Bill Introduced to Exempt “digital tokens” from the Federal Securities Laws; Change Tax Treatment of Virtual Currencies

Representatives Warren Davidson (R-OH 8th District) and Darren Soto (D-FL 9th District) introduced¹ legislation on December 20, 2018 that is intended to create a bright line test for when a digital asset is or is not a security.² If enacted, the bill, referred to as the “Token Taxonomy Act,” would define “digital token” under the federal securities laws and clarify that such tokens are not securities, and it would create a temporary safe harbor for offers and sales of digital assets that are later deemed to be securities by the Securities and Exchange Commission (SEC). The bill would also clarify the tax treatment under the Internal Revenue Code of 1986 (IRC) for investments in virtual currencies made by individual retirement accounts, exchanges of virtual currency and capital gains from virtual currency sales. 

To be a digital token under the bill,³ a digital asset must have, among other characteristics, the ability to be traded between two persons without the services of an intermediate custodian. In addition, the asset must not represent a “financial interest in a company,” including an ownership interest in a company or debt or revenue sharing interests. If the digital asset meets the definition of a digital token, it would not be a security under the federal securities laws and therefore would not be subject to registration with the SEC. 

The bill would also insert a safe harbor from registration into the Securities Act of 1933, as amended, for offers and sales of digital assets⁴ where the person who made the offer or sale had “a reasonable and good faith belief” that the digital asset was a digital token. Under this safe harbor, if the SEC subsequently determines that the digital asset is a security and not a digital token, the offeror would be required to take certain actions within ninety days of receiving notification from the SEC that the digital asset is a security, including posting a public notice, making “reasonable efforts” to stop further sales of the digital asset and returning sales proceeds to the buyers. The bill would also permit the offeror to keep proceeds that were “reasonably spent” to develop the technology associated with the digital asset. 

The bill also attempts to address aspects of digital asset custody that have not been addressed by the SEC. The bill amends the definition of “bank” under the Investment Advisers Act of 1940, as amended, and the Investment Company Act of 1940, as amended, to include “providing custodial services” among the qualifying activities of state-chartered banks and trust companies. Furthermore, the bill directs the SEC to amend Rule 15c3-3 under the Securities Exchange Act of 1934, as amended, which was adopted to protect customer accounts maintained by broker-dealers, to clarify that using “public key cryptography and following commercially reasonable cybersecurity practices” to protect a digital asset would satisfy the “control location” requirements of the rule. 

In addition to clarifying the treatment of digital tokens under the federal securities laws, the bill would also amend the IRC: 

• to clarify that the acquisition of virtual currency⁵ by an individual retirement account would not be treated as a distribution, thereby permitting individual retirement accounts to invest in virtual currency without creating a taxable distribution; 
• to set forth that an exchange of virtual currency is treated in the same manner as an exchange of real property, which would permit certain “in-kind” exchanges of virtual currency to be made tax free; and 
• to exclude from gross income, for income tax purposes, any gains made from the sale or exchange of virtual currency not exceeding $600. 

The bill also directs the Secretary of the Treasury to adopt regulations that provide for information returns for virtual currency transactions that create a gain or loss. 

The sponsors of the bill hope that clarifying the regulatory treatment of digital tokens will mitigate fraud and foster innovation in the blockchain economy.6 With the current Congress adjourning soon, the bill likely will need to be reintroduced after the next Congress convenes in 2019. Nonetheless, the bill reflects a bipartisan attempt to update the federal securities and tax laws to address some of the legal uncertainty arising from the application of the existing federal regulatory framework to digital assets. 

Footnotes 

_{1) H.R. 7356, 115 Cong. (2018). The bill was introduced to the Financial Services and Ways and Means committees of the U.S. House of Representatives.
2) Congressmen Warren Davidson, Darren Soto Introduce ICO Fix for Businesses, Consumers, Press Release (2018) (Rep. Davidson Press Release).
3) The bill defines digital token as follows: Digital token.—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 common 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.
4) The bill refers to digital assets as “digital units,” which would be defined under the federal securities laws as “a representation of economic, proprietary, or access rights that is stored in a computer-readable format.”
5) The bill would define “virtual currency” under the IRC as “a digital representation of value that is used as a medium of exchange and is not currency (within the meaning of section 988).”
6) Rep. Davidson Press Release, supra note 2.}