Cryptocurrency Industry – Promoting US Economic Growth Through Tax Regulation

Investing, Regulation | September 20, 2018 By:

An academic debate rages over the length of the Internal Revenue Code. It is widely quoted at more than 70,000 pages. That figure may be overstated by at least a few dozen thousand pages, though. Beyond pure tax law, the Code also includes related interpretive documents, such as Treasury Regulations, Revenue Rulings, and IRS Notices. What is indisputable however, is the number of pages devoted to digital currency.

Six.

There are but six pages of guidance on cryptocurrency. That guidance is approaching its fifth birthday, in a space that evolves daily.

Less is more? Not necessarily. This lack of guidance stocks a cold pond of uncertainty that prevents many of the best and brightest from jumping in. The US, home to the largest capital market in the world, ready to deploy its mighty resources, is doing no more than dip its toes in the water because the US has been too slow to create an inviting framework of legislation that tells the world to jump in; the water is just right.

In the first “Regulation Crypto” article from BX3 Capital, we tackled many issues affecting securities regulations, and presented a framework that would get the markets rightly excited for blockchain and cryptocurrency-focused projects. This article tackles the tax framework.

**Disclaimer:  Please do not misinterpret any of the following information and commentary as legal advice or investment advice; it is simply a personal expression of the author’s interest in cryptocurrency and the law.  Please consult a lawyer and/or financial representative prior to investing.**

Tax Policy as Used to Achieve an Economic Result

Call your local Congressional Representative and ask, “Should the US lead the world in developing new technology?” Ask again, “Should the US have an environment that fosters innovation?” And again, “Shouldn’t the US encourage its citizens and residents to support those innovative and technological advancements?”

Of course those answers are all “yes.” One step to getting to “yes,” to ensure we meet all of those goals is through tax legislation.

US tax legislation inextricably is tied to attempts to achieve particular economic outcomes. Electric car tax creditsresearch creditspreferential rates on capital gains– all of these provisions and many more are tied to attempts to drive an economic result. And not all of it is taxpayer friendly: penalties, interest on overdue balances, and deemed dividend provisions, all conspire to drive behavior as well.

In the context of cryptocurrencies: What type of behavior would Congress like to drive? Certainly there is a revenue raising opportunity, and that will happen if the “no real policy” policy continues to hold. At present, most every transaction in the cryptocurrency space has a conceptual taxability from a US perspective.

At the same time, there is also an opportunity to promote innovation, growth, and technological advancement. Assuming long term economic growth is preferable to short term tax revenue generation, there are some concrete steps that can be taken to bolster the development of this burgeoning industry.

Legislative Framework for Growth

Legislation of this emerging technology should have as its fundamental goals:

  1. Supporting economic expansion
  2. Promoting innovation
  3. Encouraging adoption of technology
  4. Equitably generating tax revenue
  5. Ensuring adequate and useful disclosure

Fortunately, we should be able to reach these goals through an evolution, rather than a revolution, of existing tax rules, primarily in the areas of fundraising, investing, and reporting.

Fundraising: Treat Tokens Consistently with Other Fundraising Instruments

Traditional fundraising methods in the US—through equity and debt—are generally not taxable to the issuer. Initial public offerings (IPOs) of stock, for example, allow businesses to raise the capital needed for expansion by allowing the public to invest in the future potential of the business without creating a taxable event for the company seeking expansion.

In the cryptocurrency arena, the tax results are less clear.  Notice 2014-21 provides the infamous guidance that cryptocurrency should be considered “property” for purposes of US taxation. In the context of a token offering or initial coin offering (ICO), the issuer often gives the token in exchange for something, perhaps fiat, or Ethereum, or Bitcoin. Without further guidance though, this could be a taxable transaction.

Considered in the context of what the token offering is trying to accomplish, this may or may not be the desired result. In the current state of cryptocurrency offerings, some tokens are considered utilities, and some are considered securities. For purposes of this article, let’s assume that a particular token can be considered a pure utility; it is, at its heart, no different than a gift card, metrocard, or carnival token. In these cases, the initial sale of tokens should indeed be taxable, consistent with existing tax rules. The token in these cases has no intrinsic value, and for the issuer represents something akin to selling a prepaid service.

As token issuances expand in their sophistication, more—and frankly, most—of them are aptly considered securities and from a taxation perspective, a number of contributors to the community have appropriately considered their corresponding treatment. Where a security closely resembles an equity instrument (e.g., with dividend or voting rights, or both), the issuance of that token should be treated consistently with an actual equity offering.

In other words, the Initial TOKEN Offering, should not be a taxable event for the issuer, just like an Initial PUBLIC Offering should not be a taxable event for the issuer.

While the law tends toward this result, an appropriate evolution would add the necessary clarity. This could come in a number of different forms, with the most clear form being the recognition of a token as a separate asset class which, when it exhibits the qualities of an equity instrument, should be treated in the same way that equities are treated under present rules.

In our practice, we are seeing a number of projects backing away from a token issuance and trending towards a more traditional fundraise, typically equity, because of a lack of clarity around the rules. This is an unfortunate and avoidable regression pushed largely because the lack of clarity has created an anxiety that new businesses can not afford to invest the time and resources needed to quell.

