Tips to Avoid Crypto Legal Pitfalls

Tips to Avoid Crypto Legal Pitfalls – I

virconlegal

May 17, 2022

Institutional & Regulatory

Blockchain technology has demonstrated a wide range of use cases across numerous industries, created a growing market, and, as a result, has come under the scrutiny of many judicial and regulatory authorities. Because this wide adoption brings the possibility of certain legal liabilities, users, investors, and blockchain startups must be mindful of certain legal pitfalls and their impacts when dealing with cryptocurrencies or other ‘digital assets.’

Due to their decentralized nature, cryptocurrencies and other components of blockchain technology do not fit easily into existing regulatory definitions and structures. Moreover, their borderless nature and lack of an identifiable instrument issuer constitute challenges to regulators. As regulators have been approaching highly reactive and cautious to these developing novel structures, their approaches have ranged from providing no guidance or regulation to issuing warnings and regulating certain actors in the blockchain ecosystem (e.g., exchanges, wallet providers, issuers, investors).

In this article, we do not intend to cover all legal considerations but rather to highlight several legal issues that arise concerning certain actors in blockchain technology, primarily with the laws of the United States, that may be related to the use and deployment of blockchain technology.

Jurisdictional Issues and Governing Law

A blockchain is a decentralized ledger on a network of computers that records transaction data across many computers. Because the nodes of the blockchain may be spread across many locations around the world, this transnational and decentralized nature of the blockchain makes it difficult to determine the location of a transaction and the jurisdiction(s) in which that transaction falls. In some cases, this can lead to conflicts between different legal systems, as a contract valid in one jurisdiction may be void in another.

In the absence of a global regime governing the legal issues of blockchain technology, it is not easy for investors, users, and blockchain projects to anticipate all applicable laws. Therefore, at a minimum, they should conduct a thorough review of the potential jurisdictions to which their transfers may be subject. In addition to due diligence, users and investors can look for blockchain projects that have an internal governance system that establishes the law applicable to their transactions in advance through smart contracts. Having an internal governance system allows them to determine and recognize the validity of their transactions and their rights and obligations. Including a dispute resolution mechanism would also provide greater clarity and predictability for all stakeholders involved.

Compliance with Tax Regulations

Cryptocurrencies and some other forms of blockchain technologies are decentralized in the sense that they have no physical presence, and there is no central authority responsible for regulating or taxing the digital economy they create. Governments worldwide have shown various approaches toward the compliance of digital assets with financial and tax regulations. Still, the non-custodial structure of De-Fi systems creates an ambiguity of whether these regulations apply to such systems as those regulations are generally applicable to the agents or custodians of financial products. Applying current financial and tax rules to a wide range of digital assets has also proved a legal pitfall. As each digital asset constitutes unique utilization areas, each stakeholder involved should be cautious about separate rules for taxation of cryptocurrencies, stable coins, utility tokens, tokenized securities, financial incentives, the exchange platforms, supply and chain management platforms etc.

In the United States, the Internal Revenue Service (the “IRS”) has declared that virtual currencies will be taxed as property rather than currency; therefore, various transactions regarding virtual currencies are subject to income and capital gains tax laws. [1] For this reason, users and investors need to understand the difference between taxable and non-taxable events when dealing with digital assets. Non-taxable events are the activities where the gains are not realized yet, such as holding the crypto without attempting to sell it. Transactions made between different wallets of an individual, getting/giving crypto as a gift (without consideration), may not be considered taxable events under some limits and conditions. On the other hand, taxable events include spending, trading, and exchanging to other currencies, which all are regarded as ‘selling’ in the eyes of the IRS. Therefore, whether as a store of value or a medium of exchange, virtual assets may be borne with tax implications o the extent that cryptocurrencies perform an economic function.

Within the scope of IRS’s instructions; every individual or business engaging in virtual currencies will generally need to, among other things, (i) keep its virtual currency purchases and sales recorded, (ii) pay taxes on any gains that may have been incurred upon the sale of cryptocurrency for cash, (iii) pay taxes on any gains that may have been incurred upon the purchase of a good or service in return for cryptocurrency, and (iv) pay taxes on the fair market value of any mined cryptocurrency, as of the date of receipt. [2]

As for the digital assets obtained via an airdrop or a hard fork, the IRS confirms that the new digital assets resulting from such events can constitute revenue for the taxpayer. The IRS also highlights that if the taxpayer does not receive the new cryptocurrency, that taxpayer does not have gross income due to the hard fork. Back at the time, the IRS had concluded that a taxpayer who received Bitcoin Cash due to hard fork had realized gross income and, therefore, shall bear the tax liabilities. [3]

Concerning the individual investors dealing with virtual currencies, any realized gains on virtual currency held for more than 1 (one) year as a ‘capital asset’ by an individual are subject to capital gains tax rates. On the other hand, any realized gains on virtual currency held for 1 (one) year or less as a capital asset are subject to ordinary income tax rates. For more information, please visit https://www.irs.gov.

