Gold and bitcoin: Tax implications of physical and virtual mining.

• Author: White, Craig

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.

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. (3) 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. (4) 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. (5) 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. (6)

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. (7) 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. (8) 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 recendy 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. (9) This indicates a...