On December 20th, 2018 two U.S. Representatives, Warren Davidson (R-OH, 8th) and Darren Soto (D-FL, 9th), introduced H.R. 7356, now known as the “Token Taxonomy Act” (the “Token Act”), which seeks to amend the Securities Act of 1933 (the “Securities Act”) and Securities Exchange Act of 1934 (the “Exchange Act”) to exempt digital tokens (“tokens” and/or “cryptocurrencies”) from the traditional definition of a security. The Token Act also proposes: (1) the first comprehensive definition of a “digital token” from Congress; (2) tax exemptions for pure virtual currency transactions; and (3) additional regulatory changes for “digital units.” This article breaks down the Token Act and analyzes the regulatory impact of its provisions, if enacted.
1. Excluding Digital Tokens from the Definition of a U.S. Security.
The Token Act’s attempt to exclude digital tokens from the definition of a security is not a sweeping effort to revamp nearly 100 years of precedent. Rather, it offers a narrow definition of the type of token regulatory agencies within the U.S., e.g., the Securities and Exchange Commission (“SEC”), have publicly stated do not constitute a security under the Howey test, and proposes an explicit exemption for tokens meeting such a definition. The underlying goal for this piece of legislation is twofold: (1) to address a nascent technology that disrupts traditional notions of finance and securities regulation; and (2) to provide regulatory clarity for stakeholders within the blockchain/cryptocurrency industry above and beyond the scant amount of administrative precedent set through isolated decisions and judgements.
Overall, the proposed definition outlines the technical and economic features of an exempted digital token. Specifically, the definition details the following characteristics: (1) token creation; (2) token transaction history; (3) decentralized token trading; and (4) economic token representation.
This first prong is broken down into three exclusive sub-prongs: (i) the token is created “in response to the verification and collection of proposed transactions;” or (ii) no central authority can impact the token creation or supply; or (iii) the token is created as an initial allocation of digital units in accordance with (i) and (ii). Overall, the token creation prong prohibits the token from being controlled by a common enterprise, aligning the definition with one of the four prongs of the Howey Test that is sued to determine whether a financial instrument is a security. Therefore, projects looking to fit within this definition may rely on this language as well as prior administrative precedent set by the SEC detailing how projects satisfied the Howey Test, e.g., DAO Report & Munchee Inc. decision.
Specifically, the first sub-prong contemplates a token created as a result of “the verification and collection of proposed transactions,” e.g., the Proof-of-Work (“PoW”) model underlying Bitcoin that uses computational power to verify transactions within the Bitcoin Blockchain. In other words, a major thematic point within this proposed definition is how the token is created and verified as a legitimate instrument to be used on a specific blockchain. This differs from traditional modes of finance – like fiat currency – where a medium of the currency is verified by public and private third parties, i.e., government and licensed entities. Alternatively, decentralized blockchain based tokens using PoW require consensus from a network of computational power, with no single entity controlling, verifying, or changing the processing of transactions. To be clear, not all blockchains are structured in such a way, and this proposed definition within the Token Act is attempting to carve out a specific place for tokens that fit this…for lack of a better term…decentralized model. Indeed, without getting into much detail, there are other ways of verification such as Proof-of-Stake (“PoS”) that approach the verification process differently.
Separately, tokens with a fixed set of rules dictating the token creation and supply have the ability to fit within the token creation prong. Just like no actor can control whether transactions are processed in PoW, a token business could structure the overall supply to ensure even the business itself could not change the supply. This shows how token projects like Paragon (“PRG coin”) and Munchee (“MUN”), whose tokens were categorized as securities by the SEC, clearly fall outside this prong. Recall in the Munchee decision, the SEC highlighted Munchee’s representation that it could “burn” tokens, thereby taking a portion of tokens out of circulation and causing an increase in the value of remaining tokens. This finding, among others, caused the SEC to determine Munchee Inc. was a third party controlling the value of the token, which satisfied the fourth prong of the Howey Test. Accordingly, Munchee would also fail this second sub-prong. Therefore, a portion of this creation prong relies on the notion that projects creating tokens should not code in the ability for the business to either control the verification of transaction process nor the overall supply of the token – a feat few token-based projects have accomplished.
Lastly, the third sub-prong is the hardest to decipher. It allows for an “initial allocation” of digital tokens. This seems to suggest tokens may be released at different stages, which traditionally poses issues with platform creation in the securities context. While this could change the common understanding within the industry that pre-sale tokens and airdrops may trigger securities regulation, the general takeaway for us is that pre-issued tokens still require a functioning platform and the rules dictating these tokens cannot be different from tokens created subsequently. Alternatively, this may be a special carve out for providing founders with an allocation of tokens. With that said, we believe further clarification is needed for this sub-prong language.
The “transaction history” prong of the four-part test is essentially a description of blockchain technology. Under the proposed definition, a token’s ledger of recorded transactions must be “distributed,” i.e., achieved through a mathematically verifiable consensus, and immutable by a single person or group of actors under common control. The “under common control” qualifier takes into account the open-source nature of blockchain technology and the ability of a community, rather than a centralized group, to propose and make alterations to the source code.
