In a speech today during a crypto conference in San Francisco, a top Securities and Exchange Commission official expressed his view that, at this point, sales of Ether are not securities transactions. Speaking from prepared remarks, Bill Hinman, Director of the Division of Corporation Finance said: “Based on my understanding of the present state of Ether, the Ethereum network, and its decentralized structure, current offers and sales of Ether are not securities transactions.” Hinman also said that, in his view, Bitcoin is not a security either, reinforcing what SEC Chairman, Jay Clayton, stated in his remarks recently on CNBC. The main topic of Hinman’s speech focused on whether a digital asset offered as a security can, over time, become something other than a security. To this point, Hinman noted that where a digital asset is “sold only to be used to purchase a good or service available through the network on which it was created . . . the answer is a qualified ‘yes.’” Hinman also discussed some of the factors to consider in assessing whether a digital asset is offered as an investment contract in a securities transaction. In particular, Hinman focused on the third prong of Howey and whether the efforts of an identifiable third party – be it a person, entity or coordinated group of actors – drives the expectation of a return. Also noteworthy was Hinman’s comment that the SEC is “happy to help promoters and their counsel work through . . . issues . . . [and] . . . stand prepared to provide more formal interpretive or no-action guidance about the proper characterization of a digital asset in a proposed use.” Finally, in a footnote included in the written version of the remarks, Hinman, referencing SAFTs, stated his view that a token once offered in a security offering can, depending on circumstances, later be offered in a non-securities transaction.
The primary professional organization for accounting professionals (AICPA) recently renewed their requests to the Internal Revenue Service for U.S. virtual currency guidance on key tax issues. The IRS has not shown any willingness to publish more advice in this area, so a response to the letter may not be forthcoming. The IRS has ignored the AICPA’s previous letter for 2 years now. That said, it provides thoughtful commentary, and recommendations for frequently asked questions, covering key topic areas including, among others:
- Deductions for mining expenses
- Acceptable valuation and documentation
- Computation of gains and losses
- Valuation for charitable contributions
- Taxable and non-taxable events
- Traders and dealers of virtual currency
- Holding virtual currency in retirement accounts
- Foreign reporting of virtual currency
Thus far, tax professionals have been forced to work from limited IRS guidance (Notice 2014-21), and informal public statements from government officials. The AICPA letter provides thoughtful ideas that reflect positions common among tax professionals. Their recent letter also reiterates a direct request from the ABA’s Tax Section for guidance on chain splits/hard forks (see American Bar Association Letter from March 2018).
The most prevalent tokens on the Ethereum blockchain are ERC-20-compliant (ERC-20 Tokens). However, there are many other ERC, or Ethereum Request for Comment, standards available. Recently, companies like Launch Labs, Inc. d/b/a Axiom Zen (Axiom Zen) have launched new endeavors utilizing ERC-721-compliant tokens (ERC-721 Tokens). ERC-721 Tokens each have unique characteristics, unlike fungible ERC-20 Tokens.
This post will discuss the rise of CryptoKitties, the exciting aspects of ERC-721 Tokens, and possible use cases for ERC-721 Tokens.
The CryptoKitties Revolution
Axiom Zen pioneered the ERC-721 standard for non-fungible tokens, which ultimately led to their application, CryptoKitties. CryptoKitties is an exemplary use case for how companies can utilize the ERC-721 standard. Each CryptoKitty is a ERC-721 Token that is one-of-a-kind and owned by the purchaser; it cannot be replicated, taken away, or destroyed. CryptoKitties can be purchased with Ether in descending-clock auctions. Owners can then “breed” the CryptoKitties, resulting in a completely new CryptoKitty, which is a new one-of-a-kind ERC-721 Token. The “genetic” makeup of the child ERC-721 Token is a combination of the genetic makeups of the two parent ERC-721 Tokens. The ERC-721 Tokens’ uniqueness allows for the creation of a whole new category of crypto creations. The ability for users to combine ERC-721 Tokens to generate completely new, but genetically traceable, ERC-721 Tokens allows for self-sustaining, growth-oriented networks.
Since the birth of CryptoKitties, there are now over 100 CryptoKitty variants. Blockchain users can now buy, sell and trade a myriad of self-created digital collectibles, from cats to dogs to cartoons. While the proliferation of copycats (pun intended) does not show any signs of slowing, there are many other possible uses for ERC-721 Tokens. Below we discuss a few of those use cases.
