As cryptoassets, such as bitcoin, have gained status as virtual assets, commentators have suggested that they serve as the new virtual gold.1 Both gold and cryptoassets share many characteristics, with the process of creation and distribution of new cryptoassets becoming known as virtual "mining." Satoshi Nakamoto's paper, originally introducing the idea of distributed ledgers to create virtual currencies, initiated this analogy, describing the process as "analogous to gold miners expending resources to add gold to circulation."2 This raises an interesting comparison between the tax treatment of virtual mining and physical mining. The IRS has issued brief guidance on the income tax treatment applicable to the creation of cryptoassets. The income tax treatment of the mining of gold and its use fall under specific Code provisions and general tax principles.

As cryptoassets, such as bitcoin, have gained status as virtual assets, commentators have suggested that they serve as the new virtual gold.3 Both gold and cryptoassets share many characteristics, with the process of creation and distribution of new cryptoassets becoming known as virtual "mining." Satoshi Nakamoto's paper, originally introducing the idea of distributed ledgers to create virtual currencies, initiated this analogy, describing the process as "analogous to gold miners expending resources to add gold to circulation."4 This raises an interesting comparison between the tax treatment of virtual mining and physical mining. The IRS has issued brief guidance on the income tax treatment applicable to the creation of cryptoassets. The income tax treatment of the mining of gold and its use fall under specific Code provisions and general tax principles.

Building on this analogy, this article explores the background and similarities in the taxation of the mining of each of these assets. This comparison offers insights into the tax status of bitcoin and other cryptoassets.5 The relatively recent development of virtual assets also provides a view of the potential evolution of the taxation of newer innovations.

Taxation of physical mineral mining

Looking first at the mining of physical materials, such as gold, the Code's applicable provisions regarding natural resource mining are organized around the life cycle of a mining operation.6 As shown in the chart "Stages of Tax Treatment of Mining" below, mining moves from exploration to development to operation and, ultimately, to decommissioning and post-closure. The tax provisions are encompassed in Subchapter I, Natural Resources, Secs. 611-638.

In the context of mining for physical minerals, the Code allows for immediate deduction of expenses through the exploration and development stages.7 Because the success of initial mining efforts is very uncertain, Congress provides flexibility in allowing taxpayers to deduct expenses associated with early stages of the process. The approach is similar to that afforded research-and-development expenses (Sec. 174). Development encompasses activities after the existence of ores or minerals in commercially marketable quantities has been disclosed, and can include expenses incurred during the development and production stage.8

Once in the production stage, the taxation of physical mining operations follows the format of a manufacturing company. Inventories are required to be established. The IRS notes in its audit guide relating to the "placer mining industry" (e.g., mining for minerals in stream bed deposits) that:

It is the Government's position that, under IRC section 471(a), in order to achieve the matching of income to expenses, the taxpayer is required to maintain in inventory the gold extracted from the mining operation. This is necessary in order to determine the income of the taxpayer. The matching of expense to income follows the generally accepted accounting principal [sic]. A matching principal [sic] issue generally arises when the taxpayer is in the production stage deducting expenses related to the production phase of mining with little or no income. It is not uncommon to examine a return where the taxpayer claims to be in production yet keeps no inventory. Since the gold recovered must eventually be recognized as income, inventories must be maintained. . . . Major operators produce the bulk of gold recovered and refined, but small-scale, independent miners make up the majority of the returns filed. Mining has historically been a cash-based activity. Often the miner will have little, if any, documentation to support the activity. If there are records, they are often disorganized.9

In short, the IRS does not require immediate taxation when gold is produced. This is true even though there is a well-established commodities exchange for gold, which is easily converted to revenue at a set price. The tax treatment of production follows the general rule of capitalization of costs associated with the production of the gold and current deduction of period expenses. As will be discussed later, a different rule applies to cryptoasset mining.

Entities participating in gold mining

Focusing next on the types of entities involved in gold mining, major operators produce the bulk of gold recovered and refined.10 Publicly traded corporations dominate in terms of volume of production because of the capital-intensity requirements and the scale necessary to maintain profitability. The top five mining corporations are responsible for approximately 20% of annual production. Thus, a significant portion of U.S. gold production is subject to the corporate income tax.

The larger mining operations are looking to further reduce risk through the syndication of operations. For instance, Newmont Mining and Barrick Gold Corporation recently established the Nevada Gold Mines Joint Venture. The joint venture splits ownership 38.5% to 61.5% and establishes efficiencies through integrated mine planning and processing.11 This indicates a further growth in the advantages of scale in physical mining.