Investing: Add Like-Kind Exchange Provisions for Cryptocurrency

Long-term investors in capital assets in the US are rewarded with a preferential rate on capital gains, so there is indeed precedent for tax rules tuned towards a particular outcome. The real question thus becomes whether the long-term capital gain rules are sufficient to encourage the investing behavior needed to drive meaningful growth in the market for cryptocurrencies. For a variety of reasons, I believe the answer is “no.”

In this nascent marketplace, long-term holders of cryptocurrencies likely represent the minority. Many investors sell underperformers quickly, to invest in projects with seemingly more promise. If we want to create a marketplace where the best projects survive and thrive, we WANT this to happen! To do this, the existing capital gains rules are not the appropriate mechanism to accomplish the goal.

One casualty of the 2017 tax overhaul was the addition of the word “real” before the word “property” in the like-kind exchange provisions of IRC Section 1031. This had the effect of limiting tax deferral on the exchange of similar property, to the exchange of similar REAL property. Prior to this change, many cryptocurrency investors relied on the like-kind exchange rules as a prop to avoid taxation on the trading of cryptocurrencies. This was probably an overly optimistic view of the applicability of those rules, particularly in terms of whether these investors had qualified exchanges. That is not to say, however, that those rules can’t be modified to be an excellent tool to encourage investors in this space. At the risk of oversimplicity, the word “real” should be removed from Section 1031.

Enabling investors to defer taxation on moves BETWEEN cryptocurrencies, could deploy significant capital to the space. In addition, this could have the effect of avoiding the seasonal volatility of the market, as many attribute large portions of the Q1 and early Q2 market declines to cryptocurrency sales that were needed by investors to generate enough fiat currency to pay taxes on 2017 gains.

Yes, this would be a departure from legacy like-kind exchange rules, which would say that an exchange of securities (e.g., Apple stock for Microsoft stock) was not a qualifying exchange of similar property. This distinction for cryptocurrencies would be intentional, treating different cryptocurrencies as “similar” for this purpose, because this is intended as a pro-growth effort for the market, to draw investment capital to nascent businesses and technology platforms.

Fundamental taxation principles should continue to apply. For example, a move from cryptocurrency to fiat currency should be a taxable transaction. Utilizing a cryptocurrency to pay for goods or services should also be a taxable transaction. In addition, the revitalization of like-kind exchange should perhaps be a temporary change, to allow the cryptocurrency market to develop and stabilize.

When the market reaches the point at which investors are choosing security tokens as an alternative to long-term equity or debt investments in businesses, then it could be time to reevaluate the like-kind exchange rules, as modified, and consider reverting to the capital gains rules to ensure the tax rules reflect market realities.

Reporting: Require Issuer and Investor Reporting; Enhance Transactional Reporting

Data is a critical component for the government to assess the right long-term approach to the treatment of cryptocurrencies. Data from both the investors and issuers will be crucially important to determine whether the intended goals of the tax legislation are being realized. This type of reporting should encompass at least the following components:

1. Issuer Reporting. For any US person who issues a token, there should be a disclosure requirement of the details surrounding that token issuance. These details should include, at a minimum, the amount raised and the characterization of the funds collected (consistent with security vs. utility concepts). In addition, there should be an annual reporting that tracks the status of those raised funds, which would include:

  1. Accounting of funds spent (i.e. expense detail: marketing, employee compensation, technology, etc.)
  2. Value of token, if market data such as exchange records are available
  3. Executions against token obligations for security tokens (e.g. dividends, interest, etc.)
  4. Executions against token obligations for utility tokens (e.g. tokens exchanged for goods or services)

2. Investor Reporting. Any US person who has held a greater than the de minimisamount of cryptocurrency during a taxable year should be required to disclose the nature and amount of those holdings, as well as aggregate movement in each of those holdings. The de minimislevel should be set at an amount that would exclude most novice investors, say, the equivalent of $20,000, in order to both capture the activity of the biggest drivers of the marketplace, as well as put reporting in the hands of those who are best able to bear its economic burden. Ideally, this reporting should include the elements that best position the government to analyze the marketplace and investor behavior, including the following, and in addition to any reporting required on transactions:

  1. Name of token
  2. Exchange(s) where traded (if any)
  3. Number of tokens held
  4. Dates of acquisition
  5. Basis
  6. Value at reporting date

In addition to these informational disclosures, taxpayers will need to report transactions that result in either a taxable sale (e.g. a disposition of one cryptocurrency in exchange for goods, services, or fiat currency), or a tax deferral (i.e. a disposition of one cryptocurrency in exchange for another).

3. Transactional Reporting. To the extent cryptocurrencies are used as currencies, or exchanged for goods or services, transactional reporting should continue to be required, using existing reporting frameworks. Forms such as the 1099 and W-2 adequately describe these transactions in US dollar equivalents but should be enhanced to add disclosure on the type and amount of cryptocurrencies that were used to execute those transactions.

Conclusion

The promise of the blockchain and the rise of cryptocurrencies could transform the global economy. Historical leaders of the world’s most revolutionary innovation have called—and continue to call—the US their home.  In addition, with ownership of the world’s largest and most robust capital markets, it is clear that the US possesses all of the key resources to lead global economic transformation. Tax policy should enable and encourage the deployment of these resources, and not an obstacle to growth.

Michael Minihan is a Partner at BX3 Capital and has been an international tax practitioner for more than 20 years. He holds a BBA in Finance and a JD from Pace University, and an LLM in Taxation from New York University. He can be reached at mike@bx3.io.