Despite significant recent media coverage, questions remain regarding how regulators will treat cryptocurrencies. In light of these questions, it’s critical for business leaders and investors to understand how U.S. regulators are approaching the rapid proliferation of cryptocurrencies.
Substantial price volatility, coupled with huge sums of investor money flowing into cryptocurrencies, have led regulators to issue guidance on how they view cryptocurrencies. The Internal Revenue Service (IRS), Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Financial Crimes Enforcement Network (FinCEN), Financial Industry Regulatory Authority (FINRA), and the Treasury Department are focusing on understanding how cryptocurrencies should be treated under existing laws and regulations, including those relating to protecting investors and preventing illicit activities such as “pump and dump schemes,” misuse of funds, and money laundering.
Classification of Cryptocurrencies
Traditionally, regulators classified an asset as either a security or a commodity. Regulators are concluding, however, that cryptocurrencies may be considered a separate “asset class” having the characteristics of both. In a hearing on February 6, 2018, regarding cryptocurrencies and the oversight role of the SEC and CFTC, the U.S. Senate Committee on Banking, Housing, and Urban Affairs suggested that both agencies may properly regulate cryptocurrencies. The CFTC had previously declared cryptocurrencies to be a “commodity” subject to oversight under its authority under the Commodity Exchange Act. In July 2017, the SEC issued a report determining that a cryptocurrency “token” offered by a “virtual” organization was a security under existing securities law,and that the offer and sale of the tokens was subject to federal securities law.
Raising Capital via Initial Coin Offerings
Cryptocurrency promoters use Initial Coin Offerings (ICOs) to raise capital by issuing cryptocurrency tokens or “coins.” Unlike a traditional initial public offering, the owner of a token or coin is typically not entitled to any equity or ownership interest in the offering company. Certain tokens or coins (referred to as “utility tokens”) provide the holder some benefit or right in future products or services. Often the tokens or coins can be, or at some point will be, traded on an exchange or platform.
It is clear that the SEC will seek to enforce existing securities law, with respect to ICOs and otherwise, where a cryptocurrency satisfies the traditional definition of a security. In late 2017, for example, the SEC issued a cease-and-desist order against Munchee Inc., a company issuing tokens without complying with existing securities laws. Munchee referred to its cryptocurrency as utility tokens that were to be used within its ecosystem. The SEC concluded, however, that the utility tokens, which were expected to increase in value based on Munchee’s business and efforts, and would be tradable in secondary markets, were in fact securities. In January 2018, the SEC issued a warning to cryptocurrency investors, noting that many promoters of ICOs and other cryptocurrency investments were not complying with federal and state securities laws.
The SEC has also stated that online trading platforms or exchanges for cryptocurrencies must be registered with the SEC (or otherwise satisfy an exemption from registration) and follow the same laws as other regulated marketplaces.
Due to these pronouncements, participants in an ICO should verify that the offering, and the offering company, are in compliance with existing securities laws, which may include limiting the ICO to accredited investors or other sophisticated investor classes, compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations, and satisfying certain SEC and other regulatory authority filing requirements.
In 2014, the IRS declared that it would treat cryptocurrencies as property (and not currency) for federal tax purposes, meaning that general tax principles applicable to property transactions apply to cryptocurrencies. As a result, each trade of a cryptocurrency is a taxable event which could generate gain or loss to be reported to the IRS. Some tax attorneys and practitioners have raised concerns that this view is not practical in light of the transactional nature of cryptocurrency, since each time an individual “spends” its cryptocurrency coins, it is treated as a taxable event. Indeed, early data indicates that cryptocurrency investors are not properly reporting and paying their taxes. Recently, the IRS successfully sued Coinbase, a leading cryptocurrency exchange, for access to customer records after only 802 people reported gains or losses from bitcoin in 2015.
Other countries are taking different approaches to regulating cryptocurrencies, which only adds to the existing complexity and uncertainty. Japan recently enacted its Virtual Currency Act, making it one of the first countries to allow cryptocurrencies to be used as a legal form of payment. In contrast, China recently banned cryptocurrency exchanges and is now blocking access to websites of all domestic and foreign cryptocurrency exchanges and ICOs. Some U.S. states are exploring their own cryptocurrency regulations. Arizona’s State Senate, for example, recently passed a bill to accept cryptocurrencies for income tax payments, and Vermont proposed a light tax on each cryptocurrency transaction. These, however, are all recent developments. As the technology proliferates and mainstream adoption progresses, it remains to be seen how U.S. and foreign governments will ultimately recognize and regulate cryptocurrencies.