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August 13, 2018

An Institutional Arms Race to Regulate Cryptocurrency


By Armando Martinez

Will Government Institutions Be Able to Effectively Regulate Cryptocurrencies? Many have wondered if these institutions can even define what cryptocurrencies are in a legal context. The SEC, for example, defines some cryptocurrencies as securities, rendering these digit assets within its purview, while considering others as exempt from their regulatory bounds. The SEC’s primary concern is twofold: it wants to ensure protection for American investors, and it wants to prevent cryptocurrency platforms from obtaining a windfall through circumventing the federal securities laws. Interestingly, institutional efforts to regulate cryptocurrencies have spawned beyond those entities rooted in the United States.

The Global Digital Finance Group (the “GDFC”), a new international advisory group focusing on the regulation of cryptocurrency, intends to create a comprehensive global code of conduct, which will attempt to increase the protection of market participants from any unlawful misuse of blockchain technology. The GDFC will introduce a global code of conduct that will provide a framework for the way all digital assets, including Bitcoin and Ethereum, will be regulated. This article will explore the IRS’ and the GDFC’s efforts to regulate cryptocurrency, and how these efforts may intersect, or compromise, one another.

The First Theory

The IRS has established three taxation methods to thwart the success of cryptocurrency. The first theory under which the IRS taxes cryptocurrency is the most straightforward: capital gains from investing in cryptocurrencies. If one buys virtual tokens and they increase in value, one will pay either a short-term or long-term capital gains tax when one sells the cryptocurrency for a profit. The IRS rationale is based on treating cryptocurrencies as property.

  • For example, Coinbase, a cryptocurrencies exchange, will issue a 1099-K for customers who have engaged in at least 200 cryptocurrency sales transactions valued equal to or greater than $20,000 during a calendar year.
  • Additionally, using cryptocurrency to pay employees is also taxable to the employee, as this payment must be reported on a W-2 and is subject to federal income tax withholding and employment tax.

The Second Theory

The second theory the IRS applies to tax cryptocurrencies is the capital gains tax derived from purchasing goods and services. If one has paid for anything with cryptocurrency, such as Bitcoin, Monero, Dash, or Ethereum, to name a few, the IRS defines using the cryptocurrency as a medium of exchange and disposing of an asset. If one purchased a virtual coin and then sold the coin to the retailer or service in question for the agreed upon price, and if the value of what one sold has increased from when one purchased the token, the seller of the token is responsible for paying capital gains on the difference.

The most complex aspect of this type of transaction is that the onus of accurate record-keeping is placed solely on the taxpayer – this is because if a cryptocurrency platform provides a tax form showing a user’s cost basis, the platform most likely would not show what price the assets were sold for when a good or service was purchased.

The Third Theory

The third theory, and perhaps the most complex, is taxing the cryptocurrency mining income. Cryptocurrency mining refers to the use of high-powered computers and servers to solve complex mathematical equations and, in the process, validate transaction on a blockchain network. The first person or entity to solve a group of transactions, colloquially known as a “block,” is given a “block reward,” which is paid in the tokens of the virtual currency being validated. Per the IRS, this token reward is income that one as the taxpayer needs to report on a federal tax return as “self-employment income” or as “other income.” Additionally, these miners may also have to report a capital gains tax when they dispose of their received virtual tokens. As stated previously, however, the United States faces global competition in regulating cryptocurrency activity. At the moment, the GDFC is the institution with the highest potential to directly compete with the United States’ regulatory efforts.

A Focus on Investor Protection

As the number of investors grows in the cryptocurrency space through initial coin offerings and exchanges, the GDFC’s regulatory impetus revolves around reaching a mutual understanding as to the nature of these tokens with investors, as well as monitoring their financial stability. Because risk factors with respect to cryptocurrencies remain one of the primary concerns for global regulators, the GDFC aims to improve the protection for retail investors by increasing the awareness and the education behind these currencies.

The GDFC’s blueprint is akin to the Organization for Economic Co-operation and Development, where it will encourage a coordinated policy approach from governments. This is because cryptocurrencies travel through the virtual, global space and as such, they are subject to a wide range of regulatory treatments across jurisdictions. Like the cryptocurrency space, however, the GDFC is very nascent, and its primary concern at the moment is to reach this mutual understanding with investors.

Problems Ahead?

The dynamic to regulate cryptocurrency between global institutions and national governments is also ill-established. Does this mean that global institutions and national institutions, such as the GDFC and IRS, respectively, will compromise each other’s missions by getting in the way of one another? Or does it mean that they will be able to coexist and provide vulnerable investors with the protection they need, while also ensuring the activity surrounding cryptocurrency remains financially and legally sound? The future relationship between these entities is unclear.

What is certain, however, is that for anyone interested in the cryptocurrency space, these institutional relationships and activities merit scrutiny.

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