Cryptocurrency Regulations are Taking Shape
Cryptocurrency Regulations are Taking Shape
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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.
Regulatory Environment
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 declaredcryptocurrencies
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.
Taxation
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 Jurisdictions
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.
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