In March, the U.S. Treasury Department proposed four changes to “modernize” the reporting of digital assets. The proposals, outlined in its “Green Book” on tax proposals for fiscal year 2023, come in response to the increasing use of digital assets and the need to improve tax compliance and enforcement against taxpayers that conceal assets and taxable income in offshore digital asset exchanges and wallets.
Taken together, the proposals expand the corporate and individual taxpayer accounting and reporting requirements for digital assets to provide clarity for U.S. tax purposes. They would require taxpayers to:
- Report foreign digital asset accounts;
- Expand Foreign Account Tax Compliance Act (FATCA) reporting for foreign digital asset accounts;
- Apply the securities loan nonrecognition rules to digital asset loans; and
- Amend the mark-to-market rules for dealers and traders to include digital assets.
These proposals follow the changes to digital asset reporting passed in November 2021 as part of the Infrastructure Investment and Jobs Act. The Infrastructure Act expanded broker reporting requirements to cover digital assets; expanded the definition of “broker” under Section IRC 6045(c)(1) to include the transfer of digital assets; amended IRC Section 6045A to impose an information return requirement for transfers of digital assets that are not otherwise subject to reporting; and amended IRC Section 6050I(d) to treat digital assets as cash and subject to reporting requirements.
Notably, the Infrastructure Act also expanded the definition of a covered security under IRC Section 6045(g)(3)(B) to include “any digital asset” and defined “digital assets” under IRC Section 6045(g)(3)(D) as “any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology.” These definitions presumably would apply to the Green Book proposals.
Require Reporting of Foreign Digital Asset Accounts under IRC Section 6038D
Currently, Section 6038D requires individuals that hold an interest in one or more “specified foreign financial assets” with an aggregate value of at least $50,000 to attach an information statement to their tax return. The Biden administration proposes to amend IRC Section 6038D(b) to add to this requirement any account that holds digital assets that are maintained by a foreign digital asset exchange or foreign digital asset account. The proposal would be effective for returns required to be filed after December 31, 2022.
A “specified foreign financial asset” includes financial accounts maintained by a foreign financial institution and certain specified foreign assets not held in a financial account maintained by such a financial institution. The current informational reporting rules do not explicitly include interests in digital assets owned outside the United States as “specified foreign financial assets.” The proposed rule clarifies that digital assets owned through foreign exchanges are included in the reporting requirement. The Treasury regulations would also apply the requirements of Section 6038D to domestic entities formed or availed of for purposes of holding specified foreign financial assets.
Expand FATCA Reporting for Foreign Digital Asset Accounts
The current FATCA rules require information reporting for U.S. persons and their financial accounts owned outside the United States. The Biden administration proposes to amend the reciprocal information-sharing rules under FATCA to cover digital assets. This would permit the U.S. to share information relating to foreign digital asset accounts with collaborating jurisdictions while receiving similar information in return in an effort to detect evasion of U.S. taxes or non-compliance in reporting. The proposal would require certain financial institutions to report the account balance for all financial accounts maintained at a U.S. office and held by foreign persons. It would also expand the current reporting requirement for U.S. source income paid to accounts held by foreign persons to include similar non-U.S. source payments.
Financial institutions would be required to report the gross proceeds from the sale or redemption of property held in, or with respect to, a financial account held by a foreign person; and require financial institutions to report information regarding certain passive entities and their substantial foreign owners. For digital assets held by passive entities, the proposal would require brokers to report information relating to the substantial foreign owners of the passive entities. Brokers would also be required to report gross proceeds and other customer information on the sales of digital assets.
Apply the Securities Loan Nonrecognition Rules Digital Asset Loans
IRC Section 1058(a) allows taxpayers, generally brokers, nonrecognition treatment for securities loans in which the securities that are returned are identical to the securities that were loaned. The proposals would amend the securities loan nonrecognition rules under Section 1058 to apply to loans of actively traded digital assets that have terms similar to those currently required for securities loans. The Treasury would have authority to determine when a digital asset is “actively traded,” to extend the rules to non-actively traded digital assets, and to extend the securities loan nonrecognition rules to other assets such as interests in publicly traded partnerships.
Income would be taken into account by the lender in a manner that clearly reflects income if the lender had continued to hold the loaned asset. The proposal would also provide for appropriate basis adjustments to the loan contract and when the loaned asset is returned. This would generally impact brokers who often must borrow securities when they have a time delay between obtaining securities and delivering them to a purchaser.
Amend the Mark-to-Market Rules for Dealers and Traders to Include Digital Assets
IRC Section 475 requires dealers and traders in securities and dealers and commodities to use the mark-to-market method of accounting. The Biden administration proposes to amend Section 475 to allow dealers or traders of digital assets to use the mark-to-market method of accounting for actively traded digital assets and their derivatives or hedges using rules similar to those that apply to commodities. The proposal would also provide the Treasury with the authority to determine which digital assets are treated as actively traded.
How Should Taxpayers Prepare?
With the growing use of digital assets, the IRS is looking to improve tax compliance and enforcement. Taxpayers with digital assets should begin to assess their holdings of digital assets, including in foreign accounts, and determine any possible information reporting requirements. For information or assistance, contact us.