Blockchain and the Law

Among an Array of 2020 Examination Priorities, SEC Signals Continued Interest in Cryptocurrency

On January 7, 2020, the Securities and Exchange Commission (SEC)’s Office of Compliance Inspections and Examinations (OCIE) released its 2020 examination priorities. The majority of OCIE’s priorities for the coming year involved financial regulatory issues that do not directly involve cryptocurrency – for a more detailed review of those priorities, please see the Client Alert posted on our firm’s website.

Tucked away in the SEC’s 22-page document, OCIE identified two examination priorities concerning virtual currencies and digital assets:

  • First, OCIE advised that it will continue to “examine SEC-registered market participants” engaged in cryptocurrency activities, specifically for: (1) investment suitability, (2) portfolio management and trading practices, (3) safety of client funds and assets, (4) pricing and valuation, (5) effectiveness of compliance programs and controls, and (6) supervision of employee outside business activities.  OCIE stated that the rapid growth of digital assets presents various risks, including “for retail investors who may not adequately understand the differences between these assets and more traditional products.”
  • Second, OCIE will continue to examine the core functions of transfer agents involved in the settlement of securities transactions and their role in maintaining proper records and safeguarding funds and securities. Specifically, OCIE noted: “Examination candidates will include transfer agents that serve as paying agents for issuers, transfer agents developing blockchain technology, and transfer agents that provide services to issuers of microcap securities, private offerings, crowdfunded securities, or digital assets.”

OCIE’s sustained interest in the risks associated with cryptocurrency is certainly not surprising, as evidenced by the SEC enforcement activity in the latter half of 2019 (which included, among other things, attempts to halt what it deemed non-compliant token distributions). Indeed, looking ahead, other regulators such as the IRS, FinCEN and CFTC are also watching the cryptocurrency space closely.  Thus, regulated entities engaged with blockchain and digital currency should understand the OCIE’s 2020 examination priorities in maintaining policies addressing regulatory compliance concerns.

IRS Officials Discuss Promotional Airdrops, Pre-2018 Crypto-for-Crypto Exchanges, and Other Issues Not Addressed in Recent Tax Guidance

In October of 2019, the U.S. Internal Revenue Service issued the first new guidance on the taxation of cryptocurrency transactions in over five years (the “Guidance”).  The Guidance comprising a revenue ruling (Rev. Rul. 2019-24) and answers to frequently asked questions on the taxation of cryptocurrency transactions published on the IRS’s website.

This post discusses recent news reports of statements by officials with the IRS and the Treasury Department’s Financial Crimes Enforcement Network (FinCEN) concerning issues not explicitly addressed in the Guidance.

Please refer to our earlier post for complete coverage of the Guidance.

  1. Tax treatment of promotional airdrops remains uncertain

Revenue Ruling 2019-24 indicated that cryptocurrency received in a hard fork would be taxable to the owner at the moment the new units of cryptocurrency issued in connection with the hard fork are “received” by the holder of the legacy cryptocurrency, which is generally the moment the units of the new cryptocurrency are “airdropped” to the legacy holder’s wallet, provided the holder is able to exercise “dominion and control” over the units at that time.

Because the facts of the ruling involved a hard fork (i.e., a change in the protocol of a cryptocurrency’s blockchain causing the creation of a new blockchain and, therefore, a new cryptocurrency), it was not clear whether the same rule would apply to airdrops of cryptocurrency received in other contexts.  Airdrops may occur for promotional or marketing purposes by blockchain-focused startups in order to generate interest in the startup in connection with an upcoming ICO or to encourage mass adoption of the cryptocurrency.  The coins may be distributed for free to holders of existing cryptocurrencies (such as Bitcoin or Ethereum), or may be “earned” by posting to social media or referring the cryptocurrency to other users.

An attorney in the IRS Office of the Associate Chief Counsel clarified in recent comments that promotional airdrops are not within the scope of Revenue Ruling 2019-24, but also noted that the IRS had not yet reached a decision on the tax treatment of these airdrops

  1. Valuation and receipt issues for airdropped coins

If coins of a new cryptocurrency are “received” for tax purposes, the owner of the cryptocurrency is required to include in its taxable income the fair market value—generally, the trading price—of the cryptocurrency at the moment of its receipt.  An attorney for the IRS speaking before a recent conference of the American Institute of CPAs (AICPA) in Washington, D.C., suggested that a limited market for new coins may affect their valuation and that a zero valuation may be appropriate for a cryptocurrency that cannot be disposed of at all.

The same attorney also noted that, depending on the specific facts, a taxpayer may be treated as actually or constructively receiving coins of the new cryptocurrency distributed in a hard fork even if it is necessary for the taxpayer to download new software or undertake some other ministerial-type action to accept (or later to transfer) the cryptocurrency.  Taxpayers cannot avoid or delay a taxable event simply by declining to accept the airdropped coins.

