Keyword: bitcoin

Proof-of-Stake Rewards: Payment for Services or a Baked Cake?

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Against the backdrop of rapidly evolving blockchain technology, the IRS has oftentimes been slow to update its related tax guidance, leaving participants in the blockchain ecosystem uncertain about their tax obligations. Perhaps nowhere is this lethargy more pronounced than in the context of the consensus mechanisms that drives the entire blockchain network. Whereas, traditionally, coins rewarded pursuant to proof-of-work mechanisms have been treated as payment for services, an alternative class of consensus mechanisms, called proof-of-stake, may just be different enough to result in deferred taxation. Whether this is true is the subject of a recent legal claim that may, once resolved, shed light on the tax treatment of the increasingly popular proof-of-stake consensus mechanism.

Proof-of-Work Taxation

In 2014, an IRS Notice stated that a person that mines new blocks in a blockchain through a proof-of-work consensus mechanism must include any virtual currency received in connection with such activities in the miner’s gross income at the virtual currency’s fair market value. The ruling had an immediate impact on blockchains, such as Ethereum and Bitcoin, that depend on miners to add new data or ‘blocks’ to the chain. Through the proof-of-work consensus mechanism, miners are challenged to be the first to identify the missing number needed to solve a staggeringly complex hashing algorithm. For the lucky few who succeed, thousands of dollars’ worth of Ether or Bitcoin are awarded and—according to the IRS—taxable on receipt.

In the years following the IRS’s ruling, however, the taxation of mining has been complicated by the gradual adoption of an alternative consensus mechanism referred to as proof-of-stake. Under this method, miners—now typically called validators—are required to “stake” their holdings of a blockchain’s native coin in order to be eligible to win the right to add a new block to the chain. The more coins that a validator stakes, the greater the chance that they will be selected by the blockchain’s validation algorithm to add a new block to the chain. If the selected validator proposes an invalid block, however, the validator’s coins (or portion thereof) will be destroyed. This risk of loss in proof-of-stake validation adds a layer of complexity that is not present under the proof-of-work model, which simply involves the payment of virtual currency in exchange for the use of raw computational power to solve the mathematical puzzle. In addition, token holders will often stake their holdings to allow a third party, a validator, to use their tokens to validate the transaction as part of the proof-of-stake consensus mechanism. A welcome feature of proof-of-stake validation is that it requires considerably less energy than proof-of-work validation.

Whether this new feature is enough to challenge the taxability of any tokens or coins generated by the validation process has remained an open question that has only recently been publicly considered by the IRS.

The Jarretts—Answers at Last?

Sometime in 2019, Joshua Jarrett decided to participate on the Tezos blockchain as a validator. Jarrett staked his holdings in the native coin—Tezos—and as luck would have it, he won the right to propose new blocks on the Tezos chain. In return for validating the next block on the Tezos chain via the proof-of-stake consensus mechanism, Jarrett received 8,876 Tezos coins and dutifully paid $3,293 in federal taxes on the gain reported on his and his spouse’s joint federal income tax return.

A year later, the Jarretts had a change of heart and sought a $3,293 refund by filing an amended tax return. The Jarretts took the belated position that the coins were not taxable, using the “creation of an asset” theory. They argued that “new property—property not received as payment or compensation from another person but created by the taxpayer—is not and has never been income under U.S. federal tax law.” The Jarretts further reckoned that “[l]ike the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarrett’s [sic] simply because Mr. Jarrett created new property.”  The IRS denied the Jarretts’ refund claim, and the Jarretts filed a refund suit in the Middle District of Tennessee. Had the Jarretts taken the position on their original return that the reward was not taxable upon receipt, the IRS would have had been required to assess the unpaid tax. If the Jarretts wanted to challenge the assessment, they would have had to do so in the Tax Court. The IRS (and often many taxpayers) prefers to litigate technical issues in the Tax Court because of the court’s technical expertise.

The government countered that Joshua Jarrett never created new Tezos coins. Rather, in line with the tax treatment applicable to proof-of-work, the government argued that “Jarrett exchanged Tezos tokens for goods and/or services during 2019.” As such, Jarrett received the coins as payment for successfully proposing new blocks to the Tezos chain, and those coins were indeed taxable on receipt.

In something of an about-face, at the start of 2022, the government relented and offered to refund the Jarretts, as they had initially requested. However, unwilling to accept the government’s offer, the Jarretts have since elected to press on in order to force a definitive ruling on the taxability of virtual currency generated from proof-of-stake consensus mechanisms. The case is scheduled for trial in March 2023, and a final ruling may not take place until then.

Nonetheless, the Jarretts’ case is important to the blockchain industry as many chains have adopted, or are in the process of migrating toward, a proof-of-stake consensus mechanism, including Ethereum. The government’s initial concession appears to provide some basis to argue that perhaps an alternative tax treatment is appropriate, but the IRS may simply want to identify a taxpayer that did not report the tokens as taxable, assess a deficiency and force the taxpayer to sue in Tax Court. Blockchain participants, however, will have to wait for a firmer, and much needed, answer.

Word on the Street Is That Virtual Currency Is the “New Gold,” and it’s Swiftly Moving Up the IRS Watchlist

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The IRS has been increasingly active in its effort to ensure that virtual currency does not become a tool for tax evasion. This is not surprising, given that—as we started the last month of 2020—the value of Bitcoin, by far the most well-known cryptocurrency in the world, reached its highest level since 2017. Between June 2019 and July 2020, about 3.1 million active accounts were estimated to use bitcoin in the U.S.

Guidance

The IRS first started publishing guidance and notices on the federal income tax treatment of virtual currency in 2014. The first one among many was Notice 2014-21, which concluded that convertible virtual currency (virtual currencies that can be used to make purchases in the real economy and can be converted into government-issued currencies) should be treated as property for tax purposes. The next Notice, Rev. Rul. 2019-24, addressed the tax treatment of more specific types of virtual currency transactions, “hard fork” and “airdrop.” The IRS has also posted answers to frequently asked questions about virtual-currency transactions on its website. Starting with taxable year 2019, the IRS revised Schedule 1 to Form 1040 to require taxpayers to identify whether they engaged in any transaction involving virtual currency. The IRS plans on going even further as shown in a released draft of the revised Form 1040 for 2020, where it proposed placing the question about cryptocurrencies in a very prominent location—immediately below the taxpayer’s name and address.

