Francisco A. Laguna & Wojciech Kornacki
This is the first of a three part series on bitcoins and virtual currencies. Today, we explore how U.S. and European governmental agencies view bitcoin and analyze their shaping legal framework as well as bitcoin mining.
What is a bitcoin?
Bitcoin is considered a “virtual currency”. According to the Internal Revenue Service (IRS), a virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. Virtual currency is not regulated like traditional real currencies. The European Banking Authority points out that banks are not involved in virtual currency transactions, which creates risks in itself. Also, bitcoin savings are not insured, and their value could disappear overnight.
Bitcoin creates an open financial market where you deal directly with other bitcoin users. With the continued rise of the internet, people have stated that they run into the problem of how to use their real currency on-line. Paypal or Visa allow them to use real currency on-line but for a fee. Bitcoin’s fee is significantly lower, and it has its own currency.
For U.S. tax purposes, the IRS has recently decided that bitcoin is considered property, but not foreign currency. In the United States, transactions in bitcoins must be reported in U.S. currency to the IRS. The IRS requires users to report its value in a reasonable manner that it consistently applied. Due to the volatility of the value of bitcoin, this can be difficult at times, and it can result in reportable market gains and losses, much like a security. Individuals who earn bitcoins on their own are considered self-employed.
Key difference between the money in your pocket and virtual currency
The coins and paper money in your wallet are real currency. Real currency is (1) a tangible, legal form of tender, (2) used by individuals and businesses, and (3) customarily accepted in the country that issues it. For example, you go to the store in the United States, present a U.S. dollar bill, and you make a purchase at the register. You would not be able to use your U.S. dollar in a store in a country that accepts only its national currency. The key difference between real and virtual currencies is that bitcoin is not considered a legal form of tender in any particular country because no country issues it. Individual businesses decide whether to accept it on individual basis. Virtual currency allows you to go to any store around the world that accepts it and use your bitcoin.
The Department of the Treasury re-emphasizes that virtual currency may be used by individuals and businesses, and may be customarily accepted, but it is not issued by a country. Bitcoins are issued by businesses. This creates a series of risks and opportunities which we will discuss in our next blog. For now, we can limit ourselves by recognizing that the value of bitcoin is extremely volatile.
How does bitcoin work?
Virtual bitcoin currency allows you to go to an internet store, present a digital value of bitcoins and make a purchase (assuming the on-line vendor accepts bitcoins) without paying extra processing fees. It also allows you to use your virtual currency to make purchases in brick and mortar stores that accept it.
Each bitcoin user receives a unique address from which he or she can conduct transactions anywhere around the world. Each user can have more than one address. Once a transaction occurs, the transaction is recorded in a publicly available record, and the amount of bitcoins used cannot be spent elsewhere.
Each country has a central bank that regulates its national real currency. This means monitoring its transactions, limiting or increasing the availability of its currency on the market, and defending its value. Bitcoin does not have a central bank. It relies on individual users to record the transactions through the process of “mining”.
What is bitcoin mining?
According to Bitcoin Wiki, bitcoin mining is the process of adding transaction records to the public records of past transactions. The process allows everyone to know where and when bitcoins are being spent. Thus, if you purchase an item from someone else using bitcoins, this transaction will be publicly recorded so that you won’t be able to use the same bitcoins to purchase something else. Bitcoin mining or transaction recording also allows for the introduction of more bitcoins on the market. The individuals who engage in mining, receive compensation in the form of bitcoins. This is one aspect of virtual currency where individuals can earn bitcoins.
Next week, we will discuss the risk, dangers, and opportunities created by virtual currency. While its value in dollars is very volatile, most recently one bitcoin was valued at over $1,000. Contact TransLegal with your questions concerning doing commerce in bitcoins.