  1. “Like-kind” exchange treatment for pre-2018 crypto-for-crypto exchanges remains uncertain and may depend on the facts of the transaction

Prior to the changes in the tax law brought about by Public Law 115-97 (commonly known as the Tax Cuts and Jobs Act, or TCJA), gain realized on certain exchanges of property for like-kind property used in a taxpayer’s trade or business or otherwise held for investment was not immediately subject to U.S. federal income tax by reason of section 1031 of the U.S. Internal Revenue Code.  Such transactions are commonly referred to as “like-kind exchanges.”  For tax years beginning after December 31, 2017, like-kind exchange treatment is limited to exchanges of real property.

Some taxpayers (and some tax advisors) have taken the position with respect to pre-2018 tax years that certain cryptocurrency-for-cryptocurrency exchanges qualified as like-kind exchanges.  While this question was not addressed in the Guidance, an IRS attorney speaking before the same AICPA conference indicated that like-kind exchange treatment would depend on the specific facts of the transaction, suggesting there may be circumstances in which cryptocurrency-for-cryptocurrency exchanges would qualify as like-kind exchanges under pre-TCJA law.

  1. Offshore cryptocurrency accounts may be reportable on IRS Form 8938

No official guidance has been issued confirming whether cryptocurrency assets held through a foreign exchange are required to be reported either on a foreign bank account report (FBAR) or an IRS Form 8938 (Statement of Specified Foreign Financial Assets).

A FinCEN official confirmed in comments before the same AICPA conference that cryptocurrency is not required to be reported on an FBAR.  (This is consistent with previous statements made by FinCEN to the AICPA Virtual Currency Tax Force.)

However, taxpayers may be required to report cryptocurrency held through a foreign exchange on a Form 8938 attached to their annual tax return.  Whether an asset is reportable on Form 8938 will depend on whether a cryptocurrency wallet hosted on a foreign exchange is treated as a “financial account” maintained by a “foreign financial institution.”  While these terms are defined in the instructions to Form 8938, their application in the cryptocurrency context is less than straightforward.

An IRS official speaking to the publication Tax Notes indicated that the IRS likely would not penalize taxpayers for failing to report foreign-held cryptocurrency assets in previous tax years—provided these taxpayers have properly reported their taxable cryptocurrency transactions on their federal income tax returns in prior years and properly report such assets and transactions on their tax returns (including on a Form 8938, if applicable) from the current year forward.

Smart Contracts: Best Practices

Proskauer authored an in-depth Practice Note published by Practical Law, which details best practices for the use of smart contracts on blockchains. It discusses functional and legal considerations for both standalone smart contracts and smart contracts used in conjunction with traditional written contracts (hybrid smart contracts) and explores the extent to which smart contracts can independently be legally binding.

The full text of our Practice Note is available here: Smart Contracts: Best Practices

 

CFTC, FinCEN, and SEC Warn of Crypto AML Enforcement

Based on a recent regulatory statement, entities involved with cryptocurrency or digital assets should revisit their anti-money laundering and countering the financing of terrorism obligations (AML/CFT) compliance under the Bank Secrecy Act (BSA).

On October 11, the leaders of the Commodity Futures Trading Commission (CFTC), the Financial Crimes Enforcement Network (FinCEN), and the Securities and Exchange Commission (SEC) issued a joint statement (the “Joint Statement”) regarding the application of the BSA to activities involving digital assets. The Joint Statement “reminds” those involved with such activities of their AML/CFT obligations and specifically calls out those entities that would be subject to such obligations: futures commission merchants and introducing brokers (regulated by the CFTC), money services businesses (regulated by FinCEN), and broker-dealers and mutual funds (regulated by the SEC).

Potentially indicating a key concern of the regulators going forward, the Joint Statement notes that the applicability of AML/CFT obligations is not dependent on the terminology surrounding the applicable assets, but rather the nature of the assets themselves: “Regardless of the label or terminology that market participants may use, or the level or type of technology employed, it is the facts and circumstances underlying an asset, activity or service, including its economic reality and use (whether intended or organically developed or repurposed), that determines the general categorization of an asset, the specific regulatory treatment of the activity involving the asset, and whether the persons involved are “financial institutions” for purposes of the BSA.” Thus, while market participants refer to digital assets in many different ways, how assets are referred to should not have a bearing on BSA compliance. By way of example, the Joint Statement offers that “something referred to as an ‘exchange’ in a market for digital assets may or may not also qualify as an ‘exchange’ as that term is used under the federal securities laws.”

