The Token Taxonomy Act: Is This The Turning Point?

If you are even remotely tapped into current events in the blockchain world then the Token Taxonomy Act (the “Act”) should ring some bells. The stories covering the new legislation have been posted and reposted seemingly thousands of times on reddit forums and news sites. Some articles going as far as calling it a “holiday gift” & “the answer to our pleas” for stability in an emerging industry that fears “regulation by enforcement.”

Is the Token Taxonomy Act all of those things? Is it the first step to wider and much needed favorable legislation? I believe that the bill in its current form will not pass but it is a signal to the rest of the country that favorable legislation is on the horizon and gaining support.

What is the Token Taxonomy Act?

During Congress’ 115th session, Congressmen Warren Davidson (R-OH) and Darren Soto (D-FL) introduced the Token Taxonomy Act on December 20, 2018. The bi-partisan bill aims to amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to exclude “digital tokens from the definition of a security,” as well as exempt digital tokens from the registration and reporting requirements of Section 5 of the 1933 Act. Since Congress ended its 2018 session without the bill being passed, the bill will need to be reintroduced in order to be considered. In the meantime, we can explore the provisions within the bill, how it will affect the average crypto user, and most importantly, if the bill can pass in its current form.

Provisions within the Token Taxonomy Act

According to the Token Taxonomy Act, to classify a cryptocurrency as a digital token and exempt it from being regulated as a security, four elements must be met: The term ‘digital token’ means a digital unit that

(A) is created —

(i) in response to the verification or collection of proposed transactions;

(ii) pursuant to rules for the digital unit’s creation and supply that cannot be altered by a single person or group of persons under common control; or

(iii) as an initial allocation of digital units that will otherwise be created in accordance with clause (i) or (ii);

(B) has a transaction history that —

“(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through a mathematically verifiable process; and

“(ii) after consensus is reached, cannot be materially altered by a single person or group of persons under common control;

“(C) is capable of being traded or transferred between persons without an intermediate custodian; and

“(D) is not a representation of a financial interest in a company, including an ownership or debt interest or revenue share.”

The Act is also looking to introduce more guidance for how average users to businesses will report their taxes. The Act provides that virtual currency be added to the types of property receiving tax-free, like-kind exchange, treatment under Section 1031. In addition, the Act provides an exception for certain virtual currency transactions. Under the Act, a gain of less than $600 from the sale or exchange of virtual currency for property other than cash and cash equivalents would not be included in gross income.

If the bill passes in its current form, we can expect that digital tokens will likely be regulated by the Federal Trade Commission or the U.S. Commodity Futures Trading Commission. The SEC would be limited to only regulation tokens which would fall outside of the Act’s definition of digital tokens. In regards to taxation, the Act would have the IRS create a de minimis exemption for gains realized from the sale or exchange of virtual currency.

Areas that Present Concerns with the Token Taxonomy Act

Under the Act, one of the most main issues is the statutory exemption created under Section (A)(iii). There is a common misconception that ICO’s are securities or the digital tokens themselves are securities — this is inaccurate. The SEC examines the transaction that takes place and then determines whether it qualifies as a security. The chairman of the SEC, Jay Clayton, has gone on record to state that the SEC will not be changing it’s definition of a security to conform to the ICO community. He states that

A token, a digital asset, where I give you my money and you go off and make a venture, and in return for giving you my money I say ‘you can get a return’ that is a security and we regulate that … We regulate the offering of that security and regulate the trading of that security. — Jay Clayton, SEC Chairman.

What results then from the creation of section (A)(iii) is a hard-line statutory exemption that sends the message that as long as a digital token meets the basic qualifications set forth by the Act, it will exempt from SEC regulation. We have seen in the past, a large number of ICOs that have participated in fraudulent behavior. In fact, independent studies have shown that in 2017 alone, 80% of ICOs conducted within that year were subject to fraud. A hard-line exemption like this will ask investors to forego traditional protections and block regulatory oversight from the SEC. On this provision alone, the Act needs to be reworked.

When it comes to the taxation benefits of the bill, it cannot be overstated how important guidance in this area is needed. The most recent form of guidance from the IRS was released in 2014. As stated previously, the Act states that a gain of less than $600 from the sale or exchange of virtual currency for property other than cash and cash equivalents would not be included in gross income. What about transactions over $600? Since digital tokens are not regulated as securities under the Act, they will not be taxed under capital gains. Instead, it is more likely that they will be taxed as personal income at a higher rate.

Closing Remarks

In order for the United States to compete within the industry, cryptocurrency needs to be able to thrive. Strict regulations dampen innovation. In this regard, legislation like the Token Taxonomy Act is a necessity. The Act is a good starting point but we will most likely see it reworked before it is passed in its current form.