Tax Transfer Pricing Considerations for Cryptocurrency Mining Companies

The market capitalization of cryptocurrency (“crypto”) has exploded over the last few years, bringing out in droves speculators looking to profit from this new asset class. At the forefront are crypto miners looking to profit from the creation of the coins themselves – especially profitable when the value increases rapidly as it often does.

Concerns have been raised about the environmental damage that mining can cause.

A successful mining operation will need a significant number of computers, mining rigs, and electrical power to even get to a point where the operation has a chance to become profitable. The Digiconomist’s Bitcoin Energy Consumption Index (“BECI”) estimates that one bitcoin transaction takes 1,449 kilowatt-hours (“kWh”) to complete, or the equivalent of approximately 50 days of power for the average US household. A successful crypto mining operation is reliant on significant amounts of energy, which has prompted these mining companies to search out countries that have plentiful energy sources.

More recently, crypto mining operations have experienced significant volatility related to the global economic effects of the COVID-19 pandemic and the ban of cryptocurrency mining operations in China, the global operating hub. China has been facing significant energy shortages in recent years and still primarily relies on coal energy. It has made significant investments in the renewable energy sector, however in the short and medium terms the energy consumed by the cryptocurrency mining operations are exacerbating China’s energy shortages and generate exceptionally large carbon footprints. In response, operations are relocating and starting up in jurisdictions with lower levels of political risk, appropriate climate, cheap and reliable power grid, and access to renewable energy sources.

The United States is a top destination for relocated and new operations, but that move brings with it the added challenge of managing US tax implications.

For example, the Internal Revenue Service (“IRS”) views cryptocurrencies, such as Bitcoin and Ethereum, as property. As such, taxes are based on the fair market value (“FMV”) of the cryptocurrency at the time of sale. In addition, the tax regime applied to gains realized from crypto transactions is not straight forward. Factors such as the amount of time the crypto was held, (i.e., long-term vs. short-term capital gain/losses), whether the crypto was received in exchange for goods or services, and overall taxable income can affect the tax due on the transaction.

One way to minimize exposure to the high taxes in the US is to set up multiple entities across different countries, thus benefitting from transfer pricing by enlisting different entities with different tasks.

This manifests itself when a company sets up a limited risk routine services provider. As such, an intercompany-driven business model can allow digital asset technology companies to resolve supply chains across different jurisdictions for an optimized group tax strategy. Essentially, these companies can take full advantage of the tax attributes of the jurisdictions in which they operate. In this model, a US-based limited risk mining operation (“LRM”) is set up as a US operating entity of a foreign digital asset (crypto) technology parent company (“CTP”), ideally operating in a favorable tax jurisdiction. The LRM typically owns the mining machines and uses a third-party hosting facility. The LRM leases the hashpower (which is the power that a computer/hardware uses to run and solve different hashing algorithms) it generates to CTP, which in-turn is allocated Bitcoin (“BTC”) rewards from the mining pool, which is a third party. Therefore, LRM recognizes the intercompany lease fee as income and incurs expenses related to the hosting services, i.e., electricity, connectivity, security.

The LRM is not the risk-taking or an entrepreneurial entity; companies operating in this space favor a steady income for the mining operations instead of engaging in holding and managing digital assets. As such, the LRM performs very routine functions and is primarily leasing its computing power or hashpower and would be compensated on a cost-plus markup basis. This approach allows for mining operations in high tax, yet business-friendly environments, to limit the amount of leakage.

Miners are seeking out the US to set up operations due to its reasonably priced energy supply. The regulatory bodies in the US continue to lag behind the innovation in crypto. Regulations in the US necessitate strict reporting and there could potentially be even stricter regulations coming regarding reporting information, which can make operating a crypto-centric business in the US complicated. The Friedman LLP Transfer pricing team has extensive experience in working multinationals to structure intercompany transactions, optimize tax attributes and meet compliance requirements.

Count on Friedman LLP

Our Digital Currency and Blockchain Technology practice group – among the industry leaders – works closely with our Tax department and can help you with all your cryptocurrency questions, and our International Tax and Transfer Pricing team have the industry and technical expertise to assist cryptocurrency technology companies in setting up a tax optimized structure and transfer pricing regime.

Our transfer pricing team, headed by Farnaz Amini, PhD, can assist in all matters related to transfer pricing consulting and compliance. Farnaz can be reached at [email protected] or (323) 646-7950. As always, feel free to contact your Friedman LLP advisor with any questions.