Responsible Financial Innovation Act, the new proposed crypto regulation bill, provides some clarity on tax issues

On June 7, 2022, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced a highly anticipated bill, the Responsible Financial Innovation Act, which would if enacted establish a regulatory framework for digital assets and cryptocurrency.  Also included in the bill are a number of tax provisions that have been generating attention and support from various stakeholders.  The proposed tax provisions would, if enacted, address at least a few of the industry’s largest complaints.

“Broker” definition

As discussed in a prior edition of this newsletter, the Infrastructure Investment and Jobs Act  enacted in November 2021 greatly expanded the reporting regime for cryptocurrency and digital assets, beginning in 2023.  With regard to the definition of “brokers” from the Infrastructure bill, opponents argued that the language was too broad and would capture developers, miners, and other industry players. 

To remedy this complaint, the Lummis-Gillibrand bill would provide a much narrower definition of the term “broker” – “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.” This new definition falls short of specifically limiting the reporting regime to cryptocurrency exchanges, but nevertheless seemingly excludes software and hardware developers, transaction validators, and individuals involved in developing digital assets for public use (provided they are not customers of such developer), which would be welcome news to the industry. 

Importantly, if enacted, the bill would delay by two years the reporting requirements for those included in the broker definition (to 2025).

Mining and staking rewards

Since 2019, the IRS’s position has been that cryptocurrency earned through mining is subject to tax when the rewards are earned, and, in a previous edition of this newsletter, we noted that the IRS seemingly would apply the same result to rewards earned through staking. 

The bill would, if enacted, provide for a very different treatment of mining and staking rewards – that is, mining and staking rewards would not be taxable upon receipt, but rather only when the rewarded cryptocurrency is disposed of in a taxable transaction. 

Specifically, the bill would amend Section 451 to provide that, “in the case of a taxpayer who conducts digital asset mining or staking activities, the amount of income relating to such activities shall not be included in the gross income of the taxpayer until the taxable year of the disposition of the assets produced or received in connection with the mining or staking activities.”

This change would be enormously consequential to taxpayers, both individual and institutional, engaging in staking or mining, as it would provide a significant deferral benefit.

De minimis exception for cryptocurrency transactions

Additionally, the bill contains a de minimis exception, which gives cryptocurrency transactions parity with foreign currency transactions. This provision would establish an exclusion from gross income for gain realized from digital asset transaction where the gain is $200 or less, where the taxpayer is an individual, and the digital asset is disposed of in a “personal transaction.”

The exception would provide many taxpayers with a less burdensome tax accounting exercise and could encourage retailers to accept cryptocurrency as tender for transactions.

Security loans

Further, the bill would implement a proposal made by the Biden Administration earlier this year (discussed here) by providing that loans of cryptocurrency would be taxed in accordance with the securities lending rules under Section 1058, allowing such loans to be made without realized gain or loss in the exchange. 

Safe harbors for securities and commodities trading 

The bill would specifically extend to cryptocurrency and digital assets the current safe harbors for securities and commodities trading activity made by non-US persons who use a US financial institution their trading (under specified conditions, including that the non-US person does not have an office in the United States).

The extension of the safe harbor rule is a welcome reprieve for non-US persons with concerns that their trading of cryptocurrency in the United States would submit them to US tax and tax reporting. 

DAOs

The bill also defines decentralized autonomous organizations (DAOs) as organizations which utilize smart contracts to effectuate collective action for a business, commercial, charitable, or similar purpose, and that are properly incorporated or organized under the laws of a state or foreign jurisdiction as a decentralized autonomous organization, cooperative, foundation or any similar entity.

In addition, the bill provides that, for tax purposes, the default classification of a DAO is “a business entity which is not a disregarded entity.”

Practically, this results in DAOs having an individual tax identity and associated tax return filings. Any tax and reporting changes brought about by this provision would be effective after December 31, 2022, if the bill is enacted.

Requiring IRS guidance on other issues

Lastly, the Bill would require the IRS, within one year, to issue guidance on a number of cryptocurrency related items, including airdrops, merchant acceptance of digital assets, digital asset mining and staking, charitable contributions of digital assets, and the legal characterization of payment stablecoins as indebtedness.

The next step for the bill is to advance in Congress. Senators Lummis and Gillibrand appear optimistic for its advancement; however, the final bill may contain considerable revisions to the current version.