Many companies followed CryptoKitties into the blockchain game silo. New basic games are popping up around other digital collectibles, such as trading cards, which allow the movement of physical collectibles into the virtual space. These games and other CryptoKitty adaptations prove ERC-721’s utility in basic gameplay. But now there is room to see if the ERC-721 standard can be utilized on more sophisticated gaming platforms. Some smaller gaming companies recently started to create more comprehensive games and universes with ERC-721; however, the big gaming companies have yet to include this technology on their platforms. Nonetheless, we can see the potential opportunity to grow new gaming universes and expand or extend existing franchises utilizing ERC-721 Tokens.
One of the touted promises of blockchain technology is the blockchain’s ability to ensure product authenticity. With ERC-721 Tokens, in conjunction with a blockchain, users can help prove non-fungible product authenticity. For example, if an art gallery owner encoded an ERC-721 Token into each gallery painting, the token could track everything from the painting’s original artist to its current owner. As a result, the token would allow artists to easily copyright their works. It would also ensure buyers that they own authentic products. ERC-721 is thus useful to individuals who want to protect their intellectual property and to individuals concerned about product authenticity.
ERC-721 Tokens allow for the creation of unique avatars, but at present there is no way for these avatars to interact, aside from breeding. Including a social interaction layer could dramatically increase the usability of the avatars and help enhance the growth of the ecosystem in which the avatars reside.
We are at the forefront of not only a CryptoKitty revolution but also a ERC-721 revolution. Yes, ERC-721 offers application developers the ability to create fun, cute games. But, like other uses of blockchain technology, ERC-721 offers an opportunity to find solutions to complex real-world problems. As we push forward into the ERC-721 space, we must be cognizant of the endless possible uses for this new token standard.
We believe the future is bright for ERC-721 Tokens and we look forward to helping companies develop thriving businesses utilizing this token standard.
According to recent data provided by CBOE and CME Group, the volatility and total volume of bitcoin futures in 2018 have been in a gradual decline. As displayed in the chart below, the Cboe bitcoin futures contract (XBT) volatility for the lead month declined in each month to begin 2018. In addition, according to data as of a May 22, 2018 trading date, the trading volume for CME bitcoin futures contracts (BTC) in prospective lead months is also low, with as few as 5 trades for September 2018 contracts. There have been a few instances of volume surges such as in late April when the average daily volume of XBT rose to 8800 in the single-most active session of the CBOE Global Market, according to CBOE. However, as shown in the final chart below with data from CME Group as of May 22, 2018, the daily exchange volume of bitcoin futures contracts has remained below 6000 for the last month with one exception.
Below is a summary of some of the significant legal and regulatory actions that occurred over the past weeks. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.
SEC Chairman Testifies Before the House Committee on Appropriations
U.S. Securities and Exchange Commission (SEC) Chairman Jay Clayton testified on the issue of cryptocurrencies on April 26 in a hearing before the Financial Services and General Government Subcommittee of the House Committee on Appropriations. In his testimony, Chairman Clayton clarified his position on how the SEC approaches regulatory oversight of cryptocurrencies. Clayton divided cryptoassets into two categories: (i) a “pure medium of exchange,” e.g. Bitcoin, which he indicated is considered to not be a security; and (ii) tokens, which are used to finance projects. Referencing a statement he made earlier this year about ICOs, Clayton stated that there are very few tokens, and none that he has seen, that aren’t securities. He said that the SEC should continue to regulate tokens deemed to be securities, as securities, based on the information provided in disclosures from financial firms and individuals. SEC Clayton Testimony 4.26.18; Hearing Webcast
SEC Director Testifies Before the House Committee on Financial Services
On the same day as SEC Chairman Clayton testified before the House Committee on Appropriations, SEC Director of the Division of Corporation Finance, William Hinman, testified before the House Committee on Financial Services Subcommittee on Capital Markets, Securities, and Investment, discussing the role of his Division in the areas of cybersecurity, cryptocurrencies, and initial coin offerings (ICOs). Congressman Emmer (R-MN) specifically addressed ICOs, asking whether a utility token sale could ever be considered not to be a security, noting that the purpose of issuing such tokens is not capital formation. Director Hinman stated his position that it is “hard to have an initial sale without a securities offering.” Consequently, initial sales will likely require registering as a security or operating under an exemption. He clarified that it is possible for a token to not have the hallmarks of a security, in which case the holder has purchased the token solely for its functional use, not as an investment. He noted that in certain instances, the fundraising is intended to eventually build a platform where a token is exchanged for a good or service on a decentralized network. In such decentralized networks, he noted, there wouldn’t be an asymmetry of information between a central actor and investors. (Instead, the issuer of the token and the token holder share the same information.) Questioned how to improve regulatory clarity so that entrepreneurs would not come under unwarranted SEC scrutiny (e.g. when issuing utility tokens), Director Hinman stated that the SEC is meeting with issuers of non-security/utility tokens to discuss how such token sales might be structured to avoid SEC action.