More guidance might be forthcoming. One issue is whether the rules for broker reporting should apply to cryptocurrency transactions in the same way that they apply to trades in stocks and securities. The IRS believes that increased reporting leads to greater compliance. Earlier this year, the Chamber of Digital Commerce (the “Chamber”) submitted a comment letter to the IRS and the Department of Treasury to provide its views on potential forthcoming guidance on the reporting issue. The letter pointed out there is still some lack of clarity on the tax information reporting requirement for digital asset transactions, and that further instruction is needed for taxpayers to accurately interpret existing tax rules in the digital currency context. Some of the key areas on which the Chamber had requested clarification are: how “broker” is defined in the virtual currency context—which is critical for analyzing basis reporting requirements and certain information return filing obligations—and what factors are relevant for determining the location transactions take place, which can be a critical factor for cross-border transactions.

Enforcement Efforts

At the same time that it has been providing such guidance, the IRS has begun efforts to investigate possible tax evasion using virtual currency. The agency started its enforcement efforts in as early as 2016 when it served a “John Doe” Summons on one of the largest cryptocurrency exchanges in the country. The IRS demanded that the exchange produce a wide range of taxpayer identifying information and historical transaction records, and when the exchange refused to comply, the U.S. District Court for the Northern District of California ordered the exchange to turn over taxpayer information for those who conducted transactions worth more than $20,000 on its platform for the 2013 – 2015 period.

As part of its virtual currency compliance campaign announced in 2018 to address tax noncompliance related to virtual currency, in 2019 and again in 2020, the IRS sent thousands of warning letters to cryptocurrency holders whose tax returns did not match their virtual currency transaction records. While the IRS has not made it clear where it obtained the information about taxpayers’ transactions, one possible source of data could be Form 1099 reports from virtual currency exchanges. The IRS sent three different types of letters, varying in severity. The first type, Letter 6173, raised the possibility of an examination or enforcement activity if the taxpayer didn’t respond by a specific date and noncompliance persists. The other two, Letters 6174 and 6174-A, reminded taxpayers of their obligation to report.

According to the Internal Revenue Manual (IRM 5.1.18.20.3 (7-17-19)), the IRS uses normal investigative techniques to identify virtual currency including interviews, bank or credit card analysis, summonses of exchanges and financial institutions, review of Forms 1099-K, review of FinCEN Query reports, tracking and internet searches. While this set of instructions may appear relatively old-fashioned, the IRS’ latest moves demonstrate that it is upgrading its crypto-investigation toolbox. According to published reports, in September 2020, the IRS spent approximately $250,000 on a contract with Blockchain Analytics and Tax Services LLC, which will give the IRS access to blockchain analysis tools to track cryptocurrency transactions. Earlier in the summer, the IRS also signed a deal to purchase access to certain blockchain-tracing software for a year.

Despite the industrywide complaint that the IRS’s expectations with regards to holders of virtual currency are vague and unclear, this year, the IRS and the Department of Justice have started taking more proactive actions to prosecute taxpayers who allegedly committed a greater scale of tax evasion related to the use and trade of virtual currency. In October 2020, the Department of Justice charged software pioneer John McAfee with alleged evasion of tax by using cryptocurrency. In addition, on December 9, 2020, the SEC charged Amir Bruno Elmaani, founder of cryptocurrency called Oyster Pearl, with tax evasion. Elmaani allegedly evaded tax on millions of dollars of profits from cryptocurrency transactions and using shell companies and pseudonyms to conceal his income.

Increasing Regulation and Enforcement

All indications are that regulation and enforcement of the law with respect to virtual currency is increasing. On the regulatory side, earlier this month, a new U.S. congressional bill called the “Stablecoin Tethering and Bank Licensing Enforcement Act” was introduced that aims to regulate digital currencies by requiring certain digital currency issuers to obtain a banking charter and obtain approval from the Federal Reserve. Different government agencies are working in parallel to clarify tax payment and reporting obligations with respect to cryptocurrency, and the latest movements indicate that the enforcement actions are continuing.

We expect to see more enforcement actions in the upcoming administration. In November, the president-elect Joe Biden appointed Gary Gensler, a former Commodity Futures Trading Commission Chair under the Obama administration, to its presidential transition team. Gensler has testified before Congress about virtual currency and blockchain on several occasions, and while little information is known about Biden’s stance on cryptocurrency, Gensler called blockchain technology a “change catalyst” in a 2019 CoinDesk opinion and is generally considered to be “Bitcoin-friendly.” While it is generally unclear what Gensler’s long-term official position under the Biden administration will be, he is also on top of a list of potential picks for the SEC chair. Another clue that may provide some insight with regards to Gensler’s attitude towards cryptocurrency is his 2019 statement that Facebook’s proposed digital token, Libra, should be treated as a “security,” which establishes the basis for increasing regulatory oversight. (Cryptocurrency’s uncertain status as a security for tax purposes raises other tax issues.) The general industry consensus is that, while there is a growing acceptance of the legitimacy of cryptocurrency, it is likely that more regulatory and enforcement actions will continue by the SEC against issuers and intermediaries, and by the IRS against taxpayers. More regulation is not necessarily negative—it can create clearer guidelines and landscape for exchanges and virtual currency holders and enable them to better understand the regulatory and tax authorities’ expectations. That being said, it will be important for exchanges and taxpayers to closely follow the latest government guidelines with respect to virtual currency and ensure they comply with reporting and tax payment obligations.

English High Court Recognizes Cryptoassets to be a Form of Property: Considerations Following AA v Persons Unknown

On January 17, In AA v Persons Unknown [2019] EWHC 2556 (Comm), the Commercial Court held that a cryptoasset such as Bitcoin is a form of property capable of being the subject of a proprietary injunction. Although this is not the first case before the English courts that considers whether cryptoassets might be property, it is the most detailed and effectively confirms the position set out in the Legal Statement of the UK Jurisdictional Taskforce (UKJT) on cryptoassets and smart contracts from November 2019. The decision is likely to be a matter of importance in a variety of commercial contexts from taxation and sale of goods legislation to the taking of security and insolvency scenarios.

