Overview
On June 7, 2022, Senator Cynthia Lummis (R-WY) and Senator Kirsten Gillibrand (D-NY) introduced the Responsible Financial Innovation Act (RFIA). This highly anticipated legislation is the first attempt at developing a comprehensive regulatory framework for cryptocurrency and digital assets.
The RFIA builds off proposals introduced this Congress and includes a number of provisions related to securities and commodities regulation. In addition, the RFIA amends the Internal Revenue Code to address and clarify issues related to the taxation and reporting of cryptocurrency and digital assets. Interestingly, the RFIA adopts one of the substantive provisions relating to digital assets in the Biden Administration’s “General Explanation of the Administration’s Fiscal Year 2023 Revenue Proposals,” known as the “Greenbook,” but not the other provision. Specifically, the RFIA adopts the provision permitting tax-free loans of digital assets, but not the provision permitting mark-to-market tax accounting for digital asset traders and dealers.
While this legislation attempts to address some of the largest outstanding questions related to the regulation and taxation of cryptocurrency and digital assets, it faces an uphill battle to be signed into law before the end of the 117th Congress. Heading into the 2022 mid-term elections, a number of Biden Administration and Democratic priorities are still awaiting action and will likely take priority this summer and fall over legislation like the RFIA. Further, this legislation will likely need to overcome the 60-vote threshold in the Senate to end a filibuster. However, the introduction of the RFIA in the Senate sets a new marker and will likely serve as a starting point in the next Congress for any legislation to regulate and tax cryptocurrency and other digital assets.
This update provides a summary of the tax provisions included in the RFIA.
Section 101 – Definitions
The bill would amend Title 31 of the US Code by adding several digital asset-related definitions, many of which are cross-referenced in the bill’s proposed tax provisions. In particular, the bill would broadly define “digital asset” as a natively electronic asset that confers economic, proprietary, or access rights or powers, and is recorded using cryptographically secured distributed ledger technology (or any similar analogue).
This definition seems to go beyond the approach taken in current section 6045(g)(3)(D) (as added by the Infrastructure Investment and Jobs Act (P.L. 117-58)), as well as the proposed OECD Crypto-Asset Reporting Framework, both of which limit the definition of digital asset to “any digital representation of value.”
The bill separately defines virtual currency, which is also referenced in the tax provisions. “Virtual currency” is defined as a digital asset that is used primarily as a medium of exchange, unit of account, and/or store of value, is not legal tender, and does not derive value from or is based by an underlying financial asset. Virtual currency also explicitly includes algorithmic and digital asset backed stablecoins.
Section 201 – De Minimis Exclusion
In order to make digital assets easier for people to use on a day-to-day basis to acquire goods and services, the bill exempts from gross income gain or loss from the disposition of virtual currency in a personal transaction for the purchase of goods or services, provided that the amount of gain or loss excluded does not exceed $200 (adjusted for inflation).[1] “Personal transaction” is defined by cross-reference to section 988(e), which generally provides that a personal transaction is any transaction entered into by an individual, unless the expenses properly allocable to it qualify as deductible business or investment expenses. For purposes of the de minimis exemption, all dispositions that are part of the same transaction (or a series of related transactions) are treated as one disposition. The de minimis exemption does not apply to dispositions in which virtual currency is sold or exchanged for cash, cash equivalents, digital assets, or other securities or commodities. The de minimis exemption is would apply with respect to transactions entered into after December 31, 2022.
The bill also provides that the Secretary of the Treasury (the Secretary) shall issue regulations providing for information returns on virtual currency transactions for which gain or loss is recognized. This reporting provision is an “off-Code” meaning that it is not included with other information reporting provisions in the Internal Revenue Code. The provision is potentially far broader than the amendment to section 6050I made by the Infrastructure Investment and Jobs Act, as it is not limited to acceptance of virtual currency in the context of the recipient’s trade or business and arguably applies to sales of goods or services as small as $200 (rather than the $10,000 threshold in section 6050I) or to any conversion of virtual currency to cash, cash equivalents, digital assets, or securities or commodities. Such a broad information reporting requirement would be surprising, but the language gives the Secretary that authority.
