The regulatory landscape surrounding cryptocurrencies is a complex and often confusing one. Despite being called "currencies," the Internal Revenue Service (IRS) classifies them as property for tax purposes. On the other hand, the Securities and Exchange Commission (SEC) considers many initial coin offerings (ICOs) to be securities subject to registration requirements. In this article, we will delve into the definitions of these terms and explore their implications in terms of taxation and regulation.
A Brief Overview of Traditional Asset
Various regulatory agencies, including the IRS, SEC, and others, categorize assets into different groups for tax and regulatory purposes. These definitions are often based on Supreme Court case law, such as the Howey Test for securities, or may differ between regulatory agencies. It is crucial to grasp the fundamentals of these traditional asset groups before delving into the crypto world. The three primary classifications of financial assets are as follows:
1. Real Estate: Real estate refers to land and any structures or improvements built on or attached to it. When purchasing real property, certain fees and expenses become part of the property's cost basis, and specific tax rules and deductions apply.
2. Securities: Securities include stocks, bonds, and other financial instruments representing ownership or indebtedness. They encompass shares of stock, beneficial ownership interests in partnerships and trusts, evidence of indebtedness, and certain derivative financial instruments.
3. Commodities: Commodities encompass all products traded on U.S. commodity exchanges, including physical commodities and futures contracts. Generally, commodities are raw materials used in the production of consumer goods.
However, the rise of crypto assets has raised questions about how these traditional classifications apply to an increasing number of digital assets.
The IRS: Treating Crypto as Property
Property refers to securities, real estate, business assets, or any other form of assets. From a tax perspective, property has a cost basis that affects the calculation of taxable gains or losses. The IRS considers all virtual currencies, including cryptocurrencies, non-fungible tokens (NFTs), and stablecoins, as "property" for tax purposes. The IRS does not classify virtual currencies as "fiat" since they are not coin and paper money issued by a central bank. Instead, they are deemed "convertible virtual currencies," categorizing them as property.
As property, virtual currencies are subject to income and capital gains taxes. For instance, taxpayers must pay income tax on any virtual currency received as compensation. Additionally, they owe capital gains taxes on any increase in value over the asset's cost basis. Just like stocks, if you purchase low and sell high, you must pay taxes on the gains. However, the broad definition of property leaves room for ambiguities. For example, whether wrapped tokens trigger a taxable event remains to be seen. If they do, many cross-chain bridges could result in significant tax liabilities. Although the IRS has provided some clarifications, unresolved issues have led to uncertainty and potentially inaccurate tax filings.
The SEC: Identifying Some Tokens as Securities
Securities are fungible and negotiable financial instruments representing financial value, such as stocks or bonds. ICOs enable projects to raise capital and investors to participate in investment opportunities. Consequently, the SEC believes that many ICOs qualify as securities offerings. The agency has become increasingly aggressive in pursuing individuals and companies engaged in selling unregistered securities or perpetrating securities fraud.
The Howey Test is used to determine whether a transaction qualifies as an "investment contract" subject to disclosure and registration requirements. Under this test, an investment contract exists when there is an "investment of money in a common enterprise with a reasonable expectation of profits derived from the efforts of others." Applying the Howey Test to cryptocurrencies can be challenging. For example, many decentralized crypto projects may lack a common enterprise or a "nexus" with the other elements of the test. Furthermore, miners typically refrain from participating in governance or rulemaking activities, and developers are often unincorporated.
The CFTC: Considering All Crypto as Commodities
Commodities are basic goods used in commerce that are interchangeable with other goods of the same type, such as oil or gold. The introduction of Bitcoin futures contracts introduced another regulatory authority into the mix—the Commodity Futures Trading Commission (CFTC). According to the Commodity Exchange Act, the CFTC asserts that all cryptocurrencies are commodities.
While it lacks jurisdiction over the spot market, the agency regulates Bitcoin futures contracts. The CFTC also has jurisdiction when virtual currencies are involved in derivatives contracts or interstate fraud cases. For instance, the agency oversees the regulation of crypto exchanges and ensures compliance with reporting requirements. However, the CFTC faced significant criticism following the collapse of FTX.
Increased Enforcement Activity on the Horizon
The collapse of FTX placed substantial pressure on regulatory bodies like the IRS, SEC, and CFTC to intensify enforcement efforts and safeguard investors and consumers from fraud.
In addition to lawsuits brought by the SEC, CFTC, and Department of Justice against FTX leadership, enforcement actions were taken against Nexo, Genesis, Kraken, Paxos, Terraform Labs, and others in the subsequent months. Earlier this year, top financial regulators issued a warning to banking organizations, urging caution when engaging with crypto projects. The Federal Reserve also rejected an application from Custodia Bank to join the central bank's payment system.
Consequently, crypto companies may encounter greater difficulty when conducting transactions involving fiat currencies. SEC Chairman Gary Gensler has emerged as a particularly active regulator. Following the SEC's lawsuit against Ripple, the agency's enforcement actions aim to align crypto firms with the regulatory standards applied to other financial institutions. The SEC has pursued individuals for various offenses, including insider trading and promoting digital tokens in exchange for compensation, such as influencer marketing.
MiCA: A Potential Template from Europe
The Markets in Crypto Assets (MiCA) Act in Europe could serve as a model for future U.S. efforts. This landmark legislation introduces new requirements for crypto platforms, token issuers, and traders, aiming to enhance transparency and oversee transactions to protect consumers while fostering a vibrant crypto ecosystem. MiCA addresses several concerns, including:
1. Stablecoins must maintain sufficient reserves to meet redemption requests in the event of mass withdrawals.
2. Crypto companies must disclose their energy consumption and environmental impact.
3. Exchanges and other platforms must inform consumers about operational risks.
4. Providers may be liable for losing investors' crypto assets. Experts anticipate that these new rules will come into effect next year. In the meantime, Congress and other U.S. regulatory bodies could draw inspiration from this legislation when formulating their regulations.
In Conclusion, The IRS, SEC, and CFTC classify crypto assets into various categories, significantly impacting their taxation and regulatory treatment. By understanding these classifications, crypto traders, investors, projects, and businesses can ensure compliance and avoid costly penalties. Furthermore, international regulations like MiCA offer insights into potential future developments in the regulatory landscape.
