Summary:
- The digital asset community submitted more than 120,000 comments voicing concerns about the Proposed Regulations by the Treasury and IRS, focusing on the potential negative impact on investor privacy, decentralized projects, and the unfair burden placed on the digital asset industry compared to other financial sectors.
- We need to develop a tax framework that captures economic gains without hindering technological innovation or infringing on user privacy.
- The U.S. should align globally in the digital asset space by adopting a transparent, practical, and efficient tax reporting framework that respects the unique attributes of digital assets, suggesting specific amendments and exclusions to minimize complications and encourage innovation.
A record 120,000 digital asset tax comments submitted
In mid-November, we saw the digital asset industry coalesce in raising significant concerns in response to a digital asset taxation regime (Proposed Regulations) proposed by the Department of Treasury (Treasury) and the Internal Revenue Service (IRS). While taxation is not typically a hot topic that jumps to the top of pre-Thanksgiving conversation, the digital asset community sent well over 120,000 comments to the government, many of which raised alarm regarding the draconian impact the proposals could have on investor privacy, decentralized projects, and much more.
There is a fundamental concern that can be gleaned from the community’s feedback: the Proposed Regulations impose greater obligations on the digital asset industry than to all other corners of financial services and markets, and fail to take into account the unique nature of digital assets. For instance, the Proposed Regulations expand reporting obligations on digital asset payments intermediaries where such requirements do not exist in traditional payments. And, the Proposed Regulations further seek to impose obligations on certain digital asset service providers that lack access to the very information required to be reported. It is critical to fully understand and consider how digital asset transactions are facilitated to create a workable regime and avoid hindering the technology’s full capability.
While it is important to develop a tax framework that properly accounts for economic gains, such a framework should neither stifle innovation, nor compromise user privacy. The proposed definition of “broker” and “digital assets” could have unintended significant consequences over DeFi protocols, self-hosted wallets, NFTs, and more. But, it is possible to prioritize both responsible innovation and the safeguarding of consumers.
The Proposed Regulations provide an overly broad definition of “broker”
As written, the Proposed Regulations provide an overly broad definition of “broker,” implicating activities that do not traditionally fall within the ambit of broker activities. The definition should be refined to include only brokers that directly effect sales of digital assets for customers, which would better align the regulations with the treatment of recognized financial service models. There are parallels with more familiar models to better balance regulatory oversight and innovative practices in the digital asset ecosystem while providing for a more accurate understanding of broker activities.
Material privacy concerns are raised by the Proposed Regulations
There are also material privacy concerns raised by the Proposed Regulations. As one example, the proposed rules require wallet addresses to be reported with respect to sales transactions. This ignores the fact that transmission of wallet address information significantly heightens the risk that such information is intercepted by parties other than the government and customer. The Proposed Regulations could promote excessive collection of user information because they require that multiple “brokers” report on the same consumer transactions. This poses serious data security risks in the digital age. For example, user data linked to wallet addresses increase the risks of security breaches by exposing the history of transactions of identified individuals. Striking a delicate balance between regulatory vigilance and safeguarding user privacy is essential for the sustained growth and acceptance of digital assets in the financial landscape.
Proposed Regulations could lead to redundant reporting
Relatedly, there is a concern that the Proposed Regulations would lead to redundant reporting where covered financial transactions were already subject to existing reporting regimes. To address this, a simple amendment could be added whereby existing reporting rules should control reporting in cases where a transaction can be reportable under multiple regimes. Our approach would simplify the reporting process, promote efficiency for market participants, and alleviate the regulatory hurdles that result from having to adhere to multiple guidelines.
There are also several exclusions and clarifications that would enhance the efficacy of the Proposed Regulations. Overall there is a need for an approach that is appropriately tailored to the unique nature of digital assets. Notably, NFTs offering rights to non-financial digital files could be excluded from reporting requirements. This recognizes the fact that NFTs serve purposes beyond traditional financial transactions. Another recommendation would be the exclusion of stablecoins from the Proposed Regulations as they do not pose the same risk of tax avoidance as other digital assets that have the capacity for meaningful appreciation. These recommendations should help achieve a regulatory framework that reflects the distinct characteristics of digital assets and minimizes unnecessary complications for market participants.
Overall, we should have a consistent and transparent approach to determining tax reporting responsibility. Reporting requirements should reflect how digital assets and digital asset service providers actually work. They should not treat the digital asset industry punitively and should strike a proper balance between creating accountability and preserving consumer privacy. Lastly, recognizing the undertaking required for implementing the regulations, we recommend extending the deadlines by which covered entities must comply with certain reporting requirements. Such extensions would provide any covered entities with the necessary time to build and execute appropriate compliance systems.
Global progress on crypto tax issues
We are seeing great regulatory progress, including on tax policy issues, in other global jurisdictions. Part of the reason is that regulators and policymakers in other jurisdictions are recognizing the need to acknowledge and embrace the unique attributes and transformative potential of digital assets. It is going to be a race to the top as various jurisdictions look to cement their status as true hubs of digital asset innovation and commercial growth. I certainly hope that the US will lead on this as well, including with respect to the contemplated tax reporting regime under the Proposed Regulations. To do so, it is critical that a tax framework embodies practicality, transparency, and efficiency in the reporting space, while fostering a regulatory environment that takes into account the distinct inherent attributes of digital assets and the digital asset industry.
