Wednesday, December 26, 2018

Reps. Davidson and Soto would redefine ‘security,’ clarify use of Howey test and tax treatment in new blockchain bill

By Mark S. Nelson, J.D.

A bill introduced by Reps. Warren Davidson (R-Ohio) and Darren Soto (D-Fla) would attempt to add clarity to the securities and tax treatment of digital tokens. Under the Token Taxonomy Act (H.R. 7356), a “digital token” would be excluded from the definition of security and an exemption from the Securities Act registration requirement would apply when a developer or seller of a digital token that has been notified by the SEC that it has run afoul of federal securities rules stops sales and returns sale proceeds. The bill also would clarify broker-dealer custodial rules and the tax treatment of digital tokens. The following analysis is based on a version of the bill text posted on SCRIBD and linked to from a press release issued by Reps. Davidson and Soto.

Clarify use of Howey test. Representatives Davidson and Soto said in a press release that the genesis for the bill was a desire to clarify the use of the Howey test for when an offering is an investment contract and, thus, a security. Under Howey, an offering is an investment contract if it involves the investment of money in a common enterprise with the expectation that others will generate profits. The SEC has leaned heavily on Howey in policing initial coin offerings, although other tests for whether an investment is a security exist, such as the Reves family resemblance test for whether notes are securities, something the Davidson-Soto bill appears not to address. The representatives also cited concern among the blockchain industry at what the bill’s authors believe may be conflicting statements from SEC Chairman Jay Clayton and William Hinman, Director of the SEC's Division of Corporation Finance, whom they say have “alarmed” and “encouraged” the blockchain industry.

“This bipartisan legislation draws a bright line for businesses and regulators by defining a ‘digital token’ and clarifies that securities laws do not apply to companies that use blockchain once they reach their goal of becoming a functional network,” said Reps. Davidson and Soto. “Implementing this fix will stop fraud from spreading and provide the certainty innovation needs to flourish.” Still, the representatives suggested that more regulatory initiatives will follow, while also questioning the extent to which the Federal Trade Commission has authority over digital tokens and whether legislation is needed to address the FTC.

Digital tokens would not be securities. The bill would add two definitions to the Securities Act and make conforming amendments to both the Securities Act and the Exchange Act to ensure that a “digital token” is not a “security.” As a result, “digital token” would be defined based on four features of a “digital unit” (which would be separately defined); thus, a “digital token” is a “digital unit” that: (1) is created pursuant to a verification process with rules to govern its creation and supply or as an initial allocation of digital units to be created; (2) has a transaction history recorded in a distributed, digital ledger subject to mathematical consensus verification, which cannot be changed by persons acting in common control; (3) is capable of be traded without an “intermediate custodian;” and (4) does not represent a financial interest in a company (e.g., ownership, debt interest, or revenue share). The emphasis on lack of common control appears to invoke the notion of decentralization, which has been the key to how some SEC officials think about virtual currencies (See, e.g., a June 2018 speech by CorpFin Director Hinman). Under the bill, “digital unit” would be defined as “a representation of economic, proprietary, or access rights that is stored in a computer-readable format.”

The bill also would amend the Securities Act to exempt certain transactions from the registration requirement. Specifically, the exemption would apply if a person who develops, offers, or sells a digital token with the reasonable and good faith belief it is a digital token, within 90 days after being notified by the SEC that the digital unit is a security, publishes notice of the SEC’s notification and takes reasonable efforts to stop sales and return sales proceeds (the return of proceeds provision would exclude funds for technological development).

This aspect of the bill would appear to invoke the SEC’s enforcement actions in the matters of Munchee, Inc. and, more recently, CarrierEQ Inc. (Airfox) and Paragon Coin Inc. Munchee stopped sales and returned proceeds and was not penalized or subjected to undertakings by the SEC. By contrast, the SEC penalized AirFox and Paragon Coin and subjected both entities to extensive undertakings, including an investor claims process and registration of their tokens as securities under the Exchange Act. In a press release accompanying the AirFox and Paragon Coin matters, SEC Co-Director of Enforcement Steven Peikin said the matters could serve as a “model” for ICO compliance with federal securities laws.

Moreover, the bill would make nearly identical amendments to the definition of “bank” contained in the Exchange Act, the Investment Company Act, and the Advisers Act to include other banking institutions or trust companies for which a substantial part of their business is providing custodial services. Lastly, the bill would direct the SEC to amend Exchange Act Rule 15c3-3 to provide that the “satisfactory control location” requirement can be met by public key cryptography via commercially reasonable cybersecurity practices.

Tax treatment of virtual currency. The Davidson-Soto bill also would clarify the tax treatment of virtual currencies. For one, Internal Revenue Code Section 408(m) regarding the treatment of collectibles by individual retirement accounts or individually-directed accounts per Code Section 401(a) would be amended to provide an exception for virtual currencies from the general rule that an IRA’s acquisition of any collectible is, for certain purposes, treated as a distribution equal to the cost of the collectible to the IRA. That is, IRA’s generally cannot invest in collectibles. “Collectible” generally means “tangible personal property,” such as art, antiques, metals, gems, stamps, coins, or alcoholic beverages. The bill would create an exception from the definition of “collectible” for virtual currency, in addition to existing exceptions for U.S. minted coins (See, 31 U.S.C. §5112) and for bullion of a stated fineness for contract markets under the Commodity Exchange Act (See, 7 U.S.C. §7).

The proposed amendment to Code Section 408(m) also would define “virtual currency” as “a digital representation of value that is used as a medium of exchange and is not currency (within the meaning of section 988) [i.e., certain foreign currency transactions].” This definition varies in some respects from the definition of “virtual currency” contained the IRS’s 2014 guidance. The amendment to Code Section 408(m) would apply to sales or exchanges on or after January 1, 2017.

The bill would further amend Code Section 1031 on like kind exchanges to provide that an exchange of virtual currency under Code Section 408(m) is to be treated as a like kind exchange as if the exchange involves real property. This distinction is important because the Tax Cuts and Jobs Act enacted a year ago narrowed the scope of Code Section 1031 to real property. The amendment to Code Section 1031 would apply to exchanges made on or after January 1, 2017.

Finally, the bill would add Code Section 139G to provide that gain from the sale or exchange of virtual currency (per Code Section 408(m)) can be excluded from gross income up to $600, subject to inflation adjustments in taxable years after 2018. Sales or exchanges that are part of the same transaction (or series) would be treated as one sale or exchange. Treasury would be directed to issue regulations for reporting gains or losses. Proposed Code Section 139G would apply to transactions entered into on or after January 1, 2017.