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You may not understand what all the fuss is about (and you’d probably struggle to explain how it works), but you’ve probably heard of Bitcoin.
So, what is Bitcoin?
Well, let’s start at the beginning. Bitcoin is a cryptocurrency. Cryptocurrencies are just what they sound like: digital money. Of the thousand or so cryptocurrencies available today, Bitcoin has the highest profile.
Bitcoin was introduced in 2009, the brainchild of the mysterious Satoshi Makamoto. At the time it was launched, Bitcoin was unique for its decentralised structure. This means that, unlike a conventional currency, Bitcoin isn’t backed by a central bank or administration. The currency has no physical form – it exists in the form of an online ledger called a ‘blockchain’, recording all transactions made in the currency.
Trading in Bitcoin comes with risks. Like any currency, Bitcoin’s value ebbs and flows – and these fluctuations can be extreme. The cryptocurrency market is still stabilising, and Bitcoin’s value has fluctuated wildly in the past few years. In 2011, for example, the value of one Bitcoin fluctuated between a high of $32 and a low of 11 cents.
If you’ve heard of Bitcoin, you may have heard of Bitcoin mining. ‘Miners’ use software to solve mathematical problems, and are awarded Bitcoin as a reward.
If you choose to mine (whether as a hobby, or as a business venture) be aware: Net earnings from cryptocurrency mining are subject to self-employment tax. The IRS has ruled that Bitcoin is to be treated as property for federal tax purposes. Essentially, the same general tax principles that apply to property apply to any transaction involving cryptocurrencies.
Taxpayers receiving Bitcoin must document the cryptocurrency’s fair market value (in dollars, if a U.S. taxpayer) at the time of receipt. This achieves two things - it establishes the taxpayer’s gain at the time of transaction, as well as the taxpayer’s basis in the cryptocurrency. This information is used to determine the taxpayer’s future gain or loss when the cryptocurrency is disposed or used.
Any independent contractor who is paid in virtual currency will be subject to self-employment tax on the cryptocurrency’s fair market value. In addition, if a company pays its employees’ wages in virtual currency, the fair market value of those wages will be subject to the usual federal income tax withholding, and will need to be reported on their W-2. And note that all of those U.S. taxes due will be paid in U.S. dollars—the IRS does not accept Bitcoin or other cryptocurrencies as payment. International taxation can add another layer of complexity.
Bitcoin is still new – and tax agencies worldwide are still trying to work out what to make of it. However, with increased use and the stabilisation of values, expect cryptocurrencies to attract more interest from the IRS in future.
By Andrea Mouw, J.D., HLB USA