Keyword: cryptocurrency

Transactors in Digital Tokens – New Bill Offers Hope

On December 20, 2018, Representatives Warren Davidson (R-Ohio) and Darren Soto (D-Fla) offered some early holiday hope to digital token issuers by introducing the “Token Taxonomy Act” (the TTA). If passed, the TTA would exclude “digital tokens” from the federal securities laws and would undoubtedly have profound effects for the U.S. digital token economy. The TTA is an ambitious piece of legislation that faces an uncertain future. Nevertheless, Representatives Davidson and Soto should be commended for attempting to provide some regulatory relief and certainty to an industry that has been yearning for it.

In addition to exempting digital tokens from the securities laws, the TTA would amend the Internal Revenue Code and classify the exchange of digital tokens as like-kind exchanges under Section 1031, and allow digital tokens to be held by retirement accounts.

The TTA would also amend language in the Investment Advisers Act of 1940 and the Investment Company Act of 1940 so that state-regulated trust companies, which include broker dealers, investment advisors and investment companies, would be able to hold digital assets for customers.

According to the TTA’s authors, the intention behind the bill is to provide much-needed regulatory certainty to digital token issuers and to ensure the U.S. remains competitive against other countries like Switzerland, where blockchain startups are thriving.

However, the TTA’s benefits are hypothetical at this point, since it is likely to be opposed by the SEC. On November 30, 2018, SEC Chairman Jay Clayton opined at a New York Times-hosted event that SEC rules were made by “geniuses” and “have stood the test of time.” He stated that he did not foresee changing rules “just to fit a technology.” While he was not referring specifically to the TTA, these comments indicate an unwillingness by the SEC to change its longstanding rules to accommodate a nascent technology.

Even if the bill is passed, it would permit the SEC to determine whether a particular digital unit qualifies as a security and therefore is subject to the SEC’s regulation. The SEC thus would have the power to halt an offering and force compliance with the applicable securities laws. The TTA would spare issuers from any penalties if they have acted in good faith and take reasonable steps to cease sales. But with an unclear, and a potentially costly or lengthy, appeals process, the SEC could discourage issuers from taking the risk of attempting to qualify and sell digital tokens from the start. This provision would blunt the intended deregulatory impact of the TTA.

Although its future is uncertain, the TTA shows that there are government leaders that are listening to the concerns of the digital token issuers. If the TTA is introduced in the 116th Congress, it will be a piece of legislation worth tracking. Even if this particular bill is not enacted, it might point the way to other legislation whose passage might provide some regulatory relief to those who transact in digital tokens.

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.

Dragged to the U.S. Courts (Part 3): The Importance of a Valid Forum-Selection Clause

We have said it in both part 1 and part 2 of this series: for a U.S. court to exercise its powers over a foreign defendant, it must have personal jurisdiction. But even if the court finds that it has jurisdiction, the defendant can request the court to transfer the case to an alternative forum, even to a different country, under the common law doctrine forum non conveniens. In In re Tezos Securities Litigation, the Swiss defendant Tezos Foundation failed in its attempt to transfer the action to Switzerland because of the operation of its forum-selection clause. In this final part of our series discussing jurisdictional questions for blockchain and cryptocurrency companies, we address two crucial factors that non-U.S. companies should consider when crafting a forum-selection clause.

Once a defendant moves to transfer the case by implicating forum non conveniens, the court will undertake a fact-intensive balancing of private and public factors, such as the location of witnesses and evidence, the enforceability of any judgment, avoidance of unnecessary conflicts of law, and administrative congestion. Generally, courts give great deference to the plaintiff’s choice of forum and transfer the case only if the balance of factors “strongly favors” the defendant. But this analysis changes when the parties have agreed to a valid forum-selection clause. As many courts have noted, and Judge Seeborg repeated in In re Tezos, “Because a valid forum-selection clause is bargained for by the parties and embodies their expectations as to where disputes will be solved, it should be given controlling weight in all but the most exceptional cases.”

