Do protocol upgrades have tax consequences?

On April 21, 2023, the IRS released Chief Counsel Memorandum 202316008 addressing whether a protocol upgrade on the blockchain that did not result in a change to the cryptocurrency held by a taxpayer would give rise to a taxable event.

In the Memorandum, a blockchain referred to as “K” used distributed ledger technology to record transactions involving cryptocurrency pursuant to K’s underlying protocol. The K blockchain protocol includes a consensus mechanism for adding new blocks of transactions to K, including those involving units of a cryptocurrency referred to as "C." Participants that successfully add new blocks of transactions to K are rewarded according to K’s protocol.

Under the facts, on date 1, a taxpayer purchased 10 units of C and stored it on a private key. Later, on date 2, K changed its consensus mechanism to select who may validate transactions and add blocks of transactions to the K blockchain from proof-of-work (PoW) to proof-of-stake (PoS). This upgrade in consensus mechanism did not affect any change to cryptocurrency C, and the taxpayer continued to hold the same 10 units of C following the upgrade. The taxpayer otherwise does not receive any cash, services, or property (including additional units of C) because of the protocol upgrade.

This fact pattern is similar to the Ethereum protocol upgrade, sometimes called "The Merge," which took place on September 15, 2022. In that case, Ethereum upgraded from PoW to PoS. The Merge did not result in any changes in holdings of Ethereum and did not result in new or different tokens, like the facts in the Memorandum.¹

The IRS concludes in the Memorandum that the protocol upgrade did not create a realization event whereby the taxpayer would have to recognize gain or loss on its holdings of 10 units of C because the taxpayer’s existing units were unchanged. Also, the protocol upgrade did not result in an income inclusion for the taxpayer because there was no accession to wealth as the 10 units of C remained unchanged by the protocol upgrade and the taxpayer also did not gain any value from the upgrade in the form of cash, other cryptocurrencies, or property.

This conclusion remains consistent with the IRS’s prior guidance,² including Rev. Rul. 2019-24, which stated that a taxpayer will not have a taxable event unless new cryptocurrency is received in a hard fork. Accordingly, as this guidance clarifies treatment of protocol upgrades, it is fairly clear that unless additional tokens or coins (or other value) are issued or there is a change in existing property, there will not be a taxable event.

¹ This contrasts with a "hard fork," which results in additional tokens or coins to existing holders of a certain cryptocurrency. See Q23 of Frequently Asked Questions of Virtual Currency Transactions.

² See also Q22 of Frequently Asked Questions of Virtual Currency Transactions.