At the other end of the size and scope spectrum, individuals engaged in gold mining are subject to many Code provisions that limit their use of losses to reduce taxable income.12 In its placer mining audit guide, the IRS makes a point of emphasizing the application of Sec. 183's rules on hobby activities to individual placer mining:

IRC section 183 has strengthened the position of the Service in holding that a miner must be in a trade or business or engaged in an activity for the production of income with the objective of making a profit in order to claim mining related expenses such as those for exploration and development.13

The case of gold mining highlights that the application of Sec. 183 can change at various times in the life cycle of a commodity or product, because the scale of profitable gold mining has changed over time to favor larger operations (as well as those located in particular places). A smaller-scale operation is less likely to result in a profitable operation and more likely to fall within Sec. 183's rules on hobby activities.

The evolution of cryptoasset mining has followed a similar track, but at a much faster pace. The innovation of using blockchain technology to create a cryptoasset is less than 20 years old. However, the process has already moved from profitability through using a desktop computer to the need for application-specific integrated circuit (ASIC) devices. It also requires the creative use of pooling of resources across miners to spread risk.

Taxation of virtual currency mining

The IRS has not provided a large amount of guidance regarding the taxation of cryptoasset mining.14 The primary source of discussion is found in Notice 2014-21, which states the following in question-and-answer form:

Q-8: Does a taxpayer who "mines" virtual currency (for example, uses computer resources to validate Bitcoin transactions and maintain the public Bitcoin transaction ledger) realize gross income upon receipt of the virtual currency resulting from those activities?

A-8: Yes, when a taxpayer successfully "mines" virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. See Publication 525, Taxable and Nontaxable Income, for more information on taxable income.

This required timing of the recognition of income for virtual mining differs from physical mining. As discussed above, the IRS holds that physical mining results in inventoried costs and that recognition of income does not occur until the disposition of the commodity in an exchange. In the instance of virtual mining, however, the IRS requires immediate recognition of income, even though the miner may not have yet converted it to traditional currency.

What is the justification for this difference in tax treatment? Most of the remaining discussion focuses on this question.

The issue of implicit services

The IRS does not explain in Notice 2014-21 how it concludes that the reward for successfully verifying a block is immediately taxable. The foundational income measurement principle under Sec. 61 provides the following: "Except as otherwise provided in this subtitle, gross income means all income from whatever source derived . . ." Regs. Sec. 1.61-1, in part, says that gross income includes income realized in any form, whether in money, property, or services. The key question in this instance is the timing of the taxation.

The incentive structure of cryptoasset mining, with multiple participants providing transaction recording and reinforcing security, raises an issue regarding implicit services. Arguably, the virtual miners are providing services whether they intend to or not.15 In the case of gold mining, there is no parallel benefit in the form of "services" that apply to the general maintenance of a system.

Given this difference, the IRS's position on taxing virtual currency mining can conceivably be supported with an analysis of Sec. 83. Under Sec. 83, which deals with property transferred in connection with performance of services, property does not have to be transferred as direct compensation but just "in connection with" the performance of services. The property transferred in exchange for services is immediately taxable at the time the property is transferable or there is not a substantial risk of forfeiture. In the virtual currency mining context, this would occur when the cryptoasset reward is credited and available for transfer to the miner.

Rev. Rul. 80-52 provided guidance on the application of Sec. 83 in an earlier instance of the crediting of an "alternative currency." In this situation, a barter club used "credit units" as a medium of exchange. The club debited or credited members' accounts for goods or services received from or rendered to other members. The ruling held the following:

In this case A, B, and C received income in the form of a valuable right represented by credit units that can be used immediately to purchase goods or services offered by other members of the barter club. There are no restrictions on their use of the credit units because A, B, and C are free to use the credit units to purchase goods or services when the credit units are credited to their accounts.

Therefore, members receiving credit to their barter club accounts were required to recognize income pursuant to Sec. 83.

The issue still exists whether the above type of analysis should apply to cryptoassets. It is debatable whether virtual mining should be viewed as performing services for another party. After all, the key outcome in virtual mining is the generation of the block to be added to the blockchain. The potential income from this activity is the cryptoasset reward and potential transaction fees.16

Revenue recognition principles for financial accounting

Another way to analyze how cryptoasset mining should be taxed is to consider financial accounting principles. Sec. 446 requires taxpayers to use the same book and tax accounting methods except if the method "does not clearly reflect income." At this time, there is no set financial accounting treatment for mining of cryptoassets. As described below, the financial accounting treatment is arguably consistent with either the IRS-mandated approach or with the gold mining analogy approach.

Financial accounting guidance on revenue recognition is found in International Financial Reporting Standard (IFRS) 15, Revenue From Contracts With Customers.17 IFRS 15 requires both a customer and a contract in order for there to be "revenue" recognition. There is not a specific contract between a customer and a miner for the block reward.