In the Tezos case, the Swiss defendant argued that there were no exceptional circumstances preventing the court from giving controlling weight to its forum-selection clause, which stated that “[t]he applicable law is Swiss law [and] any dispute . . . shall be exclusively and finally settled in the courts of Zug, Switzerland.” This forum non conveniens motion, however, failed because the court found that the plaintiff had not been put on notice of the forum-selection clause and thus could not have consented to it.

While forum selection is a complex subject, the Tezos decision demonstrates one necessary requirement for any binding forum-selection clause, dispute-resolution clause, or indeed even contract – consent. Below are two factors from In re Tezos and other cases relating to online businesses that blockchain and cryptocurrency companies should consider if they want their forum-selection clauses to bind their website users:

  1. Choose clickwrap over browsewrap: A clickwrap or clickthrough agreement requires the user to engage with the website, usually by checking an “I agree” or “I accept” box. A browsewrap agreement attempts to bind users of the website by inferring assent to the terms and conditions. Generally, it is easier to prove notice and consent where a clickwrap agreement has been used, since the user is required to take affirmative action to show agreement to the terms and conditions. A browsewrap agreement may also bind the user, but this requires either (i) a showing that the plaintiff had actual knowledge of the agreement, or (ii) the website putting a reasonably prudent user on “inquiry notice” of the terms. The Contribution Terms of the Tezos ICO did not include a clickwrap agreement for the forum-selection clause. And, as discussed next, the browsewrap agreement itself was poorly executed.
  2. When using a browsewrap agreement, make the forum-selection clause visible: The question of whether a user has notice of the terms is likely to depend on the design and content of the website. If a link to a website’s terms of use (which includes the forum-selection clause) is “buried at the bottom of the page or tucked away in obscure corners of the website where users are unlikely to see it,” the courts are likely to refuse to enforce the browsewrap agreement (see Nguyen v. Barnes & Noble Inc., 763 F.3d 1171 (9th Cir. 2014)). Similarly, some courts have found that browsewrap agreements were not enforceable where the link to the terms and conditions was not visible without scrolling down to the bottom of the page, which was not necessary to do to complete the purchase (see Specht v. Netscape Commun’ns Corp, 306 F.3d 17 (2d Cir. 2002)).

A fundamental problem with the Tezos ICO Contribution agreement was that it did not actually include the forum-selection clause but instead had a single sentence, on page ten of the twenty-page agreement, directing users to “refer to the legal document that will be issued by the Foundation for more details.” Adding to the problems, the court noted that the relevant website did not even hyperlink to this legal contract with the forum-selection clause. Finally, Judge Seeborg added that even if Tezos Foundation had added hyperlinks and some language indicating a user’s “purported agreement,” the browsewrap agreement might still be held unenforceable, particularly against individual consumers.

After finding that the terms of the ICO did not provide sufficient notice that the plaintiff had agreed to Switzerland as the forum, the court applied the traditional forum non conveniens analysis and dismissed the transfer motion. Judge Seeborg added, however, that if discovery later shows that the plaintiff was, in fact, aware of the forum-selection clause, then he may consider dismissal or transfer of the case to the courts of Switzerland.

Despite Alleged Fraud, Judge Denies SEC’s Preliminary Injunction Request Based on Howey

Despite evidence of egregious fraud in the marketing of tokens, a judge in the U.S. District Court for the Southern District of California recently held the line against the SEC and denied its request for a preliminary injunction. In doing so, the court reaffirmed that in order for an injunction to be issued, the SEC must make a compelling showing that the tokens qualify as securities under the Howey test.

In Securities and Exchange Commission v. Blockvest, LLC et al., Judge Curiel of the U.S. District Court for the Southern District of California ruled on November 27, 2018, on a request by the SEC for a preliminary injunction against Blockvest, LLC and its principal Reginald Ringgold. The SEC’s request for a preliminary injunction came six weeks after the court granted a temporary restraining order in the SEC’s favor.

To obtain a preliminary injunction, the SEC bore the burden of showing that Blockvest and Ringgold committed a prima facie case of a securities law violation, and that such violation would likely repeat.  Specifically, the SEC alleged that Blockvest and Ringgold had engaged in an unregistered securities offering when selling proprietary BLV tokens to 32 individuals. The SEC argued that under the Howey test, these tokens qualified as securities because Blockvest and Ringgold engaged in a marketing campaign to induce purchasers to believe that, based on the efforts of Ringgold and Blockvest’s employees, the tokens would appreciate in value. Blockvest’s and Ringgold’s wrong would allegedly repeat because Ringgold demonstrated disregard for the SEC’s enforcement efforts in the days immediately after the initial delivery of its complaint.