Director Hinman’s opening remarks addressed the Division of Corporation Finance’s roles and priorities with respect to cybersecurity, cryptocurrency and ICOs more broadly. The Division of Corporation Finance is authorized under the Securities Act of 1933 (Securities Act) and the Securities Exchange Act of 1934 (Exchange Act), and is tasked with reviewing the disclosures and financial statements of reporting companies to ensure compliance with disclosure and accounting requirements, and conduct selective review of filings that it deems warrant additional scrutiny. Among the Division’s current priorities are:
- Cybersecurity: Director Hinman referenced the SEC’s press release in February 2018, which issued guidance to assist companies in preparing disclosures about cybersecurity risks and incidents, reminding companies of the importance of the disclosure controls and their role in ensuring that a company’s policies and procedures guard against insider trading during the period between the discovery of a cybersecurity breach and public disclosure.
- Cryptocurrencies and ICOs: Director Hinman noted that his Division is dedicating significant attention and resources to these areas, stating that ICOs have the potential to facilitate capital formation, but must comply with federal securities law to prevent fraud and abusive market practices. He stated that the Division’s primary goal regarding ICOs is to ensure investors are protected and are receiving adequate information to make investment decisions.
FinCEN Issues Advisory on FATF’s List of Jurisdictions with AML/CFT Deficiencies
On April 27, the Financial Crimes Enforcement Network (FinCEN) issued an advisory directed at U.S. financial institutions to take note of the Financial Action Task Force’s (FATF’s) updated list of countries with regulatory deficiencies in international anti-money laundering and combatting the financing of terrorism (AML/CFT) standards. The FATF released the updated list of jurisdictions on February 23, 2018 in a public statement and publication on its website. FinCEN recommends U.S. financial institutions review the updated list and comply with the existing UN Security Council Resolutions on each jurisdiction where deficiencies in AML/CFT were found. Countries remaining on the list and which were of particular focus in the FinCEN advisory include Iran and North Korea. Serbia has been added to the list; Bosnia-Herzegovina has been removed. To safeguard against money laundering and terrorist financing, the FATF urges to financial institutions to apply countermeasures (e.g. against North Korea) and/or implement enhanced due diligence policies (e.g. against Iran). The remaining countries identified on the list are Ethiopia, Iraq, Serbia, Sri Lanka, Syria, Trinidad and Tobago, Tunisia, Vanuatu, and Yemen. With respect to these countries, the FATF reminds U.S. financial institutions to comply with general due diligence obligations for foreign financial institutions under 31 CFR § 1010.610(a) and 31 U.S.C. § 5318(h). FinCEN Advisory 4.27.18; FATF Public Statement 2.23.18; FATF Publication 2.23.18
France Reclassifies Cryptocurrency
The French Council of State announced that it has changed the tax rate of cryptocurrency sales from 45 to 19 percent because of a reclassification of cryptocurrencies, which will now be considered movable property. The exception to this classification are coins earned directly from mining operations, which will be taxed as income. Le Monde article 4.26.18
Japanese Regulators Pressure Exchanges to Drop Cryptocurrencies
Japan’s Financial Services Agency (FSA) is discouraging cryptocurrency exchanges to stop handling certain cryptocurrencies, including Monero, Zcash and Dash, that it believes are widely used by, and gaining popularity with, criminal actors. According to the FSA, it has identified certain cryptocurrencies as vulnerable to use by bad actors because of the difficulty of tracing them and identifying the recipients. After the hack of Coincheck in February 2018, the FSA shutdown two cryptocurrency exchanges and has boosted its regulatory actions and inspection procedures. Forbes article 4.30.18
Iran Bans Cryptocurrencies but Continues Developing its Own Local Currency
On April 22, Iran’s Central Bank banned trading of digital currencies identified by Iran’s anti-money laundering body in December 2017, including Bitcoin, citing money laundering concerns. The Bank issued a statement in which it directed banks and currency exchanges to refrain from engaging in any sale or purchase of the identified cryptocurrencies. Reuters article 4.22.18
