Reporting Requirements for Brokers (Part II) | Criminal Tax Blog

Reporting Requirements for Brokers (Part II)

Criminal Crypto Lawyers

In the first post, we laid the foundation for the new crypto broker regulations issued by the Department of Treasury (DOT).  This included discussing the overarching goals of the regulation and analyzing the crypto assets that fell under the definition of “digital asset.”  In this second post, we will review a pivotal preliminary question – who is a crypto broker?

Who is a Broker under the Regulation?

After defining the individual assets that fall under the new requirements, the DOT outlined the entities that qualify as a broker under the regulation. A broker is defined as someone who “as a part of their ordinary course of business either 1) acts an agent with respect to the sale and knows the gross proceeds of the transaction or 2) acts as the principal of the sale.”

This definition is easily applied, and understood, in the classic stockbroker model.  Most stock and commodity transactions occur in custodial online brokerages such as Charles Schwab, Fidelity, or Robinhood. These entities clearly meet the first definition of broker above. However, cryptocurrencies are not predominantly traded through custodial centralized exchanges like Coinbase.  Billions of dollars in transactions occur daily outside of a major exchange through peer-to-peer swaps, decentralized finance applications, and airdrops.  These differences in the crypto market make applying the broker definition difficult.  As you will see below, the DOT continues to struggle with the more nuanced areas of crypto regulation.

Centralized, Custodial Exchanges

Centralized exchanges are the most familiar to the average investor (examples include Coinbase, Gemini, Kraken, and Binance).  These exchanges provide unique wallets for users to deposit crypto tokens.  Once deposited, the user can buy, sell, or trade various supported cryptocurrencies through the platform.  These custodial exchanges have a centralized, corporate ownership that is responsible for facilitating the transactions and holding assets for their users.

As expected, the DOT began the broker analysis by noting that custodial, centralized exchanges qualify as brokers under the regulation.  This was the only logical application as Coinbase, and others like them, are classic custodial exchanges that facilitate transactions and profit from trading fees.  They should know the exact proceeds and basis for each transaction within the platform.  These exchanges are setup to comply with all notice requirements.  This section of the regulation is a seamless application from the stockbroker model.

Centralized Wallet Providers

Various companies have produced digital wallets that allow users to store their crypto tokens in a secure environment.  Initially, these wallets were simple products that allowed the storage of digital assets.  As the Ethereum ecosystem exploded with decentralized finance applications, the crypto wallets evolved.  Today, users can swap tokens via the wallet without connecting to any exchange.

The DOT lumped these wallet providers in with the custodial exchanges discussed above.  The wallets are owned and operated by a centralized authority, the wallets facilitate taxable transactions, and the owners should have access to the basis and gross proceeds data needed to file informational returns.

The Morasse of the Decentralized Web

Next, the DOT addressed whether a non-custodial, or decentralized, exchange fell under the definition of a broker.  The key distinction between Coinbase and a decentralized exchange is the latter does not take custody of any digital assets.  The operator merely provides a platform for users to trade with others.  Instead of forcing users to sign up for an account, and providing the user with a custodial wallet, a decentralized exchange only provides the order books for various digital assets.  The user can connect their crypto wallet to the platform and trades are executed and settled within the users’ personal wallet.  Importantly, there is no central authority that is overseeing the transactions.  Once the code underlying the order books is set, the user’s interaction with the platform is not touched by the developer of the software.

The decentralized exchange does not charge trading fees per se and remains one step removed from the trading process.  The DOT acknowledged that decentralized trading platforms did not fall under the classic definition of a broker under prior regulations.  However, the DOT understood that decentralized transactions are a huge part of the crypto market.  If left outside of the regulation, users could simply avoid the information reporting requirements by focusing their transactions on those platforms.

In response, the DOT amended prior regulations to include all digital asset “middlemen.” The middleman rule adds the following language to the broker definition, “any person who, for consideration, is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.” This addition would capture all decentralized platforms under the broker definition.  This section received numerous comments outlining the issues with the DOT’s stance, including the inability of a DeFi platform to comply without customer information to tie data to a particular person. The DOT acknowledged the complaints and decided to not rule on decentralized exchanges.  This leaves open a key question in the crypto industry as it relates to DeFi applications.  The DOT plans to field additional comments before deciding whether non-custodial platforms must comply with the new regulations.

Crypto Brokers

Addressing Digital Asset Payment Processors (PDAPs)

Over the last three years, classic Fintech applications have been adding services for digital payments.  Applications such as Square and Venmo allow users to make electronic payments using various cryptocurrencies.  The services associated with these functions include transferring the funds from the user to the merchant and taking physical custody of cryptocurrencies to be used in future purchases (akin to a user’s USD balance on cash app).