Compounding the SEC’s case was the allegedly egregious fraud perpetrated by the Defendants. Ringgold represented that his offering was endorsed by the SEC, CFTC, and Deloitte Touche, as well as a fictional regulatory agency called the “Bitcoin Exchange Commission” that had the same address as the SEC and a seal modelled upon the seal of the SEC.

Despite the strong allegations of fraud, Judge Curiel denied the preliminary injunction because he gave credence to the Defendants’ rebuttals, and because the SEC had failed to make a compelling case. For instance, the court considered Ringgold’s assertion that the alleged 32 token purchasers were simply testers who had no expectation of profit; indeed, the pre-sale program through which the purchasers obtained the tokens had not yet even been cleared by the company’s compliance officer and the website where the purchases allegedly occurred was not operational.

All told, the court found that the SEC could not show that under the Howey test, any purchase based on an expectation of profit had actually occurred.  Likewise, the court concluded that the SEC could not show a reasonable likelihood of repetition of the wrong because no wrong had occurred in the first place, and Ringgold demonstrated intent to comply with securities laws going forward.

Dragged to the U.S. Courts (Part 2): Avoiding Personal Jurisdiction as a Non-U.S. Blockchain Company

Without personal jurisdiction over a defendant, a court cannot exercise its powers. And when it comes to non-U.S. companies who want to avoid being dragged to court in the U.S., Alibaba Group Holdings Limited v. Alibabacoin Foundation, No. 18-CV-2897 (S.D.N.Y.) and In re Tezos Securities Litigation, No. 17-CV-06779-RS (N.D. Cal.) show that the traditional jurisdictional analysis applies to blockchain technologies as much as to traditional companies. To further minimize the risks of U.S. litigation, blockchain-related companies should also heed the lessons derived from case law related to online businesses – other creatures of the modern age. This is the second part of our series discussing jurisdictional questions for blockchain and cryptocurrency companies. The first part, which can be read here, focused on how the location of the blockchain nodes may affect the court’s analysis.

U.S. courts can exercise personal jurisdiction over a foreign defendant who has either a continuous and systematic presence in the state (general jurisdiction) or “minimum contacts” with the state such that the exercise of jurisdiction “does not offend traditional notions of fair play and substantial justice” (specific jurisdiction). “General” or “all purpose” jurisdiction permits a court to hear all claims against the defendant, while “specific” or “case-linked” jurisdiction permits only those claims which stem from the defendant’s forum-related contacts (see Walden v. Fiore, 571 U.S. 277 (2014)). While some states have adopted additional long-arm statutes, the federal due process requirements must always be satisfied.

Most courts analyze the “minimum contacts” for specific jurisdiction in a three-part inquiry: (1) Does the claim arise out of the defendants’ forum-related contacts? (2) Did the defendant purposefully avail itself of the forum’s laws? and (3) Is exercising jurisdiction reasonable? We will now look at the second prong of the test and the steps that non-U.S. companies setting up operations can take to avoid purposeful availment.

In both Alibabacoin and In Re Tezos, the courts found that a foreign blockchain company with few physical contacts with the United States had purposefully availed itself of the U.S. laws. These cases conform with the principles found in case law related to online businesses. Following is a list of the relevant factors that courts have found showing purposeful availment by Belarus and Dubai defendants in Alibabacoin, by a Swiss defendant in In Re Tezos, and by various other online companies in other cases:

