Forks are a unique aspect of cryptoassets which occur when a single blockchain breaks into two separate chains. These breaks can be separated into two categories: soft forks and hard forks. Enhancements to underlying technology, extenuating circumstances or even philosophical differences can lead to a fork event.
Forks have a significant impact on crypto businesses. To both decide on fork acceptance and to continue to run the business effectively after a fork event, organizations must perform an end-to-end assessment of the financial, technological, operational and customer relationship implications of the fork.
Soft forks occur when the majority of miners agree on a change to the underlying software of a cryptoasset. All transactions going forward are backward compatible with the existing blockchain, even those that did not follow the majority. This backwards compatibility is the key difference between hard and soft forks and influences the burden of their implementation on crypto businesses.
Hard forks occur when the full network makes a significant change to the underlying software of a cryptoasset. Typically, all transactions on the existing blockchain will be recognized as of the hard forked network's start date. However, any transactions that occur after this start date will be incompatible and, therefore, not recognized by the original blockchain.
Based on our experience helping organizations manage forks, here aresome key questions to consider:
Successful and efficient handling of forks requires a consistent framework and strong governance from all stakeholders of a crypto business, including front office, customer sales and trading, legal, credit and market risk, compliance, finance, tax, strategy, operations, technology, and cybersecurity.
Organizations can charter a governance committee to evaluate strategic and risk concerns and enable a decision structure for forks that will impact both the cryptoasset and related products and services. To ensure consistency in decision making around whether to participate and where to invest to support the fork, the governance committee should follow clear and documented policies that address:
It is also important to note that organizations may choose to retain the right to determine which fork will be used as the reference currency for portfolio pricing and valuation-rights that can be enforced on customers through legal agreements. In several instances, crypto entities and exchanges have chosen not to support trading in certain forked currencies. For example, in October of 2017, Bitcoin Gold was created as a result of a hard fork from Bitcoin. There was general disagreement and concern about the technology behind Bitcoin Gold and potential vulnerabilities. As a result, the cryptoasset was not recognized or listed by many major cryptoasset exchanges.
Both Bitcoin and Ethereum experienced hard forks that resulted from a change in the protocol. This led to some difficult tax-related questions that have not yet been addressed:
First, does any taxable income result from the duplication of the Bitcoin protocol? Immediately before the hard fork, the taxpayer owned one Bitcoin. Immediately after the hard fork, the taxpayer owned one Bitcoin and one Bitcoin Cash. The Bitcoin Cash has value and can besold for dollars. While not addressed in the limited IRS guidance on crypto, a number of practitioners believe that a hard fork is a taxable event to the holder under general tax principles. However, what is the nature of that income? Is it akin to a dividend? Does it occur at the time of the hard fork or later when the crypto is claimed?
Second, what is the taxpayer's tax basis in the forked coin? Consider, for example, the Ethereum fork. A taxpayer owning Ethereum on the date of the Ethereum fork received new Ethereum (ETH) at the time of the fork and continued to own Ethereum (now referenced as Ethereum Classic (ETC)). If the amount paid for the original Ethereum remained with the ETC, the taxpayer would be treated as having paid nothing for the ETH, unless the taxpayer recognized some gain at the time of the fork or when the taxpayer claimed the ETH. As a practical matter, ETH is considered the "true" Ethereum. If no tax basis is allocated to ETH in connection with the fork, a taxpayer using ETH may have significantly more gain than what seems appropriate and would not have a way to recover what the taxpayer originally paid for Ethereum prior to the fork.