Investing in Crypto? Beware of Tax Consequences

Many US investors are increasingly looking to cryptocurrency and blockchain companies as ideal vehicles in which to invest.

Early in the cryptocurrency boom, the IRS took the position that cryptocurrency was property and therefore, any purchase using a cryptocurrency is technically a taxable event (i.e. if you acquired the cryptocurrency for XX.XX and used it to purchase something for YY.YY, the difference is taxable). While enforcement has historically been somewhat weak, the IRS has recently issued subpoenas to cryptocurrency exchanges for information about non-compliant US individuals. Furthermore, the Biden tax proposals call for even further comprehensive reporting requirements for cryptocurrency, so that it would be hard to spend digital currencies without getting reported.

Some investors are turning to foreign companies engaged in crypto-related activities as investment targets. One of the main international tax issues of these investments is whether these companies are considered PFICs (Passive Foreign Investment Companies) for US tax purposes. A foreign company is a PFIC if more than 75% of its income is from passive activities or more than 50% of its assets on its balance sheet give rise to passive income. In order to determine whether a foreign corporation is a PFIC, its income and assets must be analyzed and assigned to passive and active buckets. Income from dividends, interest, capital gains, royalties, rents, and other non-trade or non-business types of income are treated as passive. In the case of a foreign company engaged in various crypto activities, this analysis can be tricky. For example, interest earned on cryptocurrency is clearly passive income, but what if the crypto is held not to earn interest but to be traded on various exchanges.

A foreign corporation that runs a crypto exchange typically has multiple different income streams. Advertising fees, wallet swap fees, exchange revenue, credit card fees, rental income, income from transfer pricing adjustments and interest income are just a few types of income that a P&L statement might contain. Each of these income streams must be analyzed to determine whether 75% of the foreign corporation’s income is passive. As for the asset test, a typical balance sheet might include among other items: Intangible Assets – such as its own crypto funds, other crypto assets held for lending and crypto assets held as collateral. Classification of these assets can be complicated. Additionally, property plant and equipment assets need to be classified based on the type of income they produce. If these assets can be traced to produce income from advertising sales, developing and maintaining the exchange platforms and other active business activities, then those assets will be grouped in the active basket.

There are many potential tax consequences to US investors who want to invest in the fast-paced world of cryptocurrency and blockchain. While the IRS is slowly catching up with the realities of the 21^stcentury, further guidance is needed in order to reflect current conditions. Revenue Rulings from 2014 do not adequately address the existing marketplace and more updated communications from the Service and Treasury is sorely needed. Withum’s tax team is your one stop to stay up to date on any new developments in the cryptocurrency space.

Author: Josh Gelernter | [email protected]