On April 28, a government minister of Iran stated that the country has developed an experimental local cryptocurrency, which would not be affected by the country’s wider ban on cryptocurrencies. Iran’s Central Bank clarified that the existing ban on cryptocurrencies does not apply to domestically-developed cryptocurrencies. Reuters article 4.28.18
Kenya Hints at Establishing Blockchain Task Force
On April 25, the Kenyan Capital Markets Authority (CMA) released a Capital Market Soundness Report, which proposed creating a task force to address challenges related to digital currencies and ICOs. The special unit would be a special unit under the purview of all relevant regulators including the CMA and the Central Bank of Kenya (CBK). This marks a shift in the CMA’s and CBK’s previous position in ICOs. In February 2018, the CMA warned investors against ICOs and stated that all offerings were unapproved, unregulated and highly speculative investments. The CBK Deputy Governor spoke at the Euromoney East Africa Conference in early April and stated that the country’s approach to blockchain technologies should be to cautiously embrace while addressing potential risks. CMA Report Vol. VI, Quarter 1 2018
For additional International Updates, see Perkins Coie’s International Tracker.
Updates: On April 23, 2018, the SEC published a third order instituting proceedings to determine whether it will approve or disapprove another proposal for Bitcoin futures ETFs (the “Direxion NYSE Arca Order”).
On April 5, 2018, the SEC published a second order instituting proceedings to determine whether it will approve or disapprove another proposal for Bitcoin futures ETFs (the “Cboe Order”).
On March 23, 2018, the U.S. Securities and Exchange Commission (“SEC”) issued an order instituting proceedings to determine whether it will approve or disapprove a proposal for Bitcoin futures exchange-traded funds (“ETFs”) (the “Order”).
Commenters will have until April 19, 2018 to submit comments. Those with rebuttals to the comments will have until May 3, 2018 to submit rebuttals.
Below is a summary of some of the significant legal and regulatory actions that occurred over the past weeks. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest.
Bermuda Announces Proposed Regulation for ICOs and other Crypto-related Activity
The Bermuda Monetary Authority released proposed regulation for initial coin offerings (ICOs) and other virtual currency activities on April 13. The proposed legislation addresses ICOs in detail, which would require potential issuers of ICOs to apply for consent to operate from the Minister of Finance. An application for consent would require the disclosure of information including corporate information of the entity planning the ICO, development and implementation plans for any product, service, or other project related to the ICO, amount intended to be raised through the ICO, timeline for the completion of the ICO, information related to the storage of identifying information of purchasers, and compliance and auditing protocols for token purchases. Bermuda Monetary Authority Consultation Paper – April 2018
Malta Seeks Feedback on ICO Consultation Paper
On April 13, the Malta Financial Services Authority (MFSA) announced that it is considering moving ahead with introducing a “Financial Instrument Test,” which would clarify how the law defines digital assets and provide guidance to determine whether a blockchain-based asset would fall under EU regulation or Malta’s proposed Virtual Financial Asset Act (VFAA). The MFSA originally introduced the Test on November 30 in a paper addressing ICOs and other services related to virtual currency and tokens. The April 13 consultation paper expands on the proposed Financial Instrument Test. The government is seeking input from the financial services industry and the public, who can respond to the proposed regulation via a survey on the MFSA’s website. MFSA website – Consultation Paper and Survey
Singapore Remains Committed to Fostering Blockchain Initiatives
Singapore’s minister of finance, Hen Swee Keat, made opening remarks at the 22nd ASEAN Finance Ministers’ Meeting in which he indicated that Singapore would continue to support innovations in the FinTech industry and acknowledged the potential that distributed ledger technology (DLT) can provide for the country more broadly. Specifically, Minister Keat discussed the current pilot project between Singapore and Thailand, a project focused on regional “fast payments linkages,” which rely on DLT. Although he did not provide details on other projects, Minister Keat indicated that Singapore is dedicated to exploring other blockchain initiatives that would facilitate financial transactions in Southeast Asia and lead to financial inclusion for underbanked areas in various countries in the region. Singapore Ministry of Finance Release 4.6.18
India and Pakistan Issue Warnings and Directives on Cryptocurrencies