Following the general statement, each leader provides additional comments, which should guide entities subject to each applicable regulator’s review. Heath Tarbert (Chairman, CFTC) notes that introducing brokers and futures commission merchants are required to report suspicious activity and implement reasonably-designed AML programs, regardless of whether the digital assets qualify as commodities or are used as derivatives. Kenneth A. Blanco (Director, FinCEN) advises those handling digital assets to review FinCEN’s May 2019 interpretive guidance, under which FinCEN makes clear that many digital asset activities would qualify a person as a money services business subject to AML/CFT obligations (unless the person is registered with and functionally regulated and examined by the SEC or CFTC, whereby they would be subject to the BSA obligations of those regulators).  Jay Clayton (Chairman, SEC) reminds persons engaged in activities involving digital assets as securities that they remain subject to federal securities laws, but certain rules also apply regardless of whether the assets are securities, such as broker-dealer financial responsibility rules.

The Joint Statement is yet another warning to the cryptocurrency markets following each regulator’s recent steps to clarify their positions on digital assets. This follows closely after the SEC’s April 2019 release of its “Framework for ‘Investment Contract’ Analysis of Digital Assets” and July 2019 joint statement on broker-dealer custody of digital asset securities with the Financial Industry Regulatory Authority. Additionally, FinCEN cited their May 2019 guidance which came shortly after FinCEN levied its first civil penalty against a peer-to-peer virtual currency exchanger for failure to meet AML requirements, amongst other violations, in April 2019.

The fact that the Joint Statement was issued jointly by multiple regulators may signal that the regulators intend to bring parallel actions in cases where they share jurisdiction, so entities operating under shared jurisdiction would have to deal with multiple cases at once. Such entities should not assume that if one regulator brings a case then the other regulators will not also do so. If anything, this Joint Statement makes clear that the regulators are most interested in those entities handling digital assets that had previously operated as though the AML/CFT obligations did not apply to them, so those without such programs in place should carefully evaluate their compliance in the near future.

SEC Attempts to Halt Telegram’s Planned Token Distribution

On October 11, 2019, the SEC filed an emergency action to stop Telegram (Telegram Group Inc. and its wholly owned subsidiary TON Issuer Inc.) from continuing its offering of tokens. Telegram raised approximately $1.7 billion in early 2018 through the sale of its tokens, dubbed “Grams”, which it originally committed to deliver to purchasers from the sale by the end of this month. The SEC brought the action to prevent Grams from “flood[ing] the U.S. capital markets.” The company filed a response a few days later and, according to Bloomberg, in a separate email to investors proposed delaying the distribution of Grams until April of next year and requested their approval.

The SEC alleged in its complaint that Grams are securities and that Telegram failed to register the offering in accordance with the Securities Act. The SEC’s analysis followed its previously released framework for determining whether a digital asset is an “investment contract” (and therefore a security), focusing on the main issue of a purchaser’s expectation of profit. The SEC argues that Telegram led purchasers to expect profit because, among other actions, Telegram told purchasers that Grams would be listed on “major cryptocurrency exchanges” and sold Grams at “deeply discounted prices from its own projected secondary market price at launch.”

Telegram reiterated the argument that the 2018 purchase agreements for Grams are securities, but continued to deny that Grams themselves are securities, instead arguing that they are merely a currency or commodity. It also emphasized its previous cooperation with the SEC, including producing documentation, participating in in-person presentations and regular communication with the SEC. It is important to note that, consistent with its position, Telegram has previously filed two Form D filings with the SEC for the purchase agreements, claiming exemptions from registration with the SEC under Rule 506(c) and Regulation S. Form D filings are required by issuers claiming an exemption from registration under U.S. securities laws, while Regulation S is a “safe harbor” for the offshore sales of securities.

Despite Telegram’s efforts and apparent cooperation, the SEC has nonetheless decided to take the step of attempting to enjoin Telegram from issuing Grams. In a press release, Steven Peikin, the Co-Director of the SEC’s Division of Enforcement, stated, “Telegram seeks to obtain the benefits of a public offering without complying with the long-established disclosure responsibilities designed to protect the investing public.” Companies should continue to exercise caution when participating in the offering of digital assets, especially where certain characteristics of the assets or the offering fall under the SEC’s analysis of the assets as securities under its framework. If the digital asset in question is considered a security, offerings are not prohibited, but may need to be registered with the SEC if the facts and circumstances require it.

IRS Answers Some, but Not All, Questions in Long-awaited Cryptocurrency Guidance

The first official guidance on the taxation of cryptocurrency transactions in more than five years has been issued.