An argument can be made that all the participants in the blockchain have an implied contract regarding the block award, making all the participants in the blockchain the customer. Therefore, the new cryptoasset can be considered revenue.18 However, it can also be argued that there can be no contract for purposes of IFRS 15 because such an implied contract could not be enforced against any one individual.

Another view is that the receipt of the block award is an accession to wealth because the miner has an increase in assets. Thus, the receipt of the award should be reported as other income. Characterizing the award as revenue or other income is consistent with the IRS's assessment of blockchain mining as immediate income.

A contrary view is that cryptoasset mining produces an internally generated intangible asset. IAS 38, Intangible Assets, provides the guidance regarding the creation of intangible assets. The miner is inputting computing power, electricity, and staff costs to build, or mine, an internally generated intangible asset, that being the cryptoasset. No revenue or gain is recognized until the resulting intangible asset, the cryptoasset, is subsequently sold. Below is Grant Thornton's commentary on this approach to the analysis:

[I]f a view is taken that no revenue or other income can be recognised and the transaction is considered to be development of an intangible asset, we do not consider that the requirements of IAS 38.57(f) will be met. IAS 38.57(f) requires that the cost attributable to the development of the intangible asset can be reliably measured. The nature of competing against other miners to create the next block will result in it being difficult to specifically identify the cost incurred to create the block reward separately from the cost incurred on all previous unsuccessful attempts to create the next block, meaning that this criterion is not met. Therefore, all costs associated with mining must be expensed as incurred and no revenue or gain is recognised until the resulting cryptocurrency is subsequently sold.19

This approach is closer in application to that of gold mining. The block reward is categorized as a self-created intangible asset, and revenue is not recognized until the bitcoin is sold to a third party. Similar to the exploration and development stage of mining, success regarding efforts to create a block are not assured (far from it), so costs would be immediately expensed.

One publicly traded bitcoin mining corporation states the following in the notes to its SEC Form 10-K regarding the financial accounting treatment of block rewards:

There is currently no specific definitive guidance under GAAP or alternative accounting framework for the accounting for cryptocurrencies recognized as revenue or held, and management has exercised significant judgment in determining the appropriate accounting treatment. In the event authoritative guidance is enacted by the FASB, the Company may be required to change its policies, which could have an effect on the Company's consolidated financial position and results from operations.20

The tax treatment from a corporate view may be open to more interpretation than that for individuals. Sec. 471 inventory considerations could come further into play as the GAAP assessment of cryptoassets continues to evolve.

Entity choice and structure in cryptoasset mining

One other notable feature of cryptoasset mining that is relevant to taxation involves mining pools. Individuals or companies that want to make a profit through cryptoasset mining have the choice to either go solo with their own dedicated devices or to join a mining pool where multiple miners and their devices combine to enhance the "hashing" output.21 The bigger a pool, the steadier and more predictable a member's earnings. Many miners are attracted to the prospect of small, steady earnings as part of a major pool, as opposed to the high-reward-but-low-odds lottery that is solo or small-pool mining.22 This strategy is similar to the syndication approach of risk mitigation in physical mining.

The reward amount that miners participating in a pool receive is usually based on the proportion of hashing power they are contributing to the aggregate of the pool. The higher the percentage of the hashing power, the greater the miner's share of the blocks earned. The organizers of the pool are compensated via a fee, usually around 2.5% of the block reward.23

Whether a miner directly participates in cryptoasset mining or as part of an overall pool, the income recognition issues are the same. As discussed above, the question is whether the reward is for provision of services (generating immediate taxable income) or, on the other hand, for participating in the creation of an intangible asset (with taxation analogous to the mining and processing of gold).24 The outcome could also potentially depend upon whether the miner is a publicly traded corporation subject to GAAP principles or operates on a much smaller scale, such as an individual.

Parallels and considerations

The background and tax treatment of gold and cryptoasset mining are parallel in some ways, and the comparison also raises additional issues. Like the natural circumstances of gold mining, the factors built into the cryptoasset algorithm tend to drive the organization of operations toward larger-scale, capital-intensive organization. Cryptoasset mining is an area that has grown exponentially over the past 10 years, and the requirements for success have shifted to heavily favor larger operations.

The incentive structure of cryptoasset mining with multiple participants reinforcing blockchain security and other attributes through competition raises a question of the substance of the work. Arguably, the miners are providing services to the system whether intended or not. In addition, just like certain levels of placer mining activity, individuals can participate in cryptoasset mining as a hobby. For individuals participating without a realistic potential for profit, this activity likely falls under Sec. 183 limitations.

Future technological innovations may follow a similar path from individuals to larger aggregations of capital. The evolution in scale in mining activities could resemble the development of many new processes and innovations with implications for the resulting taxation. The future may bring increasing questions as to how a new process or industry (likely in the virtual realm) interacts with existing tax rules as it evolves in adoption, participation, and scope.