  1. An interactive website accessible in the U.S.: The courts in both Alibabacoin and Tezos agreed that an interactive website available in the U.S., alone, is not sufficient for personal jurisdiction. But the more functional the website, the more likely a court is to find personal jurisdiction (with additional factors present). For example, in Alibabacoin, the court found it relevant that the defendants’ website allowed a user to (1) register a cryptocurrency wallet, (2) access and download content about the Alibabacoin cryptocurrency and white paper, and (3) interact and contact sales representatives with questions.
  2. Using U.S. servers: If the claims brought against a foreign defendant stem from its online activity, the location of the servers can be relevant. In the Tezos case, the court found that the Swiss defendant’s use of Arizona servers was relevant to the securities law claims and personal jurisdiction (although insufficient on its own to establish jurisdiction). And in Alibabacoin, a trademark case, the court stated that “whether Alibabacoin’s Wallet website is actually hosted on servers physically located in New York may also be relevant to the personal jurisdiction inquiry.”
  3. Blocking IP address or providing notice to U.S. viewers: A very recent U.S. appellate court case noted that to avoid purposeful availment of U.S. laws, online businesses should consider blocking U.S. IP addresses (Plixer International, Inc. v Scrutinizer GmbH, 2018 WL 4357137 (1st Cir. 2018)). Even if the technical solution does not keep out all U.S. visitors, the Plixer court stated that the blocking attempt shows intent to avoid U.S. customers and is thus relevant to the jurisdictional analysis. If blocking is too aggressive a business strategy, foreign companies can try to avoid jurisdiction by adding notices on the website that their services or products are not available and intended to be used in the U.S.
  4. Marketing and advertising in the U.S.: Avoiding U.S.-specific media and U.S.-specific discussions can further improve a company’s chances in the jurisdictional analysis. In the Tezos case, the court found that the Swiss defendant using a “de facto U.S. marketing arm” and mostly marketing the ICO in the U.S. showed purposeful availment. The same was illustrated in the Alibabacoin case by the finding that over one thousand New Yorkers visited the defendants’ website and at least one New York resident purchased the tokens.
  5. Employees or agents working in the U.S.: If possible, non-U.S. companies should avoid moving their employees to the U.S., hiring in the U.S., or using U.S. agents. This was an important issue in the Tezos case: the court noted that the defendant “kept at least one employee or agent in the United States,” and this was “responsive” to the purposeful availment test.
  6. Working with U.S. service providers: Although for any contacts in question to create jurisdiction, they must give rise to the claims at issue (step 1 in the “minimum contacts” test), limiting reliance on contacts with U.S. service providers outright can lower the jurisdictional risk. In In re Tezos, the Swiss defendant’s use of a “de facto marketing arm in the U.S.” was an important factor in the court’s analysis. In Alibabacoin, the non-U.S. defendant had dealings with a U.S. company (Digital Ocean), which hosted the Alibabacoin website. But, in contrast to Tezos, because the plaintiff had not showed that Digital Ocean had an “active role” in administering the website or that Digital Ocean’s servers were hosted in New York, the court did not rely on this relationship as a basis for finding jurisdiction. Moreover, contacts with U.S. businesses can overlap with the previous point on marketing. For example, if a company used Google Ad Words to target areas of the U.S., it might increase the chances of the courts finding jurisdiction.
  7. Voluntary sales to the U.S.: Depending on the facts, claims and the state’s long-arm statute, even a few intentional sales into the U.S. may prove purposeful availment. For example, in Alibabacoin, the court highlighted that the plaintiff “presented evidence that at least one New York resident ha[d] purchased Alibabacoin on three occasions.” And in In Re Tezos, the court stated that a “significant portion” of the 30,000 ICO contributors were in the U.S. Similarly, after analyzing the federal case law on this issue, the Plixer court held that a German cloud computing company which “voluntarily service[d] the U.S. market” and made around $200,000 should have “reasonably anticipated being haled into U.S. court.” That court also noted that the Oregon Supreme Court had found jurisdiction over an out-of-state defendant that had sold over 1000 battery chargers totalling about $30,000 (Willemsen v. Invacare Corp., 352 Or. 191 (2012) (en banc)), while a district court in New Jersey did not exercise specific jurisdiction over a defendant who had made fewer than 10 in-state sales totalling $3,383 (Oticon, Inc. v. Sebotek Hearing Sys., LLC, 865 F.Supp.2d 501 (D. N.J. 2011)). Accordingly, voluntary and intentional sales to the U.S. should not be made and, if sales occur, blocking U.S. website visitors, or at least providing clear notice, becomes crucial.