The DOT initially sought to define all PDAPs as brokers under the new regulation.  However, numerous comments were filed pointing out legitimate issues, including the lack of a relationship between many PDAPs and the transferor of the cryptocurrency.  PDAPs often only hold a business relationship with the merchant, and thus, it is impossible for a company like Square to provide an information return on every buyer.

The DOT acknowledged this inherent issue.  They chose to modify the existing regulation to narrow the world of PDAPs that fall under the broker definition.  The final regulation only applies to PDAPs that have an existing relationship with the buyer that requires them to hold their identifying information.

An example will likely assist in understanding this point.  Let’s assume a restaurant owner uses Square to process credit card transactions.  This restaurant owner allows customers to pay in Bitcoin, Ethereum, or dollars.  If a restaurant customer pays the owner .0002 BTC for a meal, Square is not obligated to report anything to the government.  Even though the customer’s transfer of the BTC resulted in a taxable event, Square does not have any identifying information on the customer.  It would be impossible for Square to tie the transaction to any particular person.

Now, let’s change the facts a bit.  Let’s say the owner decides to purchase goods from a wholesaler using Bitcoin and uses his Square application to facilitate that transaction.  Now, Square has a relationship with the person making the purchase.  Under that scenario, Square would be required to meet the information return requirements under the regulation.  They cannot hide behind their lack of identifying information for the purchaser.

Issuers of Cryptocurrencies

The owners of crypto projects are often involved in issuing cryptocurrencies.  These issuances could come via an initial coin offering or staking rewards.  These transactions involve delivering new tokens to a user based on an initial investment or productivity in securing their network.  The DOT includes these issuers as brokers in the regulation.

Unlike other brokers, the issuers are not responsible for calculating gains or losses on their information returns.  Rather, they must report the number of tokens issued and the fair market value of those tokens upon issuance.

Real Estate Reporting Persons

The DOT included facilitators of real estate transactions in the definition of a broker.  This section of the regulation will require additional information returns reporting the transfer of digital assets during a real estate transaction.

Implementation and Enforcement Issues with Foreign Exchanges

Brokers subject to the new requirements can be broken down as follows: 1) centralized exchanges, 2) wallet providers that facilitate swaps, 3) digital payment processors, and 4) real estate brokers.  The DOT is still struggling with how they will apply the notice requirements to major components of the decentralized web.  A final rule in this area could take months or years to produce.  For now, there is no regulatory clarity for those exchanges or DeFi applications that do not take custody of their users’ assets.

The current DOT memorandum is aimed at clarifying the current rules surrounding return requirements.  It does not seek to discuss enforcement of those rules.  However, the DOT should be considering enforcement obstacles when crafting the regulations.  The DOT’s clear goal is to ensure they are receiving fair income tax valuations from crypto investors.  An obstacle to that goal lies in the prevalence of foreign exchanges and wallet providers within the crypto space.

Many United States citizens trade cryptocurrencies on foreign exchanges or via foreign owned digital wallets.  Over the last few years, many foreign exchanges have barred U.S. citizens from their platforms.  Some require “know-your-customer” (KYC) rules to comply with current anti-money laundering statutes and bar anyone with a U.S. identification.  Others merely bar any users that access the platform from a U.S. IP address.  Obviously, the latter safeguard is limited given the prevalence of VPN services.

When this new regulation goes into effect, foreign exchanges will have a few options: 1) enjoy the capital inflows from the U.S. economy by implementing KYC rules and complying with the notice requirements in this regulation, 2) violate the regulations by allowing U.S. customers outside the legal requirements, or 3) bar U.S. customers altogether to avoid any need for compliance.

The decisions made here will be dictated by the capital expenditure required for compliance.  Large exchanges, like Binance, will likely set up U.S. compliant models for U.S. customers.  They have plenty of capital to implement a compliance protocol.  Smaller startup exchanges may choose to roll the dice by implementing soft measures that do not fully comply with U.S. law.  These steps could result in U.S. enforcement actions against those exchanges.  Large settlement figures could follow.

It will be interesting to track how the crypto exchange market evolves when these regulations are put in place.  For now, exchanges are operating in a grey area created by the lack of clarity in this industry.  Most exchanges are simply choosing to forego the U.S. market in fear of enforcement actions by the SEC or DOJ.  Others are willing to take the risk as new regulations emerge.  Once the regulations become more clear, these companies will be forced to make some tough decisions.

Now that we know who must report and what assets are involved, we must figure out when the reporting requirement is triggered.  In the third post, we will review the individual transactions that trigger the notice return requirements under this new regulation.