Cryptoassets as Property

In a co-authored piece published in Thomson Reuters’ Practical Law, Orrick’s Jacqui Hatfield and Rebecca Kellner recently considered whether cryptoassets can constitute property by analyzing the issue through the lens of taking security over cryptoassets. In it, the pair note that “security may only be taken over property, and the type of security that can be taken over a particular cryptoasset, and the process for doing so, will depend on the type of property that cryptoasset amounts to or represents. Therefore, in order to establish whether security may be taken over a cryptoasset, the type of property (if any) which that cryptoasset represents will need to be considered.”

To work out what type of property a cryptoasset represents, they suggest this would be looked at by the courts in the same manner with which the Financial Conduct Authority analyzes cryptoassets – by looking through the “crypto” label to consider what the token represents underneath. The court would effectively consider the underlying function of that token and the rights it confers on its owner.

The authors then set out the law as it stands as it applied to classifying cryptoassets as property:

“under English law, only (i) real property (land) and (ii) personal property (choses in possession (property that is possessed, i.e. goods or equipment) and choses in action (rights enforceable against a third party, e.g. money in a bank account or shares in a company)) are considered property.

“Cryptoassets are not real property, nor may they be physically possessed. Therefore, they can only be considered property to the extent they are choses in action. Cryptoassets that represent a right that may be enforced against a third party may be treated as choses in action and therefore, fall within the definition of property. Examples of such cryptoassets include the following:

  • Security tokens that represent shares or debentures.
  • Asset backed tokens that represent property.
  • Tokens that have been issued under terms which are enforceable against a third party.

“If a cryptoasset does not give the person holding those tokens any rights against a third party, it cannot be treated as falling within the definition of a chose in action. It would also not fall within the definition of real property, nor could it be possessed, so in this scenario, it is difficult to see how such a cryptoasset would amount to property under this strict definition of property, which enables security to be taken over it. Examples of these types of cryptoassets include the following:

  • Bitcoin, Ether and other cryptoassets that are fully decentralized and not issued by a central issuing authority. These give no rights to the holder which are enforceable against a third party.
  • Certain tokens issued by a central party for fundraising purposes (as in the case of initial coin offerings) that do not attach any claim against the issuer.” (emphasis added)

Despite the speed with which cryptoassets have infiltrated the financial system, the fact is that in England and Wales, what a cryptocurrency is in legal terms (a right, property or otherwise), owing largely to this somewhat anachronistic categorization of what constitutes property, remains unclear and unresolved.

In noting that there are already futures and exchange-traded notes in Bitcoin, Marc Jones of Stewarts Law LLP draws a comparison with conventional securities to highlight how the legal framework regarding what constitutes property in England and Wales is behind the curve when it comes to cryptoassets: “imagine a scenario where shares in a public company are regulated by a legal system in terms of how they can be promoted to the public; what information must be provided; to whom they can be promoted; in which jurisdictions, and so on. But the same legal system provides no answer as to how legal title in a share passes; whether and how security can be given over a share; what happens to a share in the event its owner becomes insolvent; whether a share can be trust property; and whether a share can be subject to a proprietary freezing order in the hands of an alleged fraudster.”

In November last year, the UKJT published its analysis of the status of cryptoassets and smart contracts under the law of England and Wales and concluded that cryptoassets are capable of being a form of property in law. It also determined that the novel features of cryptoassets (i.e. intangibility, distributed transaction ledger use, and decentralization) did not disqualify them from being property.

With regard to ownership, the legal statement declared that a person can acquire knowledge and control of a private key, and therefore become owner of the associated cryptoasset. This is considered to be the same as a person lawfully being in possession of a tangible asset and therefore being presumed to be the owner. In much the same way, a person can hold the key on behalf of another (e.g. an employer or client or on trust); and ownership can be shared through multiple keys. A person who unlawfully acquires a key through hacking is not the lawful owner, in the same way as someone who steals property is not the legal owner of that property.

The Legal Statement emphasized the ability of the English common law to adapt to new technologies and to rise to the challenge of applying existing law to new and unexpected situations. However, the Legal Statement is not legal advice, nor is it law. It is not a considered ruling from judges by way of case law, nor is it a legislative change. Therefore, while it provides (i) a potentially valuable analytical framework against which to understand the application of existing law and regulation and (ii) clarity in relation to the availability of existing legal remedies, the conclusions in the Legal Statement are not definitive and are subject to challenge.

AA v Persons Unknown

The case of AA v Persons Unknown concerned a private application for an injunction by a UK insurer. The UK insurer had insured on of its clients, itself an insurance company (albeit a Canadian one), against cyber crime attacks.

The client was the subject of an attack, where a hacker managed to encrypt all of the client’s computer systems and then subsequently sent a ransom request for payment in Bitcoin in exchange for the decryption tool. The insurer agreed to pay the ransom on behalf of the client. The insurer then hired a company to track the Bitcoin, which were placed on an account held by an exchange, Bitfinex. The insurer was seeking, among other things, a proprietary injunction in respect of Bitcoin held with Bitfinex.

Bryan J in AA v Persons Unknown noted that cryptoassets meet the four criteria set out in Lord Wilberforce’s classic definition of property in National Provincial Bank v Ainsworth [1965] 1 AC 1175 as being definable, identifiable by third parties, capable in their nature of assumption by third parties and having some degree of permanence.

The judge identified that traditionally, English law views property as being of only two kinds: choses in possession and choses in action, and that cryptoassets do not sit neatly within either category.

However, the judge considered that on a detailed analysis, it is “fallacious” to proceed on the basis that English property law does not recognize other forms of property. A cryptoasset might not be a chose in action on a narrow definition of the term, but that does not mean it cannot be treated as property. As a result, the Bitcoin (and by implication, other cryptoassets) were considered to be property and thus could be the subject of a proprietary injunction. Further, the judge noted his view that the Legal Statement was an accurate statement as to the position under English law.

Bryan J also noted that there are two English authorities where crypto currencies have been treated as property, albeit that those authorities do not consider the issue in depth. These are:

  • Vorotyntseva v Money-4 Ltd (T/A Nebus.com) and others [2018] EWHC 2596 (Ch), where there was no suggestion that crypto currency could not be a form of property, or that a party amenable to the court’s jurisdiction could not be enjoined from dealing in or disposing of it, and the High Court granted a freezing order against a company (and its directors) in respect of an amount of crypto currency which the claimant had given to the defendants. On the evidence before the court, there was a real risk of dissipation.
  • Robertson v Persons Unknown (unreported), 16 July 2019, (Commercial Court), where, following a theft of a number of Bitcoins, the judge accepted the argument that the Claimant had a proprietary claim over the Bitcoin and proceeded on the basis that Bitcoin could be personal property before making an asset preservation order in relation to Bitcoins which were stolen. By granting this order, the High Court treated the Bitcoin as property, which would allow for security to be taken over it. The Court also considered the UKJT analysis as ‘compelling’ in granting the order.

