reluctantly, I have folded on this. It seems the only hope for reasonable outcomes in future in Australia would be legislative change.

[1] Technically, they had to change to implement replay protection, otherwise in theory they could have waited for the soft fork and then mine an invalid segwit tx to fork off afterwards. That would have been an impractical method, however.

Rusty is a Linux kernel dev who wandered into Blockstream, and is currently trying to produce a prototype and spec for bitcoin lightning. Hodls bitcoin (only).