When analyzing specific personal jurisdiction, the courts generally examine these factors together, and it is difficult to rank them in order of importance. The U.S. Supreme Court is expected in the coming years to decide on when online contacts are sufficient to create specific personal jurisdiction. Until then, In Re Tezos, Alibabacoin, and case law on online businesses serve as good guidance for non-U.S. blockchain companies.

Dragged to the U.S. Courts (Part 1): Jurisdiction and the Location of Blockchain Nodes

Following the 2017 ICO boom and the more recent declines in cryptocurrency prices, blockchain-related litigation has substantially increased. U.S. courts have seen most of that action: American regulatory agencies have been more aggressive than their foreign counterparts (the SEC alone has over 200 open investigations), and private parties regularly bring individual suits and class actions. Altogether, close to 100 cases have been filed.

In two recent cases, the courts—for the first time—ruled on jurisdictional questions related to foreign companies by considering the technical aspects of blockchain technology. The opinions in In Re Tezos Securities Litigation and Alibaba Group v. Alibabacoin Foundation illustrate the following three points:

  1. The physical location of the verifying nodes can affect the court’s jurisdictional analysis.
  2. On personal jurisdiction, existing case law related to foreign online businesses serves as useful guidance for blockchain companies seeking to avoid U.S. litigation.
  3. Strategic dispute resolution and forum selection clauses can save the day.

Considering the importance of these issues for avoiding U.S. litigation and the space required to provide enough legal background to meaningfully discuss them, each issue will be addressed in a separate On the Chain post. Today we will address the first point: location of the nodes (the individual devices part of the larger data structure maintaining a copy of the blockchain and, in some cases, processing transactions).

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The physical location of the verifying nodes can affect the court’s jurisdictional analysis

When a foreign defendant is sued in a U.S. court, the court must determine that the U.S. laws in question can be fairly applied and the court has personal jurisdiction over the foreign party. While well-developed legal principles continue to govern the analysis, when a party is a company that uses blockchain and distributed ledger technologies, its reliance on multiple nodes that are physically located across the world raises unique jurisdictional questions. The following two cases tackle this issue.

In re Tezos Securities Litigation, No. 17-CV-06779-RS (N.D. Cal. Aug. 7, 2018)

In In re Tezos, Judge Seeborg addressed whether U.S. securities laws apply extraterritorially to a foreign company that sold tokens to U.S. residents in an ICO. As the readers are probably aware, the Tezos ICO was one of the largest to date, raising over $230 million in July 2017. Tezos Foundation, a Swiss defendant, argued that the sale of the security was not a “domestic transaction” and therefore the Exchange Act did not apply. The Court then posed the question, “where does an unregistered security, purchased on the internet, and recorded ‘on the blockchain,’ actually take place?”

Although the Contribution Terms of the Tezos ICO stated that Alderney (an English Channel Island) was the “legal site” of the transactions and the place where the “contribution software” resided, the Court held that the transaction occurred in the U.S. for the following reasons: (1) the plaintiff participated in the ICO from the U.S. (paying in Ether), (2) payment was made through interactive website that was hosted on an Arizona server, (3) the website was primarily run by an American co-defendant located in California, and (4) plaintiff’s contribution of Ether to the ICO “became irrevocable only after it was validated by a network of global ‘nodes’ clustered more densely in the United States than in any other country.”

Alibaba Group Holdings Limited v. Alibabacoin Foundation, No. 18-CV-2897 (S.D.N.Y. Oct. 22, 2018)

But not all judges give this much weight to the location of the nodes. In Alibaba v. Alibabacoin, Judge Oetken also addressed questions of jurisdiction and the location of blockchain nodes. In Alibabacoin, a trademark case, the Dubai- and Belarus-based defendant (Alibabacoin) argued that the Court lacked personal jurisdiction over it because its ICO sales did not occur in the U.S., since the transactions “consist of ledger entries made in Minsk, Belarus, following observation of changes in ‘blockchain data’ outside the United States.”