To qualify for the exemption, the token must also be tradable or transferable between persons without an intermediate custodian – the “exchange” prong. This is another straightforward provision and it describes an indispensable characteristic of most cryptocurrencies in that peer-to-peer transfers of tokens are available to all users.
In a similar vein, a recent ruling by the SEC against a decentralized exchange called EtherDelta throws a tangential wrench into common understandings of what a decentralized exchange actually is. Questions arise regarding the threshold of decentralization required to satisfy this prong. Does an exchange need to completely avoid data storage off of the blockchain? What if the entity behind the exchange creates a front-end user interface and promotes usage of the exchange? There are certainly questions that require clarification in this context due to the EtherDelta ruling.
With that said, there is most likely not much impact regarding this prong because it focuses on the ability of users to send tokens without any third-party intermediary. While EtherDelta was considered one of the first decentralized exchanges, it stood as a third-party intermediary in the eyes of the SEC. Regardless, this prong will most likely not be difficult for token-based projects to satisfy.
No Economic Rights
Lastly, and most importantly, the “economic” prong prohibits the token from representing a financial interest in a company or asset, including debt interest or revenue share. In the past, companies unsuccessfully touted the decentralized nature of the network to circumvent this prong. Indeed, many projects claimed their tokens where “utility tokens” that only provided functionality on a platform, and did not represent a financial interest, but SEC representatives disagree on several occasions. According to the SEC, only Bitcoin and Ether are sufficiently decentralized so as to not constitute a U.S. security. Furthermore, it is unclear whether investments in certain tokens constituted a security at their inception as opposed to after their networks were significantly developed. For now, it is important to acknowledge that any token providing an economic right will most likely not fall under the Token Act’s definition of an exempt token.
In fact, a growing sub-industry to the blockchain and cryptocurrency space deals with security tokens, which are tokens that represent some financial ownership in either a company or an asset. Akin to digital stock, security tokens are offered through a Security Token Offering (“STO”) analogous to a private placement, allowing investors to purchase ownership in a company or some future economic benefit such as a dividend payment. Indeed, companies all over the world are looking to tokenize their stock or traditional assets. We’ve worked with several companies to receive approval of a token offering from the SEC, but to be clear, these types of projects offer tokens pursuant to an SEC exemption. Thus, such token offerings are not structured to and need not comply with the definitions provided in the Token Act.
2. Taxation of Virtual Currencies Held in Individual Retirement Accounts
Moving away from the categorization of tokens, the Token Act also provides provisions regarding the taxation of virtual currencies. For example, in certain types of individual retirement accounts, the acquisition of “collectibles,” e.g., art, stamps, and coins (non-digital) constitute a distribution from the account, which constitutes a taxable event on the gain or loss from the transaction. Currently, exemptions apply for certain coins like gold and silver.
The Token Act proposes an exemption from the taxation of investments withdrawn from individual retirement accounts to invest in “virtual currencies.” (Note, “virtual currency” is a term used by FinCEN and the treasury, while the SEC typically uses “digital token,” but the terms are interchangeable).
While investors are likely not jumping at the idea of committing significant portions of retirement money to virtual currencies, some may desire exposure to Bitcoin or Ether but are unwilling to move their retirement savings into these tokens for fear of a hefty tax penalty. The Token Act offers a solution to this issue.
3. Tax Exemption for Pure Virtual Currency Transactions
The Token Act also proposes that exchanges of virtual currency be treated as nontaxable events. An analogy is the exchange of like-kind real property. If you traded your residence for another residence, you do not realize gain or loss on the transaction for tax purposes. In contrast, you do recognize gain or loss when you sell your house for currency.
The Token Act proposes to treat the exchange of virtual currency akin to the exchange of like-kind property, effectually deeming the transaction a non-taxable event. Therefore, after you traded BTC to ETH to PRL to XVG to LTC to BTC, you report your ultimate gain or loss rather than the gain or loss from all five transactions., which is the current model and has caused significant confusion for actors within the cryptocurrency industry. This tax exemption alleviates an enormous burden faced by all who took seriously their tax burden in the early days of trading cryptocurrency.
4. De Minimis Tax Exemption for Gains Realized from the Sale or Exchange of Virtual Currency for Other Than Cash
Finally, the Token Act proposes a second solution that addresses the problem discussed above – the tax reporting burden implicated when constantly exchanging virtual currencies. Under the Token Act, a gain of less than $600 from the sale or exchange of virtual currency for cash or cash equivalents will be excluded from gross income.
Overall, we believe the Token Act proposes sound adjustments to the regulatory treatment of digital tokens that would benefit users and businesses and help pave the way for increased adoption. If passed, several onerous tax reporting requirements for cryptocurrency transactions will be curbed. While the SEC has been the most active regulatory player as of late, comments from the Token Acts backers suggest that regulation of digital assets will continue to overlap among agencies including the Financial Crimes Enforcement Network (“FinCEN”), the Federal Trade Commission (“FTC”), and the Commodity Futures Trading Commission (“CFTC”). Accordingly, those operating within the space as well as others looking to enter should certainly consult legal and financial advisors in navigating the myriad of laws that might apply to their projects…especially when considering a token issuance.
Note: This Article does not address the Bill’s amendments to the Investment Advisor’s Act of 1940.