Bates Research  |  11-15-21

New Crypto Regulation: Taxation and Oversight Underway, Stablecoins Gaining Support

New Crypto Regulation: Taxation and Oversight Underway, Stablecoins Gaining Support
Image © [Vitalii Vodolazskyi] /Adobe Stock

Government entities have begun in earnest to address concerns over the rapidly expanding crypto marketplace. Recent industry reports assert that the crypto market surpassed $3 trillion in market cap this month, and there are projections that the global crypto-asset management market size will grow from $0.4 billion in 2021 to $1.2 billion by 2026. Since our last post on the subject, which highlighted SEC Chair Gary Gensler’s observations on regulatory gaps on cryptocurrency trading platforms, Congress passed the Infrastructure Investment and Jobs Act, and the President’s Working Group on Financial Markets issued a substantial report on a framework for regulating stablecoins. 

These actions on taxation and oversight are the first real steps toward regulation of an industry that the SEC Chair only recently likened to the "Wild West." Here’s a closer look at the soon-to-be-new law on digital asset taxation and the proposed regulations on stablecoins amid the broader debate on crypto regulation. 

The Infrastructure Act and Crypto

The Infrastructure Act, signed into law by the president on November 15, 2021, has two significant features. It amends the Internal Revenue Code to expand broker reporting obligations to digital asset transactions, and — consistent with anti-money laundering regulations — it requires the filing of reports to the IRS when crypto-assets are moved from an exchange and/or on transactions valued at more than $10,000.

As to tax reporting, the law would impose on brokers who provide services effectuating transfers of digital assets the obligation to issue a Form 1099-B to their customers. Cryptocurrency exchanges like Coinbase and Robinhood are considered brokers under the new law.

Implementation will be problematic. First, the broad definition of “broker” in the law remains a source of real objection, as unintended digital market participants (including, e.g. noncustodial blockchain intermediaries, software developers, crypto-wallet developers or “miners”) could be included under the term. Second, information on the sales of digital assets by exchanges could create significant reporting and accounting inaccuracies if an exchange does not have access to information regarding the cost basis for a sales transaction. (Where it does, the 1099 will be accurate.) The use of self-custody wallets would add to the accounting complexity, and creates additional implementation questions, as they store private keys and can be used for transactions in, for example, decentralized finance applications.

As to the filing of reports on digital assets valued at more than $10,000, that provision of the new law purports to apply the same rule to digital assets as to cash. Under the new provisions, cryptocurrency exchanges must now report information to both the IRS and to their customers. However, the implementation of the provision between individuals not using an exchange has been called “unworkable and arguably unconstitutional” by a cryptocurrency non-profit research center. The gist of the legal criticism is that the new provision “asks one American citizen to inform on another if the transactions in which the two are engaged are ‘business’ and if they take place using … cryptocurrencies.” That is arguably different than the reporting obligation on a traditional transaction permissible under the Bank Secrecy Act, as such obligation is placed on a third party and judged allowable under the Fourth Amendment “Third-Party Doctrine.” (For an interesting discussion, see also: “What You Need to Know about the Third-Party Doctrine.”)

In short, the new law obligates both parties to a transaction to collect “sensitive information from her counterparty and hand that to government officials without any warrant or reasonable suspicion of wrongdoing.”

The reporting requirements under the law take effect January 1, 2023, and will affect tax returns filed in 2024. The Treasury Department will have to work out the guidance and issue new implementation regulations in the interim.

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A Legislative and Regulatory Framework for Stablecoins

On November 1, 2021, the President’s Working Group (“PWG”), together with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, issued a report detailing both the promise and financial and economic stability risks from stablecoins – a “type of digital asset generally designed to maintain a stable value relative to the U.S. dollar.” The report acknowledged that, “if well-designed and appropriately regulated, stablecoins could support faster, more efficient, and more inclusive payments options” for households and businesses as a means of payment.

The report also cites myriad risks, in light of rapid technology advances and the advent of digital asset trading platforms. These include market integrity and investor protection risks such as speculative trading (either on exchange platforms or under decentralized finance arrangements), fraud and misconduct in trading (e.g. “market manipulation, insider trading, and front running, as well as a lack of trading or price transparency”), illicit finance and anti-money laundering risk, risks associated with fluctuations in a stablecoin’s value (and the possibility of a run), or risks related to a stablecoin’s payment chain, among others.  

The agencies urged Congress to act promptly to pass legislation “to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.” The agencies recommended that Congress (i) require stablecoin issuers to be insured depository institutions, subject to appropriate supervision and regulation; (ii) require custodial wallet providers to be subject to appropriate federal oversight; (iii) provide the overseeing regulator the authority to require appropriate risk-management standards of all those involved in the functioning of the stablecoin arrangement;  (iv) require that stablecoin issuers comply with activities restrictions that limit affiliation with commercial entities; and (v) authorize federal supervisors to be able to impose criteria that encourage stablecoin interoperability. A fact sheet accompanied the publication of the report.

While the PWG report was supported by the financial regulators — acting Comptroller of the Currency Michael J. Hsu stated: “I fully support the recommendations in today's paper. Stablecoins need federal prudential supervision to grow and evolve safely.”) — it was SEC Chair Gensler who reminded firms that, while Congress considers the recommendations, “we at the SEC and our sibling agency, the Commodity Futures Trading Commission, will deploy the full protections of the federal securities laws and the Commodity Exchange Act to these products and arrangements.”

Conclusion

The new infrastructure law contains provisions that will expand tax reporting obligations on all digital transactions — an effort that in practice will likely require significant legislative interpretation, rulemakings, and regulatory guidance for effective implementation. As to the PWG report, the administration urged speedy enactment of legislation on stablecoins — perhaps the most straightforward (and some might say least risky) type of digital asset in the crypto market. These actions on taxation and oversight may seem tentative in the context of the speed and growth of the market (and their implementation is several years out), but they are real steps forward in building a framework to address the unique risks inherent in blockchain products and services. That said, until we see what a fully formed regulatory regime for crypto looks like, firms should recognize the substantial enforcement tools regulators already have and the recent statements by those regulators to use them. Bates will keep you apprised.

Editor’s note: This article was updated 11/16/2021 to reflect that President Biden signed the Infrastructure Act into law on Monday, 11/15/2021.

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