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Treasury offers framework for regulating crypto internationally

The Treasury Department has developed a framework with other federal agencies for engaging with foreign countries on the regulation of digital assets, in response to an executive order from President Biden, even as lawmakers in Congress have proposed their own industry friendly legislation.

The Treasury Secretary, in consultation with heads of the State Department, the Commerce Department, the U.S. Agency for International Development and other agencies, offered details on the framework Thursday. They aim to take an interagency approach to address the risks and harness the potential benefits of digital assets such as cryptocurrency and their underlying technology, including through international engagement to adapt, update, and enhance adoption of global principles and standards for how digital assets are used and transacted. 

The move comes in response to an executive order that Biden signed in March on ensuring the responsible development of digital assets. The crypto market has experienced turmoil this year, with the prices of popular cryptocurrencies like Bitcoin and Ether tumbling, and crypto companies declaring bankruptcy and refusing withdrawals from customers. Last November, the global crypto market reached a high of $3 trillion in market cap and now is estimated to have lost over $2 trillion in value since that time.

Logos for Binance Coin, top, Ether, left, and Bitcoin

Angel Garcia/Bloomberg

The framework aims to protect consumers, investors and businesses and maintain the safety and soundness of the global financial and monetary system, while also promoting access to safe and affordable financial services and supporting technological advances. Among the objectives are curbing illicit finance and national security risks posed by misuse of digital assets and countering efforts by foreign adversaries to drive standards and promote their protocols. The administration hopes to reinforce U.S. leadership in the global financial system and in technological and economic competitiveness, through responsible development of payment innovations and digital assets and by advancing technology and regulatory standards that align with U.S. values.

Senate legislation

Not only the Biden administration has been making moves to regulate crypto, but last month a pair of senators, Cynthia Lummis, R- Wyoming, and Kirsten Gillibrand, D-New York, introduced bipartisan legislation that would impose some sweeping rules on the industry (see story). The prospects for passage of the bill are dubious given it’s an election year and Congress remains deadlocked on a host of pressing issues. However, the bill includes several notable tax provisions that have been requested by the embattled crypto industry and could point the way for a possible path forward if more members of Congress from both parties decide to cosponsor it.

The Responsible Financial Innovation Act includes a provision that would set limits on the requirements in last year’s bipartisan infrastructure law for crypto brokers to report information to the Internal Revenue Service. The bill also provides a tax exemption for capital gains that don’t surpass $200 when using cryptocurrencies to buy goods and services, clarifies that crypto miners should not be faced with paying income taxes and specifies that digital asset lending agreements aren’t generally taxable events. The definition of a crypto broker under the infrastructure law was one that the industry had lobbied heavily, but unsuccessfully, to narrow before it was passed last year, and the new bill could do that, allowing many crypto companies to avoid the new IRS reporting requirements.

“The Lummis-Gillibrand bill would essentially narrow the definition of a broker,” said Chris Kotarba, a managing director at tax consulting firm Alvarez & Marsal Taxand. “It would only cover exchanges and other players that are acting on behalf of customers as part of their ordinary business. It would not, for example. cover other players in the ecosystem that would not have access to customer information, such as validators, nodes, software developers and miners. All of those would be exempt, and it really would just pertain to exchanges, and others effecting sales on behalf of customers and their organizations.”

Crypto technology companies and crypto miners had been especially worried about the new reporting requirements in the infrastructure law. “People who are just mining Bitcoin or Ether and they’re just doing it for themselves, they’re not going to fall under the definition of a broker, which is what people are concerned about,” said Charles Kolstad, a partner in the private client and crypto and digital asset practices at the international law firm Withers.

The other provision in the legislation that has been in heavy demand from the industry has been lowering the reporting requirements for small crypto transactions. 

“They provided a de minimis rule that said if your crypto transactions are less than $200 in the aggregate, then you don’t have to report that as income,” said Kolstad. “Whether that’s a reasonable number, some people say it should be $600, similar to the 1099 numbers, but at least it’s a step in the right direction. If someone has a de minimis amount of crypto taxable income, they don’t have to worry about that. That is very helpful.”

“Purchases of goods and services under $200 would be exempt from tax and reporting,” said Kotarba. “Right now, if you go to the store and buy a cup of coffee and you pay with Bitcoin, you have to pay tax on that, so they’re going to have a $200 limit. In a previous bill, it was $600, which I think is better because it ties in with the same threshold for independent contractor rewarding, but anything is better than what it is, which is currently zero.” 