Compliance with Financial Regulations

Due to the cryptographically secure, anonymous, and fast nature of cryptocurrency transactions on the blockchain, crypto exchange platforms may come under various threats from criminals that harness technology to launder money and cover their tracks virtually. The anonymous or pseudonymous nature of cryptocurrency transactions makes them well-suited for many despicable activities such as unauthorized or illicit transactions, money laundering, and tax evasion. As cryptocurrencies or the digital tokens that represent them may be exchanged directly between blockchain users or via crypto exchange platforms that enable fiat and digital currencies transactions, financial regulators started to update their standards to include certain actors, such as exchanges and wallets.

In the United States, certain activities associated with “convertible” virtual currency may be subject to the Bank Secrecy Act and money transmitter laws. For example, in-game coins or collectibles that cannot be cashed out are not likely to be convertible virtual currency and not be subject to such regulations. The Financial Crimes Enforcement Network (FinCEN) regulates convertible virtual currency, which is indicated to either have an equivalent value to real currency or substitute for real currency. FinCEN also addressed that accepting and transmitting anything of value substitutes for the currency may make a person a money transmitter under the Bank Secrecy Act regulations. The term money transmitter indicates a person who accepts currency, funds, or other value that substitutes for currency to another location or person. Blockchain projects should be mindful of whether they fall into the description of money transmitter and so are obliged to conduct an anti-money laundering (“AML”) program which includes strong know-your-customer (“KYC”) procedures.

Users and investors should also be careful about the Specially Designated Nationals and Blocked Entities List (“SDN List”) of the U.S. Department of the Treasury’s Office of Foreign Assets Control (“OFAC”). According to the OFAC requirements, engaging in or doing business with foreign persons on the SDN List is prohibited for all U.S. citizens. The assets of individuals and companies engaging in transactions with countries subject to U.S. economic sanctions or certain companies or entities, or individuals that act as agents for such countries, are required to be blocked by the U.S. citizens to comply with the OFAC requirements. All individuals and businesses should be cautious about the SDN List and OFAC’s further implementations to avoid non-compliance by conducting a comprehensive analysis of the presence of a robust compliance program integrated into the transaction/system they engage in. As for the stable coins, the Director of FinCEN has already pointed out that stable coin issuers and dealers are money transmitters within the scope of the Bank Secrecy Act and are required to follow and implement AML procedures. [4]

As cryptocurrencies provide a broad spectrum of anonymity regarding identity and transaction level, it conflicts with the standard KYC and AML practices. The main subjective is to “know and identify the customer” and “identify the transaction”. Moreover, many blockchain projects store mass amounts of users’ KYC information on their centralized servers, which brings up data security and privacy concerns for users to consider.

Lastly, for the entities operating a marketplace of any kind regarding virtual currency, it is crucial to analyze whether their activities fall within the scope of FinCEN’s guidance and, if so, to ensure compliance with the financial regulations. As there is no harmonization regarding KYC/AML regulations, it may be wise to follow the United States’ approach since KYC/AML practices and legislations are heavily influenced by the Unites States’ approach in a global sense.

Gambling Risks

Gambling laws and their implementation may vary across different states; however, the courts have adopted a test for deciding whether dealing with certain virtual assets is regarded as gambling. According to the widely adopted test, for a transaction to represent gambling, “(i), there should be staking or risking something of value, (ii) upon the outcome of a contest of chance or a future contingent event not under the person’s control or influence, (iii) upon an agreement or understanding that the person or someone else will receive something of value in the event of a certain outcome.” [5]

If certain virtual assets and the digital economy created amongst them are not appropriately structured, they could run afoul of gambling laws. For example, if a blockchain-based game makes it possible for a user to stake or risk something in value for a chance to win virtual items that a user can also sell in an open marketplace offered by the game’s publisher, an analysis for gambling should be performed.

As many actors and industries are still wondering about possible use cases for blockchain technology, the legal pitfalls are expected to rise. However, many legal pitfalls should be avoidable through risk assessments, comprehensive due diligence, acknowledgment of the technology, and careful structure of the digital economy.

[1] The Internal Revenue Service, https://www.irs.gov/pub/irs-drop/n-14-21.pdf