Partner Nicola McKinney explores IRS crypto proposals in Bloomberg

Partner Nicola McKinney argues that recent US Treasury proposals that would force crypto brokers to disclose details of their clients’ transactions fail to address the cross-border nature of many digital assets.

Nicola’s article was published in Bloomberg Tax and Bloomberg Law, 13 September 2023, and can be found here.

The US Treasury recently announced the roll-out of a new regulatory regime, aimed at the transparent taxation of crypto assets, and has opened a period of consultation and public hearings ahead of finalising these new rules. The new rules will extend the existing Inland Revenue Service (IRS) reporting regime for non-digital financial products and bring reporting for digital assets in line with traditional finance requirements. Despite this, however, early concerns have already been raised over the potential limitations of this regime, and its ability to effectively manage the evolving digital assets space.

Under the proposed regulations, brokers of digital assets will be required to collect internal customer information and to make reports about digital asset sales and exchanges.  This is a shift away from the current tax system, which places the burden on individual taxpayers and which can require them to provide information more easily gathered by digital asset service providers. Brokers, as a category, will include digital asset trading platforms, payment processors and some hosted wallets. Certain real estate transactions involving digital assets as consideration will also be caught in this drag net. However, crypto miners, who work to verify blockchain transactions, are exempted. The new regulatory regime, as currently envisaged, will also extend beyond cryptocurrencies to other types of digital assets. NFTs, for example, will also be caught by the regime, and this wider definition builds some futureproofing into the framework against new digital asset innovations and products.

Transfers of digital assets are recorded on the blockchain or similar distributed ledger technology and, while the transfers are themselves clearly visible, the ultimate owners – whether they hold the private and public keys or whether there are custodial arrangements in place – are not publicly recorded.  Where tax reporting and calculations are left to individuals who may have tax liability, the pseudonymous nature of blockchain transactions can therefore make it easier for those individuals to successful bring that liability to the attention of the IRS. Moving the burden to defined brokers and digital asset trading platforms is seen as a way to make these transactions more visible to the US tax authority and, by casting the net to a wider set of transactions, and reducing evasion in this way, it is estimated that the new rules will bring in additional tax revenue of about $28 billion over a decade.

The proposed rules look to target the increased usage of digital assets, and transactions which would attract reporting requirements were they carried out in fiat (standard currency) and are also aimed at reducing the scope for digital assets to be used to facilitate tax evasion and avoidance. Given the prevalence of this form of financial crime which is calculated to exist in the sector, it is unsurprising that the Treasury is looking to crackdown on crypto.

These proposals have been announced against a landscape of increasing regulatory action in the crypto industry. Notably, the SEC has significantly increased its enforcement action against crypto businesses in 2023. For example, a recent court ruling against the SEC in a dispute with Grayscale, which allows the crypto business to offer exchange traded funds to investors, seems unlikely to halt the commission’s efforts to normalise and regulate the industry, bringing it in line with traditional finance, and regulators are continuing to demonstrate a tough stance on digital assets.

Initial reactions to these proposed rules are mixed. Investor groups seem to welcome the regime as giving increased clarity to individual taxpayers, as much of the legwork for applicable transactions, including complex calculations, move away from them. Political reactions, however, have been divided. While Republican commentators have framed these proposals as anti-industry, key Democratic actors have stated they do not go far enough to police the sector and will move too slowly in a fast-paced an industry.  Crypto insiders will also likely carefully scrutinise whether the framework properly describes the ‘broker’ role, where the intermediary function may be minimal or non-existent, and this may impact the degree to which this regime will be effective.

With the IRS having first signalled reforms in 2021, there has been a significant delay in the publication, and with public hearings scheduled for November 2023, industry players will also likely offer written and oral contributions to the proposed regime. The initial target to finalise the rules by the end of this year is unlikely to be met. The new rules are also scheduled to be implemented in stages, with reporting requirements on sales due to be introduced first, and implementation of reporting on transfers to follow, so that the first real revenues are likely to be collected no earlier than 2026.

The Treasury’s regime also leaves a large potential lacuna, as these rules only apply to US-based sales and brokers, and don’t effectively tackle the cross-border nature of many digital asset transactions. The territorial limits of the proposed rules are clear and, while the definition of ‘broker’ is broadly drawn, the application in the sales context is limited to US-based transactions. If a transaction occurs at an office outside the US, it is exempt unless it involves a US payor or middleman. Non-broker and peer-to-peer transfers, as well as a potentially enormous number of offshore digital asset sales, will no doubt also limit the effect of the regulations, and the reality is that the burden on individual taxpayers may not change significantly due to the number of transactions which occur across borders. Enforcement in certain multi-jurisdiction transactions, which are technically caught, is also likely to prove difficult.

A broad spectrum of regulations and cross-border cooperation will still be required, if full oversight and regulation of the sector is the aim.