Implications

This is the first reported judicial consideration of the UKJT’s analysis of cryptoassets (otherwise a non-binding statement) and provides some further legal certainty over the classification of cryptoassets. Classifying cryptoassets as property has far-reaching implications that can have a real impact on how the asset can be dealt with. It enables (i) the law to recognize the legal rights of crypto currency investors, (ii) cryptoassets to sit more comfortably within the existing legal framework on property, which governs how they can be owned, used and transferred, as well as whether they can be charged and whether they would form part of insolvency/bankruptcy procedures, and (iii) courts to impose freezing and proprietary injunctions over them in cases of cyber attacks and theft.

It should be noted that the case considers the question of whether cryptoassets could be property only in the context of proprietary injunctions and therefore it is possible that alternative views could be reached in the context of other areas (e.g. corporate insolvency). Although this judgment is a helpful indication of how the law could apply in those circumstances, it would not be a binding precedent in matters beyond the context of proprietary injunctions. Nevertheless, the analysis relating to the definition of “property” did not solely rely on the definition of “property” in the context of injunctions but was drawn from broader sources, which may prove instructive for the application of this analysis in other contexts. Further, the alternative interpretation (i.e., that cryptoassets can never be property) could lead to unfair and unexpected results.

With the crypto currency market continuing to grow exponentially, this increased legal certainty will likely serve to shore up market confidence. However, while the judgment is a helpful confirmation that cryptoassets could be considered property, it remains to be seen whether the other conclusions of the Legal Statement of the UKJT will be confirmed in the English courts – e.g., the recognition of a valid granting of security over cryptoassets. In fact, the City of London Law Society’s submission to the UKJT suggests it prefers to wait for a dispute to work its way to the Supreme Court before the fundamental legal status of cryptoassets is clarified – an obviously unsatisfactory result for interested parties such as investors, insolvency practitioners and trustees.

As Sir Geoffrey Vos, Chancellor of the High Court, remarked in a speech at the University of Liverpool in May 2019, when considering why smart contracts had not become ubiquitous yet: “mainstream investors are unwilling to part with real money without the assurance that there is a legal foundation for their engagement. Thus far, the legal uncertainty that pervades the use of so-called crypto currencies and cryptoassets for financial transactions has meant that the starting line has not been crossed. It will be crossed at some stage soon.”

While the relative legal certainty offered by Bryan J in AA v Persons Unknown does not represent a crossing of the proverbial starting line for smart contracts and cryptoassets to become more mainstream in financial transactions envisaged by Sir Geoffrey, it does bring this moment one step closer.

Still Waiting: SEC Again Delays Approvals of Bitcoin ETFs

As further evidence of the SEC’s resistance to the development of a regulated secondary market in bitcoin, on August 12 it delayed making a decision on three additional bitcoin exchange-traded fund (ETF) proposals.

On January 28, 2019, NYSE Arca, Inc. filed a proposed rule change under the Securities Exchange Act of 1934 to list and trade shares of the Bitwise Bitcoin ETF Trust. Also, on January 30, CBOE BZX Exchange, Inc. filed a proposed rule change under the Exchange Act to list and trade shares of SolidX Bitcoin Shares issued by the VanEck SolidX Bitcoin Trust. Finally, on June 12, NYSE Arca, Inc. filed a proposed rule change to list and trade shares of the United States Bitcoin and Treasury Investment Trust.

The Exchange Act mandates that a final decision be made within 240 days of such filings. In the case of the first two proposals, the SEC exercised its discretion and found it appropriate to designate the remaining time available under the 240-day maximum period “so that it has sufficient time” to consider it. Based upon the same rationale, the SEC delayed action on the other NYSE Arca proposal for 45 days. Accordingly, it designated October 13, October 18 and September 29, 2019, with respect to the Bitwise Bitcoin ETF Trust, the VanEck SolidX Bitcoin Trust and the United States Bitcoin and Treasury Investment Trust, respectively, as the dates by which it “shall either approve or disapprove the proposed rule change.”

These delays come as no surprise given the SEC’s disapprovals of similar proposals to list other bitcoin ETFs, most notably the multi-year effort of investors Cameron and Tyler Winklevoss to list the Winklevoss Bitcoin Trust on the Bats BZX Exchange, Inc. In rejecting these proposals, the SEC has cited numerous concerns, including the risk of market manipulation, market surveillance and a potential divergence with futures trading as some issues. It remains to be seen whether the SEC will have the same concerns when it rules on the pending proposals.

Three Yards and a Cloud of Dust: SEC Staff Provides Its “Plain English” Framework to Guide Future Discussions

The SEC chose a week that saw the price of Bitcoin spike by over $700 in an hour, kicking off a rally reminiscent of the go-go days of 2017, to issue its long-awaited “plain English” guidance for determining whether a digital asset constitutes a “security” under the federal securities laws.

The SEC also unexpectedly released its first no-action letter to a company planning to issue a digital asset without registering the transaction under Section 5 of the Securities Act of 1933 and Section 12(g) of the Securities and Exchange Act of 1934.

Now that the dust has settled, we can start to analyze what all this means for the digital asset industry. Upon review, the Bitcoin rally might have been the more impactful event.

On April 3, a statement entitled “Framework for ‘Investment Contract’ Analysis of Digital Assets” (the “Framework”) was issued by Bill Hinman, Director of Division of Corporation Finance, and Valerie Szczepanik, Senior Advisor for Digital Assets and Innovation; and the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service.

The Framework goes out of its way to caution that it represents the views of the Strategic HUB for Innovation and Financial Technology of the Commission and is not a rule, regulation or statement of the Commission: that the Commission has neither approved nor disapproved its content; and that it is not binding on the Divisions of the Commission. The Framework further emphasizes its limited scope: “Even if no registration is required, activities involving digital assets that are securities may still be subject to the Commission’s regulation and oversight,” for example buying, selling, or trading; facilitating exchanges; and holding or storing digital assets. Thus, the Framework has limited utility from a factual, legal or precedential standpoint. Nevertheless, we expect it to be a significant source document that will be cited by the Commission, practitioners, and courts alike.