If the provision gets passed into law, he expects to see structuring rules and anti-abuse rules similar to those used by taxpayers who try to avoid the $10,000 limit on foreign bank account reporting so people don’t buy small transactions under $200 to try to stay under the threshold.

Another provision in the Lummis-Gillibrand bill concerns decentralized autonomous organizations, or DAOs, a new type of company that relies on blockchain technology similar to that used for cryptocurrency for voting, decision making and so-called “smart contracts.” 

“There’s been some ambiguity on how you would tax these DAOs because they’re not legal entities,” said Kotarba. “By definition, they only exist on the blockchain. What this bill does it declares that all DAOs are business entities under the Tax Code, and by being a business entity that means by default you are subject to tax and reporting, so if you’re a partnership, then the partners have to pay tax on the DAO’s income, and if you’re a corporation then the DAO itself pays corporate tax. This bill also requires that DAOs register as a legal entity in some jurisdiction. It doesn’t have to be the U.S. It can be a foreign jurisdiction, and it can be any type of entity, but they’re essentially requiring some legal entity registration for DAOs. It’s a bit unusual for them to require this, but that’s what they seem to be doing. That will lead to a lot of upheaval in the crypto world, but they also made an exception for DAOs that are more charitable in nature. Not all DAOs are created equal, and some DAOs will be allowed to register as a 501(c)7 nonprofit organization if they’re involved in charitable activity, which I think is right.”

DAOs have become more popular as blockchain technology and crypto have become more widely accepted. “There are lots and lots of them,” said Kolstad. “They’re viewed by the proponents of DAOs as being a more efficient and effective way to manage an organization. You have these smart contracts that hold the DAO’s governance tokens, things get put to a vote, and there are rules built into the smart contracts as to how you decide that the vote passes or doesn’t pass and so forth.”

However, there are many questions about this relatively new form of organization and how a governance token works. 

“What is that from a tax perspective? Is that a partnership interest? Is it equity in a company or is it something else? What this proposed legislation does is treat it as a business entity, which means a couple of things,” said Kolstad. “One is that if you’re a business entity, presumably although it doesn’t explicitly say this, when you issue the tokens, those are treated as if they are equity, secured issued by the DAO, which means that now your investors who put money into a DAO are treated as a tax-free transaction under Section 351. You don’t have to worry about the DAO having taxable income and having to pay taxes on something that otherwise really was intended to be an investment. I think that shows they are responsible, well advised and forward thinking on the whole issue. If you go on Twitter and search for DAO, there’s a lot of discussion about what is a DAO and is it a partnership, and if it is a partnership under corporate law, then who has future obligations. It’s good to get that addressed in here.”

The bill also includes a safe harbor that will be useful for foreign crypto investors. “There’s a safe harbor for doing business in the U.S., specifically if you’re trading in securities and commodities in the U.S.,” said Kotarba. “This bill broadens and extends that exemption to include cryptocurrencies in the U.S., which is a nice relief for any foreign investors and foreign funds who may be doing business in the U.S., and for financial institutions as well, and really treat cryptocurrency on the same level as stocks and commodities.”

Tax advisors who work with clients abroad could also benefit from the provision. “If you’re a non-U.S. person and you’re trading through a non-U.S. exchange or you’re trading with U.S. counterparts, there’s an issue of when you are considered to be engaging in a trade or business, which means you have to file a U.S. tax return,” said Kolstad. “There’s a provision entitled sources of income that says if you’re trading digital assets through a broker, etc., that is excluded from constituting a U.S. trade or business, the same as if you’re trading from your own account. That’s going to be helpful for people like me that advise non-U.S. people trading in U.S. exchanges and U.S. markets.”

In addition, the Lummis-Gillibrand bill would assign regulatory authority over digital asset spot markets to the Commodity Futures Trading Commision. “This puts crypto in the court of the CFTC, not the SEC, and the SEC is not happy about that,” said Kolstad. “I’m sure that will affect people’s views.”

The bill also includes a provision that would clarify the issue of so-called “proof-of-stake rewards,” or staking rewards, which was the subject of a lawsuit this year against…

Read More: Treasury offers framework for regulating crypto internationally

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