In asserting U.S. jurisdiction, Judge Oetken did not buy this argument. The Court held that the place where the transaction is put on the ledger is not relevant, comparing this situation to an everyday online purchase: “it would constrain common usage to say that the transaction occurs at the potentially remote location of the servers that process the buyer’s banking activities and not at location where the buyer clicks the button that commits her to the terms of sale.” The Court concluded that the plaintiff had demonstrated with reasonable probability that personal jurisdiction over Alibabacoin existed, based on other factors, which will be addressed in the next post.

In the future, the courts are likely to continue to focus on blockchain data structure

In Re Tezos appears to be the first time the courts have considered the location of the nodes to be relevant for jurisdictional analysis. But the cases also show that the courts are only beginning to wrestle with this issue.  Jurisdictional analysis will always depend on individual facts and the claims asserted. For example, when focusing only on the fourth factor of Judge Seeborg’s analysis (the location of the nodes), all projects using ERC-20 tokens, which depend on the same cluster of Ethereum nodes, could be considered to operate to some extent in the U.S. Furthermore, the importance of the nodes in jurisdictional analyses is likely to rise because the cases currently in courts are mostly ICO-related. That is, most of the ongoing litigation does not stem from the operation of the blockchain technology but is related to fraud, trademark disputes, and failures to register with various regulatory agencies.

Soon when more blockchain projects become operational and disputes arise in relation to such issues as on-chain transactions, hacking, security failures, and disputes over the governing of the networks, the importance of the data structure of these networks will increase. As a result, the influence of nodes as a factor in the courts’ analyses is also expected to increase, and many foreign blockchain companies that are avoiding the U.S. may, nevertheless, be dragged to U.S. courts.

As will be discussed in the upcoming posts, there are steps a company can take to avoid litigating in U.S. courts, including the set-up of its operations, drafting of its contracts with customers and partners, and litigation strategies pursued in court.

IRS Advisory Committee Identifies the Need to Enforce Compliance on Cryptocurrency Transactions

A recent report (the “Report”) of the IRS Commissioner’s Information Reporting Advisory Committee (“IRPAC”) has identified the need for additional guidance on cryptocurrency transactions to enforce compliance on cryptocurrency transactions. The Report heavily relies on the recent experience the IRS had in enforcing the Coinbase summons, as recently reported in On the Chain. The IRS explained the problem earlier this year: because transactions in virtual currencies can be difficult to trace and have an inherently “pseudo-anonymous” aspect, some taxpayers may be tempted to hide taxable income from the IRS. IRS News Release, IR-2018-71, March 23, 2018. Taxpayers in this situation are at risk, given that, as recently reported in On the Chain, there is no voluntary disclosure program for taxpayers that have failed to report crypto related income.

In the Report, the IRS estimates that potentially unreported cryptocurrency tax liabilities represent approximately 2.5% of the estimated $458 billion tax gap. The calculation relies upon a recent article by Fundstrat Global Advisers, which sets cryptocurrency-related labilities at $25 billion, based on taxable gains of approximately $92 billon and a noncompliance rate of 50%. The Fundstrat Report estimates that approximately 30% of the investors in cryptocurrency are in the U.S., which is more than $500 billion at the end of December 2017 (up from about $19 billion at the start of January 2017!), according to data from CoinMarketCap.

While the IRS previously addressed certain issues in Notice 2014-21, there remain significant open issues that will need additional analysis and further guidance to refine the reporting of these transactions.  For example, the reports cites the following:

  1. whether virtual currency held for investment is a capital asset;
  2. whether the virtual currency ought to be treated as a security, subject or not subject to the wash sale rules, or affected by mark-to-market implications under section 475 of the Code;
  3. whether a taxpayer may use LIFO or FIFO to determine the basis of virtual currency sold;
  4. how to track basis through activities in the blockchain;
  5. whether broker reporting is required under section 6045 of the Code for transactions using virtual currency;
  6. whether a taxpayer may contribute virtual currency to an IRA; and
  7. whether virtual currency is a commodity.

Also, while an initial reading would suggest that virtual currency would not be considered a financial account for FATCA purposes, various guidance notes issued by foreign jurisdictions for purposes of implementing the Common Reporting Standard (CRS) have indicated virtual currency does represent a financial account.  This inconsistency, the Report notes, between regimes that purportedly try to maintain a high level of consistency will be confusing to withholding agents and subject to inherent error.

