The RFIA could ease tax compliance burdens for parties transacting in digital assets and defer or eliminate tax on some transactions.
By Jiyeon Lee-Lim, Elena Romanova, Ted Gkoo, and Jacob Nagelberg
Latham & Watkins presents a blog series on the Responsible Financial Innovation Act, which was introduced in the US Senate on June 10, 2022, to create a framework for digital assets, cryptocurrency, and blockchain technology. This fifth post in the series covers taxation issues.
Taxation issues are covered in Title II of the bill (Responsible Taxation of Digital Assets), which incorporates the new definitions for digital asset and virtual currency provided for in Title I of the bill (see discussion in this previous post).
The RFIA would modify the Internal Revenue Code (the Code) to provide new rules and extend certain existing rules to cover digital assets. It would also require that the Internal Revenue Service (IRS) issue guidance on several topics frequently requested by the digital asset industry.
In particular, Title II of the RFIA would:
- Defer recognition of income on mining and staking. The IRS has taken a position in Notice 2014-21 (and has subsequently reinforced the position through other guidance) that “convertible virtual currency” — a term defined in the Notice that includes Bitcoin and other cryptocurrencies — created by mining is taxable upon receipt by the miner. In a departure from the current IRS approach, the RFIA would provide that a taxpayer who conducts digital asset mining or staking activities would not recognize income upon receipt of digital assets until the taxable year of the disposition of the assets produced or received in connection with the mining or staking activities. An enactment of this provision would allow miners and stakers to defer income from their activities and may alleviate various administrative concerns related to valuing and tracking digital assets received by miners or stakers.
- Extend certain existing safe harbors to digital assets:
- The trading safe harbor for non-US persons. The Code currently exempts income of non-US traders (that are not dealers) in securities or commodities from US net income taxation regardless of such traders’ activities in the US. The RFIA would expand this safe harbor to all digital assets that trade on digital asset exchanges. A digital asset exchange would be defined to include any platform that facilitates the transfer of digital assets. Non-US traders currently may limit their trading within the US to digital assets that qualify as commodities. This provision would allow such non-US traders to diversify their trading in digital assets within the US significantly.
- Lending digital assets. The Code currently provides that no gain or loss is recognized on the transfer of securities under certain lending agreements. The RFIA would extend this non-recognition treatment to lenders when lending digital assets under agreements that provide for the return of identical assets. The RFIA would require that the lender include in its gross income an amount that would have been earned on loaned assets if the lender had not loaned and continued to hold such digital assets. The bill also would apply the non-recognition treatment to fixed term loans of securities or digital assets.
- Introduce a de minimis gain or loss exclusion. The RFIA would allow up to $200 gain or loss on disposition of virtual currency per transaction to be excluded from taxation, if the virtual currency was used by an individual in personal transactions to purchase goods or services. The bill provides for aggregation of related transactions and inflation indexing of the amount of exclusion. This proposal is analogous to the existing gain exclusion for personal transactions in foreign currencies. The proposal appears to encourage the use of virtual currencies as a payment method by reducing the tax compliance burden.
- Modify information reporting requirements. Information reporting requirements with respect to digital assets would be narrowed to apply only to persons who “stand ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers.” The current rule applies to anyone “providing compensated services in connection with transfers of digital assets.” On the other hand, the scope of the assets to which such information reporting requirements could apply would be broadened because of the expansion of the definition of a digital asset. In particular, digital assets would include any asset “that confers economic, proprietary, or access rights or powers,” in contrast to the current definition of a digital asset under the Code, which is limited to “digital representation of value.” However, the information a broker must report would be limited to customer information that is voluntarily provided by the customer and held by the broker for a legitimate business purpose.
- Clarify the status of decentralized autonomous organizations (DAO). DAOs are unique structures that often do not register as corporations, limited liability companies, partnerships, or other forms of business organizations. DAOs’ decentralized nature makes their characterization under the current Code and regulations unclear. The RFIA would provide that a DAO is treated as a business entity that is not disregarded, if such DAO is properly incorporated or organized under applicable laws of a US or foreign jurisdiction as a DAO, cooperative, foundation or any similar entity. Given most DAOs are not incorporated or organized in a formal manner, the practical application of this rule is unclear.
- Require the IRS to issue guidance on certain matters. The IRS would be required to issue guidance regarding:
- airdrops forks, and similar subsidiary value (based on the principle of the value being taxable to the recipients contingent upon the affirmative claim and disposition by a taxpayer);
- stablecoins being characterized as indebtedness;
- administrative requirements for valuation of certain charitable donations without a qualified appraisal;
- merchant acceptance of digital assets in connection with changes in broker reporting requirements; and
- mining and staking activities treatment introduced in the bill.
The RFIA, if enacted as introduced, would clarify significant aspects of the tax treatment of transactions in digital assets and activities related to such digital assets. Many of the proposed rules appear to be favorable to the parties trading, investing, and transacting in digital assets. Stakeholders have raised some concerns that such rules may create preferential treatment for digital assets or opportunities for tax avoidance. In that regard, the RFIA marks a significant step forward in creating a taxation framework tailored to meet the challenges of the developing digital assets technology, and opens public debate about striking the appropriate balance between encouraging technical innovation and maintaining tax revenues.