On the same day, the Commission’s Division of Corporation Finance issued its first no-action letter regarding digital assets to TurnKey Jet, Inc., a U.S.-based air carrier and air taxi service (the “No-Action Letter”). The No-Action Letter is not binding on the Commission and only applies to the very specific, and restrictive, set of conditions presented in the No-Action Letter request and, therefore, it does not have broad implications for the industry in general. Like the Framework, the No-Action Letter provides little guidance to the industry, but it should be touted as a step in the right direction, albeit a small step.

Though the Framework and No-Action Letter are not as helpful as some might have hoped, both are key developments that shed light on the Staff’s current views regarding the regulation of digital assets and the activities of industry participants under the federal securities laws.

The Framework

The Framework, which the Staff emphasized does not “replace or supersede existing case law, legal requirements or statements or guidance” from the SEC, largely relies on the 73-year-old Howey test for determining whether a digital asset is a security in the form of an “investment contract.” The Howey test is composed of four prongs: (i) an investment of money; (ii) in a common enterprise; (iii) with a reasonable expectation of profit; (iv) derived from the efforts of others.

The Framework succinctly analyzes the applicability of the first two prongs to an offer and sale of a digital asset in three sentences and reserves the other nine pages for the latter two prongs. It is reasonable to ask whether the existence of a common enterprise in an offer and sale of a digital asset is as foregone a conclusion as the SEC evidently believes.

The Framework introduces a term to identify the principal actor or actors in the development or maintenance of a digital asset network, an “Active Participant” or “AP,” broadly defined to include a “promoter, sponsor, or other third party (or affiliated group of third parties).” The activities of the Active Participants are emphasized as critical factors for determining whether a purchaser has a reasonable expectation of profits (or other financial return) to be derived from the efforts of others. This is an expansive reading of the Howey test. For example, under the Framework the following are indicative of reliance by the purchaser of a digital asset on the “efforts of others”: (i) when an AP promises “further developmental efforts in order for the digital asset to attain or grow in value”; (ii) when the purchaser expects that the AP will be “performing or overseeing tasks that are necessary for the network or digital asset to achieve or retain its intended purpose or functionality”; (iii) an AP creates or supports a market for the digital asset; (iv) an AP maintains a managerial role in the project; and (v) when a purchaser would reasonably expect the AP to “undertake efforts to promote its own interests and enhance the value of the network or digital asset.” As an aside, introducing the concept of “Active Participant” suggests that the SEC might be in the early stages of promulgating a refined regulatory scheme for digital currency that focuses on the role of actors whose efforts help maintain or enhance the value of existing currency.

In the section entitled “Other Relevant Considerations,” the Framework spells out how a digital asset can be structured to avoid being considered a security. As a general matter, the stronger the presence of certain identified characteristics, the less likely a digital asset would constitute a security under the Howey test. These characteristics include (i) the network is fully developed and operational; (ii) holders of the digital asset are immediately able to use it for its intended functionality; (iii) the good or service underlying the digital asset can only be acquired, or more efficiently acquired, through the use of the digital asset on the network; and (iv) the digital asset is marketed in a manner that emphasizes the functionality of the digital asset. However, some of the other characteristics cited would pose challenges for “traditional” digital asset issuances, including: (i) prospects for appreciation in the value of the digital asset are limited, e.g. the design of the digital asset provides that its value will remain constant or even degrade over time; and (ii) if the AP facilitates the creation of a secondary market, transfer of the digital asset may be made only by and among users of the platform.

The Framework briefly discusses when a digital asset “previously sold as a security” should be reevaluated at the time of later offer or sale. Relevant considerations in that reevaluation include whether purchasers “no longer reasonably expect that continued development efforts of an AP will be a key factor for determining the value of the digital asset.” The broad definition of AP is especially troubling when coupled with the Framework’s broad list of examples of continued involvement by the AP in the development or management of the network or digital asset because it arguably could apply to almost any project in the industry.

This discussion is largely a restatement of Director Hinman’s oft-cited speech “When Howey Met Gary (Plastic),” and is generally not helpful in addressing the great leap required to transition from a product developed by a group of identifiable individuals to a “de-centralized” organization. Note that the Framework does not address, among other things, the status of SAFTs and the issuance of tokens thereunder. It also says nothing about projects where sale of tokens are restricted to non-U.S. buyers, and U.S. residents later wish to use the tokens.

No-Action Letter

In the No-Action Letter, the Division of Corporation Finance indicated that, subject to specified conditions, it would not recommend enforcement action to the Commission if TurnKey Jet offers and sells its tokens without registration under the Securities Act and the Exchange Act. The No-Action Letter is instructive because it provides an example of the narrow range of activities that, under the Framework, would exclude a digital currency from treatment as a security. Some of the key features of the digital asset represented in the No-Action Letter request include:

  • TurnKey will not use any funds from the token sale to develop its platform, network, or application, and “[e]ach of these will be fully developed and operational at the time any tokens are sold.”
  • TurnKey’s tokens will be immediately usable for their intended functionality when they are sold.
  • The seller must restrict transfers of the tokens to its proprietary wallet.
  • The token’s marketing focuses on the functionality of the token and not its investment value.
  • The tokens will be priced at US$1 per token “through the life of the program” with each token essentially functioning as a prepaid coupon for TurnKey’s air charter services.

While TurnKey can celebrate being the recipient of the first no-action letter regarding the registration requirements of the Securities Act and the Exchange Act applicable to digital assets, the highly restrictive covenants it must abide by to avoid registration are in conflict with the characteristics of most ICOs and, therefore, the No-Action Letter provides little relief to the typical industry participant.

Although the Framework and the No-Action Letter largely reiterated what digital asset market participants already knew, taken together they have opened the door to further constructive discussions with the Staff that, hopefully, will produce more clear-cut guidance based upon the analysis of specific cases.

Appellate Court – Selling Bitcoin in Florida Requires a Money Services Business License

Following a recent opinion by a Florida appellate court, virtual currency dealers who do business in, from, or into Florida – even individuals in the business of selling their own virtual currency for cash – may be required to obtain a “money services business” license from Florida’s Office of Financial Regulation and maintain costly anti-money laundering programs in accordance with Florida and federal law or face criminal penalties.