Section 202 – Broker Clarification
This bill addresses concerns related to the scope of the definition of broker included in the Infrastructure Investment and Jobs Act. The bill clarifies and narrows the current definition of broker for reporting requirements under section 6045(c)(1)(D) (as amended by the Infrastructure Investment and Jobs Act) to better align with the definition of a traditional broker. The bill defines a broker as “any person who (for consideration) stands ready in the ordinary course of a trade or business to effect sales of digital assets at the direction of their customers.”
The existing statutory language “responsible for regularly providing any service effectuating transfers” is arguably broad enough to include ancillary services that keep the platform running, for example validators, wallet providers, and software developers who create the digital assets or protocols for transferring the digital assets. In a February 2022 response to a December 2021 letter from a group of six senators, the Department of Treasury (Treasury) stated that, in their view, ancillary parties who do not have information useful to the Internal Revenue Service (IRS) are not intended to be captured by the broker reporting requirements. The broker clarification in the bill attempts to codify Treasury’s anticipated narrower interpretation of broker into law. The bill builds off similar legislation that was introduced in the House and Senate to clarify the definition of broker.[2]
The bill also limits the information reporting requirement for transfers from digital asset brokers to non-brokers to apply to transfers from accounts “wholly controlled” by the broker and to limit the information to be reported to customer information that is voluntarily provided by the customer.
The bill also modifies the definition of a digital asset subject to reporting in section 6045(g)(3)(D) (as added by the Infrastructure Investment and Jobs Act) to align with the definition of digital asset included in this bill. The bill also extends the date for reporting the basis and holding period of digital assets to begin in January 2025 instead of January 2023.
Section 203 – Trading Safe Harbor for Non-US Persons
Generally, non-US investors are subject to US income tax on income that is effectively connected with the conduct of a US trade or business unless an exception applies. The bill would expand the so-called “trading safe harbor” exception under section 864(b)(2), which currently covers trading in securities and commodities, to explicitly cover trading in digital assets with respect to sales and exchanges occurring after December 31, 2022.
Under the expanded safe harbor, a non-US investor trading in digital assets in the United States through a resident broker, commission agent, custodian, digital asset exchange, or other independent agent would not be treated as engaging in a US trade or business (and therefore income effectively connected with such activities generally would not be subject to US income tax). In addition, provided that the non-US taxpayer is not a dealer in digital assets, trading in digital assets for the taxpayer’s own account, whether by the taxpayer, the taxpayer’s employees, or through an agent also would not be treated as a US trade or business. The expanded safe harbor would apply only to the extent the relevant digital assets are of a kind customarily dealt in on a digital asset exchange and if the transaction is of a kind customarily consummated at such exchange. Additionally, the expanded safe harbor does not apply if the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in digital assets are effected.
Section 204 – Decentralized Autonomous Organizations (DAO)
The bill defines and clarifies the tax treatment of DAOs. The bill defines a DAO as an organization that utilizes smart contracts to effectuate collective action for a business, commercial, charitable, or similar entity. In addition, the governance of a DAO must be achieved primarily on a distributed basis, and the organization must be incorporated or organized under state law as a DAO, cooperative, foundation or any similar entity.
The bill provides that a DAO is treated as a business entity that is not a disregarded entity. Because a DAO is unlikely to have only one member, that would leave its default classification for tax purposes to the existing regulations, which would not advance the ball much. Under the existing default rules, the DAO would be a partnership if the DAO is domestic or if it is foreign and at least one of its members does not have limited liability. This would create administrative difficulties, as DAOs have many members and there may be significant turnover which would make passthrough treatment burdensome. Presumably, a DAO would be able to file a check-the-box election to be treated as an association taxed as a corporation in order to alleviate the administrative difficulties.