In separate but similar statements, the Reserve Bank of India (RBI) and Pakistan’s central bank cautioned about the use of digital currencies in the respective countries. Both countries consider digital currency illegal. The Indian government and RBI previously issued cautions to the public earlier this year about digital currency, in which they indicated a commitment to eliminate the use of digital currency in the country. On April 6, the RBI began prohibiting banks from having any links to virtual currency businesses. On the same day, Pakistan’s central bank reiterated that cryptocurrencies are illegal in the country and the government directed banks and other financial services providers to refuse customers seeking to transact in cryptocurrencies. Reuters article 4.6.18
UK’s Financial Conduct Authority Issues Statement on Cryptocurrency Derivatives
The Financial Conduct Authority (FCA), a financial regulatory body in the UK, announced on April 6 that companies offering cryptocurrency derivatives would likely require authorization from the FCA. Any company seeking to offer cryptocurrency derivatives would need to comply with applicable FCA rules and EU regulations. The FCA does not currently regulate cryptocurrencies unless they are part of other regulated products or services; however, cryptocurrency derivatives could be considered financial instruments under the EU’s Markets in Financial Instruments Directive II (MiFID II). According to the FCA statement, activities that will likely require FCA authorization include cryptocurrency futures, cryptocurrency contracts for differences, and cryptocurrency options. FCA Announcement 4.6.18
On Monday, April 2, 2018, the U.S. Securities and Exchange Commission (SEC) charged two co-founders of Centra Tech, Inc. (Centra), a purported financial services company headquartered in Florida, with conducting a fraudulent unregistered initial coin offering (ICO) that raised more than $32 million from thousands of investors from July to October 2017. In a parallel action, the two co-founders were separately charged and arrested by the U.S. Attorney’s Office for the Southern District of New York.
According to the SEC’s complaint, Sohrab “Sam” Sharma and Robert Farkas, the two co-founders of Centra, allegedly conducted a fraudulent ICO in which Centra offered and sold unregistered investments through a “CTR Token”—an ERC20 token on the Ethereum blockchain. The defendants allegedly claimed that funds raised in the ICO would help build a suite of financial products and provide benefits, including a “crypto debit card” backed by Visa and MasterCard that would allow users to instantly convert cryptocurrencies into fiat currency, as well as a “Centra token rewards program” that would entitle investors to a share in Centra’s future earnings. In reality, the SEC alleges, Centra had no relationships with Visa or MasterCard. The SEC also alleges that to promote the ICO, Sharma and Farkas allegedly created fictional executives with impressive biographies, posted false or misleading marketing materials to Centra’s website, and paid celebrities to endorse the ICO on social media.
The SEC’s action follows previous enforcement actions and public pronouncements that the SEC intends to take action against actors in the ICO space who fail to comply with federal securities laws, and in particular those who engage in fraudulent conduct. Indeed, the SEC’s complaint specifically highlights the timing of the conduct at question—after the release of the SEC’s DAO Report of Investigation, which according to the SEC “warned the industry that digital securities can be, and often are, securities.” The SEC’s investigation is ongoing, and the SEC acknowledged the assistance of the U.S. Attorney’s Office for the Southern District of New York, the Federal Bureau of Investigation, and the Financial Industry Regulatory Authority. Read the SEC press release here.
Below is a summary of some of the significant legal and regulatory actions that occurred over the past weeks. This alert is not intended to be a comprehensive list of all such developments, but rather a selection of publicly-reported news that may be of particular interest. Please visit our sister blog, FintechLegalReport, for the Fintech in Review – Weeks of March 19th through March 30th, 2018 portion.
NFA Comments on CFTC’s Proposed Interpretation of “Actual Delivery”
On March 20, the National Futures Association (NFA) issued a letter to the Commodity Futures Trading Commission (CFTC) in which it provided its comments to the CFTC’s proposed interpretation of “actual delivery” in the context of virtual currency transactions subject to the Commodity Exchange Act (CEA) Section 2(c)(2)(D)(ii)(III)(aa), released on December 15, 2017.