On January 30, Florida’s Third District Court of Appeal reinstated criminal charges against Florida resident Michell Espinoza for money laundering and “unlawfully engaging in the business of a money transmitter and/or payment instrument seller without being registered with the State of Florida.” State v. Espinoza, No. 3D16-1860, slip op. (Fla. Dist. Ct. App. Jan. 30, 2019). The trial court had previously dismissed the charges against Espinoza, agreeing with his argument that selling Bitcoin does not qualify as “money transmitting” under Florida law because Bitcoin is not “money,” among other reasons. State v. Espinoza, No. F14-2923 (Fl. Cir. Ct. July 22, 2016). The appellate court disagreed and determined that even a person in the business of selling his own Bitcoin for cash is a “money transmitter” and “payment instrument seller” under Florida law and is therefore required to be licensed as a “money services business.”

The charges against Espinoza stem from a sting operation in 2013, in which undercover detectives contacted Espinoza through a Bitcoin exchange site, LocalBitcoins.com. Espinoza posted on that site that he would sell Bitcoins for cash through in-person transactions. Espinoza was not licensed or registered as a “money services business” with Florida or federal regulators. An undercover detective met Espinoza several times and paid him a total of $1500 cash for Bitcoin, earning Espinoza a profit. During those transactions, the undercover detective allegedly made clear his desire to remain anonymous and said he was involved in illicit activity. For example, the undercover detective allegedly told Espinoza that he needed the Bitcoin to buy stolen credit card numbers from Russians.

The Florida appellate court’s determination that Bitcoins are “monetary value” and “payment instruments” under Florida law fits within a line of cases finding that Bitcoin qualifies as “money” for the purposes of money laundering and anti-money laundering laws. For example, in 2014 Judge Rakoff, a United States District Judge for the Southern District of New York, found that Bitcoin clearly qualifies as “money” or “funds” for the purposes of the federal money transmitter statute because “Bitcoin can be easily purchased in exchange for ordinary currency, acts as a denominator of value and is used to conduct financial transactions.” United States v. Faiella, 39 F. Supp. 3d 544, 545 (S.D.N.Y. 2014) (citing SEC v. Shavers, 2013 WL 4028182, at *2 (E.D. Tex. Aug. 6, 2013)). Some states have also codified virtual currency into their anti-money laundering regulations. For example, after the trial court determined that Bitcoin was not a “monetary instrument” that could be laundered under Florida’s money laundering statute, the Florida legislature amended the statutory definition of “monetary instruments” to explicitly include the term “virtual currency.” Fla. Stat. § 896.101(2)(f) (2017). Other states, however, have taken a different approach. Pennsylvania’s Department of Banking and Securities (“DoBS”), for example, recently published guidance that virtual currency, including Bitcoin, is not considered money under Pennsylvania law. “Money Transmitter Act Guidance for Virtual Currency Businesses,” Pennsylvania Department of Banking and Securities (Jan. 23, 2019).

The Florida appellate court found that Espinoza was operating as a “money transmitter” and therefore was a “money services business,” simply by engaging in the business of selling his own Bitcoin for cash and not otherwise acting as a middleman between parties. The trial court had applied the more common and narrow understanding that a “money transmitter” operates “like a middleman in a financial transaction, much like how Western Union accepts money from person A, and at the direction of person A, transmits it to person or entity B,” as explained by the appellate court.

To reach its conclusion, the Florida appellate court looked to the text of Florida’s money services business statute – which the court believes is critically different from federal regulations. Under both federal and Florida state law, a “money services business” is defined to include a “money transmitter.” Compare 31 C.F.R. § 1010.100(ff) with Fla. Stat. § 560.103(22). According to the Florida appellate court, the federal definition of “money transmitter” includes a third-party requirement. Under federal regulations, a “money transmitter” means a person engaged in the “acceptance of currency, funds or other value that substitutes currency from one person and the transmission of currency, funds, or other value that substitutes for currency to another location or person by any means.” 31 C.F.R. § 1010.100(ff)(5(i)(A) (emphasis added). In comparison, the Florida statute defines a “money transmitter” as an entity “which receives currency, monetary value, or payment instruments for the purpose of transmitting the same by any means.” Fla. Stat. § 560.103(23). The Florida appellate court found that, in contrast to the federal regulations, the Florida statute’s “plain language clearly contains no third party transmission requirement in order for an individual’s conduct to fall under the ‘money transmitter’ definition” and, as such “decline[d] to add any third party or ‘middleman’ requirement.”

The appellate court’s interpretation of the text of Florida’s statute is disputable. From a statutory interpretation perspective, the middleman requirement is arguably inherent in the plain meaning of the word “transmit,” which is defined by Merriam-Webster as “to send or convey from one person or place to another.” (Notably, Pennsylvania’s DoBS recently issued guidance interpreting the word “transmitting” in a comparable state statute to include a third-party requirement. See “Money Transmitter Act Guidance for Virtual Currency Businesses,” Pennsylvania DoBS (Jan. 23, 2019) (interpreting statute that “[n]o person shall engage in the business of transmitting money by means of a transmittal instrument for a fee or other consideration with or on behalf of an individual without first having obtained a license from the [DoBS]” to impose a third-party requirement).) It would, therefore, be reasonable to interpret Florida’s statute as consistent with federal regulations. Moreover, the Florida appellate court’s interpretation of the statute could have broad and troubling consequences. Although dicta in the Florida appellate court’s decision make it seem like the court is making a distinction between “merely selling [one’s] own personal bitcoins” and “marketing a business,” the court’s statutory interpretation leaves open the possibility that the mere act of selling one’s own property – without registering as a “money services business” – could be a crime.

While we watch to see whether Espinoza will appeal this decision to the Florida Supreme Court, virtual currency dealers should be aware that selling virtual currency in, from or into Florida may require a money services business license and the maintenance of an anti-money laundering program.

FCA Proposes Guidance on Cryptoassets, but Questions Remain

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In January, the UK’s Financial Conduct Authority (FCA) released a consultation on potential guidance on cryptoassets that provides useful direction on how cryptoassets fall within the current regulatory regime. This consultation, one of the publications resulting from the Cryptoasset Taskforce’s October 2018 final report, does not drastically alter the current regulatory landscape, but rather provides clarity on the FCA’s current regulatory perimeter. The consultation also references a consultation by Her Majesty’s Treasury (HMT) that is expected in early 2019, which will explore legislative changes and potentially broaden the FCA’s regulatory remit on cryptoassets.

