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GAO Report Urges IRS to Consider Taxing Virtual Currencies

Joe Mont | June 18, 2013

Adding to requirements placed upon virtual currencies by the Treasury Department, the Internal Revenue Service may soon seek a slice of the fast-growing, but controversial marketplace.

A new report by the Government Accountability Office makes the case that using virtual currencies, including the popular Bitcoin, may produce taxable income.

The GAO determined that transactions within a “closed flow” virtual currency system, such as buying items or “points” within an online game, do not produce taxable income because that currency can be only be used to purchase non-tangible goods or services. In an “open-flow” system, however, a taxpayer who receives virtual currency as a payment for real goods or services may have earned taxable income because it can be exchanged for government-issued currency.

“Virtual economies and currencies pose various tax compliance risks, but the extent of actual tax non-compliance is unknown,” the report, issued on Monday, says. “Some identified risks include taxpayers not being aware that income earned through virtual currencies is taxable, or not knowing how to calculate such income.”

Lacking market specific data, the GAO said it is difficult, at this time, to assess how much tax revenue is left unclaimed as virtual currencies continue to gain popularity.

In 2009, the IRS posted information on its website on the tax consequences of virtual economy transactions. However, it has not yet provided taxpayers with information specific to these transactions. As such, the GAO report said, it “may be missing an opportunity to address virtual currency tax compliance risks,” even though formal guidance or regulations, “may not be warranted.” IRS officials have said that developing formal guidance would require an extensive and expensive review.

A recent study by Juniper Research has predicted that the amount of money spent on virtual currency in mobile apps—just a slice of the total marketplace—will hit $4.8 billion by 2016 and has been growing as much as 40 percent a year.

Among the most widely used open-flow virtual currencies is Bitcoin, a decentralized digital currency that is issued, valued, and moved via a peer-to-peer computer network. It has evolved into a substitute for real world currency and, facilitated by exchanges, can be used to pay for goods and services.

As of May 1, 2013, approximately 11 million bitcoins were in circulation and exchange rates against the U.S. dollar have historically been volatile. From May 2012 through February 2013, bitcoin prices ranged between $5 and $20 per unit. In recent weeks, prices have spiked as high as $237. The number of daily bitcoin transactions currently ranges between 8,000 to 70,000.

In March, the Treasury Department's Financial Crimes Enforcement Network (FinCEN), which focuses on money laundering and other monetary crimes, issued new guidance for distributing and using virtual currency. It targeted “convertible virtual currencies” that either have an equivalent value in real currency or act as a substitute for it.

FinCEN's interpretive guidance clarifies the applicability of Bank Secrecy Act regulations to virtual currencies, defining certain businesses and individuals as money services businesses (MSBs) depending on the nature of their financial activities. MSBs have registration requirements and a range of anti-money laundering, recordkeeping, and reporting responsibilities under FinCEN's regulations.

Those who use virtual currencies exclusively for common, personal transactions, like receiving payments for services or buying goods online, are not affected by the guidance. Intermediaries in the transfer of virtual currencies from one person to another are designated as “money transmitters” that must register with FinCEN as MSBs.

Last month, in a first-of-its kind action, the Treasury Department invoked the Patriot Act to strike against a Costa Rican company accused of using a web-based money transfer system and “virtual currency” to facilitate money laundering by cyber-criminals.

According to the Treasury Department, Liberty Reserve was “widely used by criminals worldwide to store, transfer, and launder the proceeds of a variety of illicit activities” and its virtual currency had become “a preferred method of payment on websites dedicated to the promotion and facilitation of illicit web-based activity. The Treasury's Financial Crimes Enforcement Network (FinCEN) proposed rulemaking that would prohibit covered U.S. financial institutions from opening or maintaining correspondent or payable-through accounts for foreign banks used to process transactions involving Liberty Reserve, effectively cutting it off from the U.S. financial system.