The concept of “actual delivery” exists as an exception for retail commodity transactions under the Commodity Exchange Act (CEA) Section 2(c)(2)(D), a provision of the CEA intended to protect retail investors making a margined, leveraged, or otherwise financed purchase of a commodity. Transactions falling under this provision are treated as futures contracts and are subject to the full extent of the CFTC’s futures regime, unless an exception applies. The “actual delivery” exception provides that a sale is excepted from this provision if the purchaser takes possession of the commodity within 28 days of the transaction, and the seller relinquishes all control over the commodity. The CFTC’s proposed interpretation of “actual delivery” puts the exception in the context of purchases of virtual currency. The proposed interpretation sets forth two criteria necessary to establish “actual delivery” in a retail commodity transaction:
(1) a purchaser has the ability to (i) take possession and control of the entire quantity of the commodity (i.e., the virtual currency), and (ii) use it freely in commerce (both within and away from any particular platform) no later than 28 days from the date of the transaction; and
(2) the seller does not retain any interest in, or control over, any of the commodity at the expiration of 28 days from the date of the transaction.
The proposed interpretation additionally offered examples of when “actual delivery” would and would not be found to have occurred.
In its Comment Letter, the NFA proposed the following:
- Shortening of the 28-day period (a measure which would likely require action by Congress) on the basis that many virtual currency products are extremely volatile, offered for speculative investment purposes, and have attracted many retail investors;
- Clarification of the terms “depository,” “possession,” and “control” in the context of virtual currencies;
- Further consideration of the potential impact on certain virtual currency exchanges under the proposed interpretation of “actual delivery”–Specifically, exchanges that purchase virtual currencies for their own account and only allocate them to purchasers via internal bookkeeping entries. Under this model, the exchange collects large amounts of customer funds to buy and hold virtual currencies on behalf of the customers, although the purchases remain allocated in the public ledger as to the exchange, not the customer. Consequently, the NFA notes, those exchanges are not subject to the same level of regulatory scrutiny as other depositories, custodians, and intermediaries that hold customer funds in a similar fashion. The NFA expressed concern particularly in instances where a retail investor purchases virtual currency using a credit card or other leveraged means.
The CFTC’s proposal was open for public comment until March 20. NFA Comment Letter 3.20.18
OFAC Indicates That It May List Cryptocurrency Addresses on its Sanctions List
The Office of Foreign Assets Control (OFAC) of the U.S. Department of the Treasury released an FAQ on its website on March 19 indicating that it may add digital currency addresses to its Specially Designated Nationals (SDN) List to alert the public to those identifiers associated with a sanctioned person or entity who is otherwise on the SDN List. The FAQ indicates that anyone who identifies a wallet address believed to be associated with a blocked individual should file a report with OFAC that includes the digital wallet address, ownership, and any other relevant information. The field for digital currency addresses on OFAC’s SDN List would indicate the unique alphanumeric identifier and the digital currency stored in the wallet. OFAC’s FAQ provided definitions of “virtual currency,” “digital currency,” “digital currency wallet” and “digital currency address” for the purposes of its sanctions program:
“Virtual currency is a digital representation of value that functions as (i) a medium of exchange; (ii) a unit of account; and/or (iii) a store of value; is neither issued nor guaranteed by any jurisdiction; and does not have legal tender status in any jurisdiction.
Digital currency includes sovereign cryptocurrency, virtual currency (non-fiat), and a digital representation of fiat currency.
A digital currency wallet is a software application (or other mechanism) that provides a means for holding, storing, and transferring digital currency. A wallet holds the user’s digital currency addresses, which allow the user to receive digital currency, and private keys, which allow the user to transfer digital currency. […]
A digital currency address is an alphanumeric identifier that represents a potential destination for a digital currency transfer. A digital currency address is associated with a digital currency wallet.”
OFAC FAQs: Sanctions Compliance (See Questions on Virtual Currency, Paragraphs 559-563.)
IRS Issues Reminder to Taxpayers Regarding Virtual Currency
The Internal Revenue Service (IRS) issued a notice on March 23 in which it reminded taxpayers that income from virtual currency transactions is subject to federal tax regulation and must be reported on income tax returns. The Notice reiterated that the IRS treats virtual currency as property for federal tax purposes, meaning that the same general tax principles for other property apply equally to virtual currencies. Among other points, the IRS noted the following:
- A taxpayer who received virtual currency as payment for goods or services during the 2017 tax year must include the fair market value in U.S. dollars of the virtual currency at the time the payment was received.