The FCA consultation on guidance asks for responses to the questions it poses by April 2019. The FCA does not intend to publish its final guidance until this summer; the guidance noted in this consultation paper is subject to change and should not be considered the FCA’s definitive position. However, subject to the feedback that is received, the consultation gives a good indication of the FCA’s thinking with regards to the regulation and classification of cryptoassets. Some of the points highlighted in the consultation are discussed below.

Exchange Tokens / Anti-Money Laundering

The FCA has confirmed that exchange tokens, such as Bitcoin, Litecoin or Ether, do not fall within the regulatory perimeter. This had already been expressed in the Cryptoasset Taskforce’s report, but it is useful to have it repeated here.

However, exchange tokens will be caught (along with other cryptoassets) by the 5th Anti-Money Laundering Directive (5AMLD), which will be transposed into UK law by the end of 2019. HMT will formally consult on this, but the FCA expects that 5AMLD will catch exchange between cryptoassets and fiat currencies or other cryptoassets, transfer of cryptoassets, safekeeping or administration of cryptoassets and provision of financial services related to an issuer’s offer and/or sale of cryptoassets. Being caught by the 5AMLD does not, by itself, mean the cryptoasset will be subject to FCA regulation.

Security Tokens

The FCA’s discussion on the classification of security tokens is arguably the most anticipated part of its guidance on cryptoassets. The discussion makes clear that cryptoassets that fall within the definition of a security will be treated as such. However, given that cryptoassets can provide a range of rights and other characteristics, it can be difficult to determine whether they do fall within such definition. While noting that it can be difficult to categorize tokens, the guidance describes the most relevant traditional forms of specified investments that security tokens may fall into. The guidance also notes that products that derive their value from or reference cryptoassets, such as options, futures, contracts for difference and exchange-traded notes, are likely to fall within the regulatory perimeter, even if the underlying cryptoasset does not.

The FCA states in its guidance that tokens that are issued in exchange for other cryptoassets, and not for fiat currency, will not necessarily be exempt from the regulatory regime if they are considered security tokens.

Issuing of one’s own security tokens does not require the issuing company to have a regulatory licence, in the same way that issuing one’s own shares does not require a licence. However, authorization must be obtained by any exchanges in which the tokens are traded, advisers and brokers, and the financial promotions regime will need to be complied with.

Shares / Debt instruments

According to the consultation, if a cryptoasset has the features of a share then it will be considered a specified investment and certain activities involving it will require authorization or exemption. In determining whether a cryptoasset is classed as a share, the FCA has noted that a separate legal personality, and a body which survives a change of member, are significant but not determinative factors in classifying the cryptoasset. Other factors include whether the cryptoasset provides voting rights, control, ownership, access to a dividend based on the performance of the company or rights to distribution of capital on liquidation. Interestingly, the FCA has noted that the definition is dependent on company and corporate law.

There is a trend for token offerings to be packaged as “security token offerings” and promoted in accordance with security requirements, as ICOs are no longer attractive to investors. However, many of these “security token offerings” do not give equity rights. Calling a token a “security token” will not change the nature of the token itself. The FCA has not been clear on this subject, but arguably a security token that does not meet the company law and corporate law definition of a share can be treated as a utility token and not require the trading platform, broker or advisers to be licensed.

A cryptoasset that represents money owed to the token holder will be considered a debt instrument, and therefore will be considered a security token.

If the cryptoasset is considered a share or debt instrument, and is capable of being traded on the capital market, it will be considered a transferable security under the Markets in Financial Instruments Directive (MiFID), and the MiFID regime will apply. As with traditional securities, this does not require the security to be listed. If the cryptoasset is able to be transferred from one person to another in such a way that the transferee will acquire good legal title, it is likely a transferable security. It is important to note that a cryptoasset may be considered a share under the UK law, but not a transferable security under MiFID.

Warrants, certificates representing certain securities and rights and interests in investments

Warrants may be issued as cryptoassets in situations where an issuing entity issues A tokens, which will provide the token holder the right to subscribe for B tokens at a later date. If the B tokens represent shares or debentures (or other specified investments), then the A tokens will be considered warrants and therefore specified investments. It is important to note that for the A tokens to be warrants, the B tokens will need to be new cryptoassets issued by the issuing entity. If the A tokens provide a right to purchase B tokens from a secondary market, the A tokens will not be considered warrants.

Similarly, A tokens that provide the token holder with a contractual or property right over other investments (either in cryptoasset or traditional form) will be considered certificates representing certain securities. Cryptoassets which represent a right to or interests in other specified investments are also classified as securities.

Units in collective investment schemes

Certain cryptoassets may be considered units in a collective investment scheme, notably tokens that allow investors to invest in assets such as art or property. Provided the investments in the cryptoassets are pooled, and the income or profits that the cryptoasset holders receive are also pooled, it will likely be considered a unit in a collective investment scheme. Importantly, if the token holders have day-to-day control of the management of the investment, it will fall outside this definition.

Utility Tokens

Tokens that represent rewards, such as reward-based crowdfunding, or the access to certain services, will be considered utility tokens. Utility tokens do not have the features of securities, and therefore fall outside the regulatory perimeter. The FCA has noted that the ability to trade utility tokens on the secondary market will not affect the classification of the token – even though this may mean individuals purchase these as investments.

Payment Services and Electronic Money

The guidance confirms that the use of cryptoassets is not covered by the payment services, unless the cryptoasset is considered electronic money. However, where cryptoassets act as a vehicle for money remittance (i.e. the transfer of money from one account to another, perhaps with a currency exchange) then the fiat sides of the exchange will be caught by the payment services regulations.

While cryptoassets do not fall within the payment services regime, they may fall within the e-money one. To the extent that the cryptoasset is issued on receipt of funds (i.e. fiat currency, not other cryptoassets) and the cryptoasset is accepted by a person other than the electronic money issuer, it may be considered electronic money (unless it is excluded). This would include cryptoassets that are issued on receipt of GBP and are pegged to that currency, as long as the cryptoasset is accepted by a third party. Therefore, stablecoins that meet the definitions set out above may fall within the definition of electronic money.