The guidance includes both a Revenue Ruling (Rev. Rul. 2019-24, 2019-44 I.R.B. 1) and answers to Frequently Asked Questions on Virtual Currency Transactions (the “FAQs,” together with Revenue Ruling 2019-24, the “Guidance”) was issued on October 9, 2019 by the U.S. Internal Revenue Service (the “IRS”).  The Guidance provides much sought information concerning the tax consequences of cryptocurrency “hard forks” as well as acceptable methods of determining tax basis for cryptocurrency transactions.  The Guidance also reasserts the IRS’s position, announced in Notice 2014-21, 2014-16 I.R.B. 938, that cryptocurrency is “property” for U.S. federal income tax purposes and provides information on how the rules generally applicable to transactions in property apply in the cryptocurrency context.  However, important questions remain unanswered.  It remains to be seen whether more definitive regulatory or administrative guidance is forthcoming.

The Guidance comes amidst an ongoing campaign by the IRS to increase taxpayer compliance with tax and information reporting obligations in connection with cryptocurrency transactions.  In 2017, a U.S. district court ordered a prominent cryptocurrency exchange platform to turn over information pertaining to thousands of account holders and millions of transactions to the IRS as part of its investigation into suspected widespread underreporting of income related to cryptocurrency transactions.  Earlier this year, the IRS sent more than 10,000 “educational letters” to taxpayers identified as having virtual currency accounts, alerting them to their tax and information reporting obligations and, in certain cases, instructing them to respond with appropriate information or face possible examination.  Schedule 1 of the draft Form 1040 for 2019, released by the IRS shortly after publishing the Guidance, would require taxpayers to indicate whether they received, sold, sent, exchanged, or otherwise acquired virtual currency at any time during 2019.[1]

Taxpayers who own or transact in cryptocurrency or other virtual currency should consider carefully any tax and information reporting obligations they might have.  Please contact the authors of this post or your usual Proskauer tax contact to discuss any aspect of the Guidance.  Read the following post for background and a detailed discussion of the Guidance.

Except where the context indicates otherwise, the tax consequences discussed in this post generally apply to transactions involving cryptocurrency held by a taxpayer as a capital asset.  This post does not consider tax consequences other than U.S. federal income tax consequences.

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CFTC Chairman States Ether is a Commodity

In remarks made at the Yahoo! All Markets Summit in New York, Heath Tarbert, Chairman of the U.S. Commodity Futures Trading Commission (CFTC), said that he believed the Ether cryptocurrency was a “commodity” and should be regulated under the Commodity Exchange Act (CEA). This statement follows the agency’s December 2018 announcement that it was seeking public comment to better understand the technology, mechanics and markets for virtual currencies beyond Bitcoin, namely Ether and the Ethereum network. The “commodity” issue has come up previously in court proceedings regarding virtual currency offerings, with some courts finding that the virtual currencies at issue were commodities subject to CFTC jurisdiction.  However, this was the first announcement by the CFTC Chairman regarding Ether’s characterization as a commodity.

“A commodity has a very broad definition. […] We’ve been very clear on Bitcoin. Bitcoin is a commodity under the CEA. We haven’t said anything about Ether…until now. It is my view as Chairman of the CFTC that Ether is a commodity and therefore it will be regulated under the CEA. And my guess is that you will see in the near future Ether-related futures contracts and other derivatives potentially traded.”

The Chairman also responded to what the interviewer characterized as “murky” regulation surrounding cryptocurrency (and related securities law issues) and explained how the nature of a virtual asset might even change over time:

“The analysis can be somewhat challenging, but ultimately the question is: Is it a security, first and foremost? And if it’s not a security, it is most likely a commodity.  So that is the initial test. Unlike other kinds of investment contracts, a digital asset can transform itself throughout time.  You can have a situation where something in an initial coin offering is a security, but over time, the system becomes more and more decentralized, the enterprise that originally sponsored the currency is no longer in the fore and there’s an intangible value there, so you can have things that switch back and forth.  [One could imagine another potential scenario] where something is decentralized but then all of a sudden, the company gets more involved in it, it starts to look more like a common enterprise, where profits are derived from the activities of others, thereby meeting the Howey test.”

The CFTC Chairman also offered an opinion on forked digital assets, such as Bitcoin Gold, that have “spun off” from the original cryptocurrency, and how such forked currencies might be treated by the agency:

“It stands to reason that similar assets should be treated similarly. If the underlying asset, the original digital asset, hasn’t been determined to be a security and is therefore a commodity, most likely the forked asset will be the same. Unless the fork itself raises some securities law issues under that classic Howey Test.”

While the remarks by the CFTC Chairman are not officially binding as a regulatory matter, they are important to understanding the evolving regulatory environment (note, last year’s statement by SEC Director William Hinman at the All Markets Summit regarding offers and sales of Ether not being securities transactions). We will continue to follow the regulatory developments surrounding cryptocurrencies, including Libra, the stablecoin being developed by Facebook, which Chairman Tarbert commented the agency was still studying.

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