Roger M. Brown is the Global Head of Tax Strategy at Chainalysis.
On August 25, 2023, the U.S. Internal Revenue Service released proposed regulations that would require domestic and foreign exchanges and other types of “brokers” who “effect sales” of digital assets to (1) collect identifying information on their customers, and (2) report trading activity of U.S. customers to the IRS and those U.S. customers. U.S. taxpayers and the IRS would receive the same type of information returns for digital assets that they receive for trading in traditional financial assets with existing brokers, such as stocks and bonds, when the regulations become effective — generally in 2025.
The 282-page regulatory package implements portions of the Infrastructure Investment and Jobs Act, and will only have legal effect after the IRS considers comments of stakeholders and implements the regulations in temporary or final form. The proposed regulations are more easily understood when analyzed through a lens focused on four questions:
Who has to report?
Brokers who “effect sales” of digital assets have documentation and reporting obligations. Under the proposed regulations, brokers include exchanges, digital asset payment processors, digital asset kiosks, and digital asset “middlemen.”
The way a digital asset middleman is defined would cause certain entities and individuals supporting the operation of decentralized exchanges to be treated as brokers. In particular, a digital asset middleman is defined as any person, including a company or decentralized autonomous organization (DAO), who provides a “facilitative service” with respect to a digital sale and would ordinarily would be in a position to know:
- The identity of the party that makes the sale, and
- The nature of the transaction potentially giving rise to gross proceeds from the sale
“Facilitative services” are services that directly or indirectly effectuate a sale of digital assets, including providing access to an automatically executing contract or protocol, trading platform, automated market maker system, order matching service, service to discover the most competitive buy and sell prices, or escrow service ensuring that both parties to a sale perform under their obligations.
A person is in a position to know the identity of the party making the sale when the person has the ability to modify the operation (or terms of use) of the platform providing the facilitative service, such as a website through which the platform is accessed. Similarly, a person is in a position to know the nature of the transaction when the person can determine that the transaction is a sale based on the proceeds (consideration) received when a sale is completed.
The proposed regulations contain a number of exemptions to broker status. These include persons whose activities are limited to validating transactions as part of proof of work, proof of stake, or other blockchain consensus mechanism. However, centralized or decentralized businesses that offer these services may still need to evaluate the potential application of other withholding and/or information reporting provisions to assess their potential applicability. Artists who sell NFTs and merchants who directly receive digital assets as part of sale of goods or provision of services also are not brokers, but merchants may need to consider other reporting obligations if the transaction value involving digital assets exceeds $10,000.
When does reporting apply?
Generally, brokers must report sales of digital assets effected for their customers unless the broker can treat the customer as an “exempt foreign person” based on the documentation the broker receives or the application of certain presumptions. Another exemption to reporting exists for sales of digital assets effected for “exempt recipients.” Categories of exempt recipients are outlined in the existing regulations and generally include corporations, dealers in securities or commodities, and government entities. Some degree of onboarding still may be necessary in order to apply this exemption for exempt recipients. Alternatively, certain technology solutions can be employed to aid in compliance.
Regarding customer documentation, there are many nuances in how the rules apply, including variation based on whether the broker is engaged in a money services business; whether the broker is organized in or outside the United States; whether the sale occurs at an office (including kiosk) of the broker inside the United States; how certain presumption rules apply; and whether a non-U.S. broker receives indicia of the U.S. status for the customer, such as U.S. address, U.S. telephone number, transfer to/from U.S. broker or U.S. financial institution, or the customer’s use of a U.S. internet service provider (ISP).
As the most effective time for obtaining customer documentation is during onboarding and U.S. indicia may arise after a customer initially onboards, many digital asset brokers may seek to obtain (electronic) withholding certificates from their foreign customers. In addition, onboarding processes may be augmented to screen for indicia of U.S. status, including, when appropriate, confirming non-U.S. status through other documentation that the non-U.S. person provides.
What to report?
The proposed regulations require a broker to report identifying information for the U.S. taxpayer and certain information relating to the transaction. The forms on which brokers actually report information may add to or revise this list, but in particular, the broker is to report:
- The U.S. taxpayer’s name, address, and taxpayer identification number
- The name, type, number, date, and time of digital assets sold
- Gross proceeds the seller received from the sale
- Gross proceeds from using digital assets to pay trading fees to the broker
- Wallet address(es) from which a digital asset was transferred as part of the sale
- The transaction identification or hash associated with the sale, where the sale or transfer into the customer’s account occurs on-chain.
For purposes of the required reporting, transactions involving fungible and non-fungible tokens are treated as digital assets subject to reporting. Although transactions involving stablecoins are also subject to reporting under the proposed regulations, transactions involving Central Bank Digital Currencies (CBDC) are not unless the CBCD is exchanged for a digital asset. This is because a CBDC is treated as cash under the proposed regulations.
When to report?
The proposed regulations state reporting for proceeds from digital asset sales would begin for transactions occurring after January 1, 2025.
Reporting of tax basis would begin for transactions after January 1, 2026. However, where a U.S. customer of a broker acquired a digital asset in an account of the broker on or after January 1, 2023, the post-January 1, 2026 reporting would apply to that basis where the digital asset was continuously held in the broker’s account (for brokers providing hosted wallet services).
Conclusion
As suggested by their length, the proposed regulations contain many more details on a variety of topics such as documenting customers, computing gain, allocating transaction fees, derivatives, and coordination rules between different reporting regimes. In addition, the preamble to the proposed regulations expressly invites comments on more than 49 questions. This is a clear sign that the IRS is interested in input from a variety of stakeholders.
If social media posts are indicative of the focus of many of the comments that will be shared in advance of the November 7, 2023 public hearing, the application of the proposed regulations to participants involved in decentralized finance and the reporting of wallet addresses will be key topics. These issues were foreshadowed in the FATF (2021), Updated Guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers and the original draft of the OECD Crypto Asset Reporting Framework.
If commentators are to be successful in influencing the drafters of the regulations, they may need to allay the IRS’ tax compliance concerns arising from reports that trading volumes on some decentralized exchanges exceed trading volume on some large centralized exchanges; basis tracking on transfers to, from, and between unhosted wallets; and, given the majority of digital assets are held in private wallets, the increase in noncompliance when there is no third-party reporting (as described in the preamble to the proposed regulations).
Commentators may also need to distinguish a broker’s ability to comply with the Travel Rule, and address the applicability of technology solutions that currently allow customers of U.S. centralized exchanges to do technology-enabled onboarding (including electronic KYC and W-8BENs).
Appropriately crafted, many in the public and private sectors may view a tax information reporting framework as positive development, as it places digital assets on regulatory par with traditional financial assets in seeking to address tax compliance challenges (and can reduce taxpayer challenges in computing taxable income). That said, the digital asset ecosystem is more complex, nuanced, and dispersed than the traditional financial system. There will be clear instances where a participant is a broker, and other instances where one is not. Ideally, the lines drawn between each of these poles will strike the appropriate balance between satisfying tax compliance objectives while promoting the entrepreneurial innovation present throughout the ecosystem.
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