Citing the recent Coinbase summons and the failures to report income identified in that case, the Report opines that many, if not most, taxpayers will report their virtual currency activities correctly if they are able to determine their tax implications.  Some taxpayers will be tempted to do otherwise, however, because anonymity is inherent in the structure of the block chain activities.  In light of Coinbase, these taxpayers are likely to use exchanges outside the jurisdiction of the U.S.  The Report notes that it is unclear at present whether the U.S. may obtain information from foreign exchange activities (determining the exact nature of residence of the virtual activities of an exchange is itself vexing under existing source and jurisdiction rules, and leads to issues of whether the activities are sourced to any jurisdiction or are stateless income).

The Report concludes with IRPAC stating that it would be very interested in helping develop information reporting and withholding guidance on these important issues.

https://www.irs.gov/pub/irs-pdf/p5315.pdf

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.

The IRS is Closing in on Cases Regarding Bitcoin Income Reporting

Following a several-year court fight, the Internal Revenue Service (the IRS) appears to have obtained a substantial amount of information regarding individuals’ transactions in cryptocurrency, and the agency might be in a position to make criminal referrals of failures to report income from such transactions. In December 2016, the IRS, believing that virtual currency gains have been widely underreported, issued a summons demanding that Coinbase, the largest U.S. cryptocurrency exchange, produce a wide range of records relating to approximately 500,000 Coinbase customers who transferred Bitcoin, a virtual currency, from 2013 to 2015. Formed in 2012, Coinbase has served at least 5.9 million customers and handled $6 billion in transactions. Coinbase did not comply with the summons.

In seeking to enforce the summons in the Northern District of California, the IRS cited the fact that while approximately 83 percent or 84 percent of taxpayers filed returns electronically, only between 800 and 900 persons electronically filed a Form 8949, Sales and Other Dispositions of Capital Assets, that included a property description that was “likely related to bitcoin” in each of the years 2013 through 2015. Presumably, the IRS believes that more than 900 people made gains on bitcoin trading during that period.

On November 28, 2017, the court enforced but modified the summons by requiring Coinbase to provide documents for accounts with at least the equivalent of $20,000 in any one transaction type (buy, sell, send or receive) in any one year from 2013 to 2015. The order required Coinbase to provide: (1) the taxpayer’s ID number, name, birth date and address; (2) records of account activity, including transaction logs or other records identifying the date, amount and type of transaction, i.e., purchase/sale/exchange, the post-transaction balance and the names of counterparties to the transaction; and (3) all periodic statements of account or invoices (or the equivalent).

The IRS appears to be getting closer to the prospect of criminal cases:

  • In March 2018, Coinbase informed 13,000 of its customers that it would be giving information on their accounts to the IRS.
  • At the recent Tax Controversy Institute in Beverly Hills, Darren Guillot, Director (Field Collection), IRS Small Business/Self-Employed Division, said that “[he] has had access to the response to the John Doe summons served on Coinbase, Inc. for two months and has shared that information with revenue officers across the country.”
  • Bryant Jackson, Assistant Special Agent in Charge (Los Angeles), IRS Criminal Investigation Division, recently said that CI has been expecting fraud referrals from the Coinbase summons response.
  • CI and the Justice Department Tax Division have been discussing those anticipated cases and issues that may arise in them, such as proof of willfulness.

It is noteworthy that in Notice 2014-21, the IRS answered a series of questions related to the taxation of cryptocurrency (which it refers to as “virtual currency”). In the Notice, the IRS indicated that penalties would apply for failures related to the reporting of gains under section 6662 and failure to file information returns under sections 6721 and 6722. While the Notice specifically provided that penalty relief may be available to taxpayers and persons required to file an information return who are able to establish reasonable cause, it did not provide any indication as to whether reasonable cause relief would be available for taxpayers who failed to report cryptocurrency-related gains. More recently, on July 14, the Large Business and International division of the IRS initiated a Virtual Currency Compliance Campaign to address noncompliance issues.

While there may be valid reasons for failure to report cryptocurrency-related gains, taxpayers who are among the 13,000 Coinbase customers should be particularly concerned about the penalties that might apply due to the failure to report their gains.