The bill also allows for management of the DAO’s treasury and charitable fundraising to be excluded from the calculation of business activity, if the organization would otherwise be a social club as described in section 501(c)(7). It is not clear how tax-exemption will work with DAOs that are not engaged in a trade or business, but this provision would open the possibility for a DAO to be tax-exempt under section 501(c)(7).
Section 205 – Digital Asset Lending Agreements
Under current law, section 1058 generally provides that no gain or loss will be recognized by a taxpayer that lends securities if the transfer of a security is pursuant to an agreement that meets certain requirements. In recent years, a market for the lending of digital assets has developed, and it is now growing rapidly. Except in the case of digital assets that may also be treated as securities, section 1058 does not currently apply to loans of digital assets. The bill would amend section 1058 to treat digital assets as securities for purposes of the exclusion from gross income, thus subjecting digital assets to the same requirements applicable to securities. However, the bill provides that this section will not be construed to classify digital assets as securities for purposes of securities laws. The bill would also provide authority to the Secretary to implement the provision, including application of section 1058 to forks and airdrops.
The bill also incorporates additional changes to section 1058 that were proposed in the Greenbook to: (1) clarify that fixed-term loans are subject to the nonrecognition rules if they are made in the ordinary course of a securities lending or investment management business; (2) provide that income must be taken into account by the lender as it would have accrued to the lender if it continued to hold the asset; and (3) provide authority to the Secretary to determine appropriate basis adjustments, including when the loaned asset is returned.
Section 206 – Implementing IRS Guidance
The bill would require the Secretary to issue guidance within one year, a highly ambitious timeline, relating to five different tax issues.
First, the bill would require the Secretary to issue guidance providing that forks, airdrops, and similar subsidiary value is taxable only upon the affirmative claim and disposition of the subsidiary value by the taxpayer. This appears to require Treasury and the IRS to modify their conclusion in Revenue Ruling 2019-24 that hard forks are taxable at the time they are recorded on the blockchain.
Second, the bill would require the Secretary to provide guidance to implement the broker reporting and cash reporting rules enacted by the Infrastructure Investment and Jobs Act.
Third, the bill would require the Secretary to provide guidance to implement section 208 of the Act deferring income related to mining and staking rewards.
Fourth, the bill would require the Secretary to provide guidance treating charitable donations of digital assets greater than $5,000 that are traded on established financial markets as readily valued property not requiring a qualified appraisal.
Fifth, the bill would require the Secretary to provide guidance characterizing payment stablecoins (as defined in section 101 of the Act) as indebtedness for tax purposes.
These grants of authority are “off-Code” meaning that they will not appear in the Internal Revenue Code.
Section 207 – Retirement Investment in Digital Assets
The bill directs the Comptroller General of the United States to conduct a study and report to Congress by March 1, 2023, on issues related to retirement investing in digital assets.
Section 208 – Digital Asset Mining and Staking Rewards
In Notice 2014-21, the IRS provided guidance that mining rewards are included in income at the time they are received. The same presumably holds for staking income, but the IRS has not addressed staking rewards in guidance. The bill would provide that mining and staking rewards are not included in income until the taxpayer disposes of the digital asset produced or received in connection with the mining or staking activities.
Section 209 – Conforming Language/Charitable Contributions
Section 206 of the bill instructs the Secretary to allow for the charitable contribution of digital assets that are traded on established financial markets to not require a qualified appraisal. However, the conforming language in section 209 of the bill is much broader and would exempt contributions of any digital assets, not just ones traded on established financial markets, from the appraisal requirements.
Endnotes
[1] The bill is similar to, but further developed, than the Virtual Currency Tax Fairness Act of 2022 (H.R. 6582).
[2] See Keep Innovation in America Act (H.R. 6006); see also S. 3429.