Issues Outstanding

None of the guidance’s declarations is new, but the guidance does provide useful clarification. What is not clear is how utility or payment tokens wrapped in a security token wrapper but not containing traditional security/equity rights will be treated. In our view, if the token is a utility token dressed in a security token wrapper, it should not necessarily be treated as a security, for UK regulatory purposes including requiring an authorized multilateral trading facility (MTF) to carry out secondary trading. The FCA says nothing here conflicting with this, but it would be useful to have clarity in this regard.

The CFTC Wants to Know More About Ether: Your Feedback Could Impact Ether Futures in 2019

The CFTC is giving the public an opportunity to influence its views as they relate to Ethereum, Ether or similar virtual currencies or projects. On December 11, 2018 the CFTC issued a Request for Information (the “Request”) seeking public comments and feedback on Ether and the Ethereum Network. The Request “seeks to understand similarities and distinctions between certain virtual currencies, including Ether and Bitcoin, as well as Ether-specific opportunities, challenges, and risks,” according to the accompanying press release. The version of the Request published in the Federal Register states that public comments must be received on or before February 15, 2019.

Individuals and companies involved in cryptocurrency, especially if related to the Ethereum Network or one of its competitors, should consider making a submission. The Request states that information submitted to the CFTC will be used to inform the work of LabCFTC (a dedicated function of the CFTC, launched in 2017 to “make the CFTC more accessible to FinTech innovators”) and the CFTC as a whole. It appears likely that the CFTC will look to the submissions to assist it in deciding whether to green light Ether futures trading.

Of the over 2,000 cryptocurrencies currently in circulation, Bitcoin is the only one for which futures contracts are traded on regulated futures exchanges. Bitcoin is also the only cryptocurrency which the SEC (through Chairman Clayton’s testimony) has officially deemed not to be a security. As mentioned in the Request, a certain SEC senior official recently stated that offers and sales of Ether, in its current state, are not securities transactions. The SEC’s stance on Ether likely paves the way for the CFTC to green-light regulated futures exchanges, such as the Chicago Board Options Exchange, to offer Ether futures contracts.

The cryptocurrency market is desperate for some good news to pull it out of the prolonged bear market it is currently enduring. Many had hoped that the announcement of Ether futures would be the catalyst that turns the market around. It appears possible that the CFTC will authorize Ether futures contracts, once it has reviewed the comments submitted in response to this request.

 

HMRC Publishes UK Tax Guidance on Cryptocurrency for Individuals

On December 19, HM Revenue and Customs (“HMRC”), the UK’s counterpart to the US Treasury, published long-awaited (and arguably long overdue) guidance on the taxation of cryptocurrencies (which it refers to as “cryptoassets”), building on the UK government’s Cryptoassets Taskforce’s report that was published last year. This guidance is welcome in an area of law that needs to play catch-up to apply to income and gains on technology and digital assets. It is important to note that this guidance is limited to HMRC’s view in relation to individuals holding cryptoassets and does not extend to tokens or assets held by businesses. However, HMRC states its intention to publish further guidance in relation to the taxation of cryptoasset transactions involving business and companies sometime in the future.

The guidance confirms that HMRC does not consider cryptoassets to be currency or money for tax purposes and separates cryptoassets into three categories of “tokens”: exchange tokens, utility tokens and security tokens. This guidance focuses on the taxation of “exchange tokens,” a term encompassing assets such as Bitcoin, which presumably it considers to be the most prevalent and widespread. The approach is very similar to the IRS’ approach in this area in Notice 2014-21. HMRC considers that in the “vast majority” of cases, individuals hold (and acquire and dispose of) cryptoassets as part of a personal investment and will, therefore, be liable to capital gains tax. The analysis of whether the cryptoassets are held in the nature of a trade or an investment, and the consequential tax treatment, will largely follow the existing approach and case law but HMRC only expects individuals to be buying and selling cryptoassets with such frequency, level of organization and sophistication such that it amounts to a financial trade in itself in “exceptional circumstances”. If, following the application of the traditional analysis, the cryptoassets are considered to be held as part of a trade, then the Income Tax provisions will take priority over the capital gains tax provisions.

Individuals will be liable to Income Tax (and national insurance contribution, where appropriate) on cryptoassets which they receive from their employer as a form of non-cash payment (and which may be collected via withholding tax) and/or in return for “mining” the cryptoassets, “transaction confirmations” or “airdrops” The guidance describes these transactions and the applicable taxes. As discussed in the guidance, miners are the people that verify additions to the blockchain ledger. They may receive either cryptocurrency or fees for this function. An airdrop is where someone receives an allocation of tokens or other cryptoassets, for example as part of a marketing or advertising campaign in which people are selected to receive them. As pointed out in the guidance, while the receipt of cryptoassets is often subject to the income tax, appreciation will be subject to capital gains tax upon disposition.

In addition to the tax analysis, HMRC points out that cryptoasset exchanges might only keep records of transactions for a short period, or the exchange might no longer be in existence when an individual completes their tax return. The onus is, therefore, on individuals to keep separate and sufficient records for each cryptoasset transaction for the purposes of their tax records.

IRS to Virtual Currency Traders: No Formal Voluntary Disclosure Program

The IRS recently announced that it is not planning to establish a formal voluntary disclosure program for taxpayers who have unreported income derived from virtual currencies. Specifically, Daniel N. Price of the IRS’s Office of Chief Counsel stated on November 8, 2018 that he needed to dispel the rumor that had been circulating since last year that the IRS intended to establish a separate voluntary disclosure program for unreported income related to offshore virtual currencies. This is in contrast to the voluntary program that the IRS established for unreported income from offshore financial accounts.

Under IRS guidance from 2014, the IRS classified Bitcoin and other virtual currencies as property (rather than foreign currency). Accordingly, any income from virtual currency transactions is treated as either ordinary income or capital gains, whichever is applicable based on the activity that gave rise to the income (e.g. investment or mining). Because the IRS requires a U.S. taxpayer to report its worldwide income regardless of where that income was generated or where the taxpayer lives, a U.S. taxpayer could have significant income tax liability for its cryptocurrency activities that were conducted and remain offshore. In spite of this substantial U.S. taxpayer exposure, and despite the potentially enormous amount of unreported income from virtual currency activities, the IRS has provided relatively little guidance to taxpayers and tax professionals, given the complexity of the tax issues and reporting requirements triggered by virtual currencies. At the same time, as discussed previously in On the Chain, the IRS is preparing to collect the massive amount of tax from unreported income from Bitcoin-related trades.