- If the fair market value of the property received was higher than the value of the virtual currency paid by the taxpayer, the taxpayer has a taxable gain. Conversely, if the FMV of the property received is lower than the value of the virtual currency paid, the taxpayer has incurred a loss.
- Virtual currency paid by an employer is considered taxable wages. Additionally, virtual currency paid to an independent contractor in exchange for services is considered self-employment income.
- Miners of virtual currency must report as gross income successfully mined cryptocurrency, the value of which is to be calculated in U.S. dollars as of the date of receipt.
For further discussion of the tax implications for virtual currency and additional information about IRS actions with respect to taxpayers, see Perkins Coie’s Virtual Currency Report: Urgent Tax Reporting Considerations for Virtual Currency Traders, Miners, and Anyone Contemplating Investment 3.26.18
G20 Calls for Recommendations for Cryptocurrency
Following several G20 meetings held March 20-21, international economic leaders issued a statement (“communiqué”) seeking proposed cryptocurrency regulations by July 2018. The first G20 meetings began in December 2017 as precursors to the G20 Summit, scheduled to take place November 30 – December 1, 2018 in Buenos Aires. The communiqué suggested agreement among the members that cryptocurrencies need to be examined across the world, but it stopped short of calling for a regulatory crackdown. The members expressed a belief that the technological innovation underpinning cryptocurrencies is of great value to the worldwide financial system, but noted concerns about consumer and investor protection, risks of money laundering and funding terrorist activity, tax evasion, and volatility and stability of cryptocurrencies. The communiqué took the position that cryptocurrencies should more appropriately be considered assets, not currency, and regulation should flow from that position. Some countries, including Brazil and the UK, did not agree with that position, and asserted that cryptocurrencies would not be regulated according to such an approach. Reuters Article 3.19.18
Liechtenstein Proposes New FinTech Regulations
Prime Minister Adrian Hasler of Liechtenstein announced on March 21 at a Finance Forum in Vaduz that the government will introduce a bill in the summer of 2018 with proposed regulation for blockchain technology. The bill will provide legal and regulatory clarity for businesses developing distributed ledger technology (DLT), in addition to potential consumers of the technology, in an effort to attract FinTech innovation to the country. More broadly, Liechtenstein has taken a lighter regulatory approach to blockchain technologies, including digital currencies, which are not currently subject to licensing requirements. The Financial Market Authority of Liechtenstein has issued two formal statements related to digital currencies and ICOs FMA Digital Currency Statement 2.16.18; FMA ICO Statement 9.10.17, both of which are favorable to the industry in terms of taking a permissive approach to regulation and taxation of digital assets. Announcement 3.21.18
 CEA Section 2(c)(2)(D)(ii)(III)(aa)
As first published on Bloomberg’s Daily Tax Report.
- The Internal Revenue Service is obtaining significant records about virtual currency holders
- These records not only implicate taxpayers who sold virtual currency at a profit, but also anyone who bought, sold, sent, or received virtual currency
- Exchanges of one virtual currency for another, mining of virtual currency, and receipt of units like Bitcoin Cash can create current tax obligations
- These issues have criminal and civil implications, and IRS pressure will only increase
It is no secret that the value of many virtual currencies (in particular, cryptocurrencies such as Bitcoin) rose over the past year. The associated legal and tax challenges are less well-known but vitally important (at least for those looking to avoid potential criminal and civil penalties). As the April tax deadline fast approaches, one of the most notable issues affecting holders of virtual currency is their tax reporting obligations.
As noted in a March 23, 2018 press release on the issue, IR-2018-71, the IRS argues that the sale of all assets, including virtual currencies, must be reported on an individual’s federal income tax return. Based on its own review, the IRS argued that fewer than 1,000 taxpayers reported virtual currency sales on their tax returns between 2013 and 2015, for example. While virtual currencies were certainly less well-known three to five years ago than they are today, a court recently found the IRS argument persuasive enough to order disclosure of thousands of names and records.
