While the cryptocurrency and crypto-related investment market has grown exponentially in the last few years, the US Internal Revenue Service (the “Service”) has provided little concrete guidance as to the appropriate US tax treatment of crypto transactions, particularly in the decentralized finance (“DeFi”) space.
Non-US investors in particular face a unique array of US tax concerns when investing in US-based crypto assets or through US trading platforms, brokers and funds, potentially including US income tax on certain elements of their return and, possibly, US estate tax.
A non-US individual, trust or corporation is generally subject to US federal income tax only on (i) passive US-source income, or (ii) income which is effectively connected with the conduct of a United States trade or business (“US trade or business”) (“ECI”). An investor is generally deemed to have a US trade or business to the extent it engages in regular or continuous business activities in the United States, or is deemed to engage in such activities by imputation through, for example, a US-based agent or limited partnership interest in a US-based fund.
A non-US individual, trust or company that invests passively in crypto assets can normally sell a crypto asset at a gain without attracting any US federal tax liability, even if the issuer of the token is based in the United States or the trade takes place on a US crypto platform. This is because, for US tax purposes, gain on the sale of property is generally treated as tax-free foreign source gain in the hands of a foreign seller.
However, if a non-US investor makes more than a handful of crypto sales in a particular year through a US trading platform, broker, or fund, the Service could argue that this default tax-free treatment should not apply on the basis that the non-US investor is engaged in a US trade or business by imputation through a US-based agent. In that case, the gains could be taxable to the non-US investor as ECI.
In many instances, a non-US investor would have a robust defense against ECI treatment even where it has engaged in regular, continuous crypto trades through a US-based platform. The US Internal Revenue Code generally provides that “trading in commodities” does not constitute a US trade or business for a non-US investor, regardless of the nature and extent of the commodities-trading activities in question, so long as those commodities are “of a kind customarily dealt in on an organized commodity exchange” and the transaction itself is “of a kind customarily consummated at such place.” Many crypto assets could appropriately be characterized as commodities. On this basis, there is a loose consensus that the commodities trading safe harbour should be available to shield non-US crypto or crypto derivatives traders from crossing the US trade or business threshold. Yet the IRS has not addressed this issue and so there is no assurance that this position would be upheld if challenged.
Some crypto traders seek to generate additional returns on crypto assets by engaging in DeFi activities—specifically, by lending the tokens to other crypto borrowers, whether through direct lending, as part of broader liquidity pooling arrangements, staking, yield farming, or similar activities. A crypto lender in these kinds of transactions may receive periodic fee income (usually in the form of additional tokens) as an interest-like or rent-like return on the crypto assets they have tied up in the transaction. For non-US investors, the Service may seek to characterize this yield as withholdable US-source income at a 30% gross rate, particularly if the “borrower” is perceived as being tax resident in the United States.
Furthermore, to the extent the yield is derived from regular, continuous activities on the part of the investor, their broker, or a fund in which they are invested, then the yield could be also plausibly be treated as ECI. In this case, the yield could be taxable at rates up to 37% for investing individuals and most trusts and in the range of 45% for investing entities classified as corporations for US tax purposes (an effective rate, after application of the “branch profits tax”). In either case, the non-US investor also would be required to file a non-resident tax return (which also requires the disclosure of any other sources of US income).
Generally speaking, a non-US individual is subject to US estate tax on the value of all “US situs” assets he owns or is treated as owning death (minus a small lifetime exemption amount), whether held directly or through certain trust structures.
There is no specific rule or guidance for determining the situs of crypto assets for US estate tax purposes. Yet a catchall rule generally provides that most types of “intangible personal property” have a US situs for estate tax purposes to the extent they are “issued by” or are “enforceable against” a US resident (which for this purpose includes a US-incorporated business entity). While this situs rule is clearly intended to address conventional IP assets such as patents and trademarks, the language has a broader reach.
Under this rule, a crypto asset could theoretically be treated as having a US situs if (i) it has a US issuer, or (ii) to the extent the asset lacks an “issuer” in the conventional sense, the person or entity who is most closely analogous to an issuer of securities is tax resident in the United States. For example, a US-based ICO sponsor could in some circumstances be characterized as an “issuer” of the resulting tokens, causing non-US holders to potentially be subject to US estate tax, which generally applies at the rate of 40% of market value at the time of passing.
Our team advises investors in a range of tax, regulatory, litigation and arbitration services in the cryptocurrency and fintech space. For example, many fund investors find themselves needing to make representations in their subscription agreements as to their status under several US regulatory regimes. We are experienced with the existing and changing regulatory and tax framework applicable to individuals and entities operating in or adjacent to this growing area in a wide range of jurisdictions including the US, UK, Hong Kong and Singapore and more.
For further information get in touch with your usual Withers contact, or speak to either of the authors of this article.