Bought, Sold, Sent, or Received
As part of a federal summons enforcement proceeding in the U.S. District Court for the Northern District of California, the IRS will receive the names and personally identifiable information of more than 13,000 virtual currency account holders. This includes account holders who met or exceeded the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in 2013, 2014, or 2015. Notably, it does appear to exclude account holders who only bought and held Bitcoin during the 2013 through 2015 period, or those who received a Form 1099-K. While the recent proceedings involved Coinbase, the U.S.’s largest digital currency exchange, IRS demands for records will touch many more companies and users going forward.
Thus far, IRS demands for records are not limited to virtual currency sales or transactions that actually produced a profit in U.S. dollars. This goes to a broader consideration for virtual currency holders—transactions such as an exchange of one virtual currency for another are taxable events, and what triggers tax recordkeeping requirements may surprise some holders.
A taxpayer, for example, might use Bitcoin or Ethereum to acquire one of the many other virtual currency offerings that debut on a near-weekly basis. Under the law informally known as the 2017 Tax Cuts and Jobs Act, these exchanges must be reported to the IRS. If the virtual currency given up in the exchange is worth more than what was paid for it (or reported upon being mined), then income tax will be due from this exchange. In essence, exchanging one virtual currency for another is treated no different than a sale for U.S. tax purposes. The IRS will undoubtedly review tax returns to determine if these exchanges of virtual currency are being reported.
To date, the IRS has issued limited guidance on reporting exchanges of virtual currency. IRS Notice 2014-21, states that virtual currency should be treated as “property” for tax purposes. Because virtual currency is treated as property, not currency, there are several less-than-familiar scenarios in which an individual may be unaware that reporting is required. Specifically, miners and those who exchange one virtual currency for another have current reporting obligations, described further below.
Acquiring Virtual Currency and Mining
An individual can “mine” virtual currency by using their “computer resources to validate [virtual currency] transactions and maintain the public [virtual currency] transaction ledger.” IRS Notice 2014-21 (specifically referring to Bitcoin). A U.S. taxpayer must report as gross income the fair market value of the virtual currency that they obtain from mining.
In addition to having gross income to report, the IRS expects that an individual who mines as a trade or business will report and pay both income and self-employment taxes. This means that individuals mining virtual currencies may be liable for quarterly tax payments throughout the year, even if they have not sold any of the units they mined. It is essential for miners to maintain proper books and records to track income and expenses. Income is dependent on the value of the virtual currency the day it is discovered. Mining-related expenses for computer equipment and electricity can be very high and can be deductible for people conducting their mining operations as a business.
The timing of a miner’s virtual currency sale could also affect the character and tax rate of the sale proceeds. Proceeds from currency mined and held for over one year should be considered long-term gain, while currency held for less than one year is short-term gain (and typically has a higher tax rate). This is another reason why tracking the dates on which currency is obtained and then sold is critical.
No More Possibility of Like-Kind Exchanges
Like-kind exchanges are transactions that allow a person to exchange property for “like” property within six months without immediate tax implications. For sales prior to 2018, it is arguable that an exchange of one virtual currency for another (e.g., Bitcoin for Ethereum) could qualify as a non-taxable like-kind exchange. Beginning Jan. 1, 2018, Congress amended the like-kind exchange rules to no longer apply to virtual currency (or anything other than real property). Now, there is no question these virtual currency exchanges are recognition events. Because digital currency exchanges are not explicitly required to report these transactions to users on a Form 1099, this remains a trap for the unwary.
Distributions to Holders
On Aug. 1, 2017, Bitcoin Cash emerged after a hard fork in the Bitcoin blockchain. Many who held Bitcoin on August 1, automatically became owners of Bitcoin Cash coins as a result. There also have been dividend-like distributions of one type of virtual currency to holders of another type. From a taxpayer’s perspective, these types of transactions could be treated in similar fashion to stock-splits or dividends or even another alternative, depending on the facts and how the IRS construes these events. This creates yet another question of when and what amounts must be reported.
The broad takeaway is that U.S. taxpayers who have held any virtual currency should be very wary of government scrutiny. U.S. taxpayers under investigation or those who believe they sold, exchanged, or sent virtual currency through any exchange or medium should consider their options with great care to minimize exposure to criminal liability and civil penalties. With limited IRS guidance currently available, it is in taxpayers’ best interest to establish a clear reporting plan as soon as possible.