Nelson Suit, Tax Compliance Officer at Refinitiv, analyses the challenges of U.S. cross-border tax information reporting for institutions that facilitate crypto transactions.
- Even as industry is still determining the parameters of domestic Form 1099 tax reporting for crypto transactions, conversations regarding potential Form 1042-S reporting for non-U.S. customers likely should begin.
- The calculus on whether Form 1042-S may be applicable changes as the focus of crypto transactions goes beyond sales and exchanges and onto such transactions as staking, crypto lending and dividend-paying tokens.
- Staking presents one case in point on payments deserving at least initial evaluation for potential Form 1042-S reporting impact, raising issues relating to classification and how it may be sourced for tax purposes.
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Up to now, the focus with respect to U.S. tax information reporting by institutions that facilitate crypto transactions has been on tax reporting to U.S. customers. The topic of conversation: is reporting on a Form 1099 applicable and if so, what is the correct Form 1099 type for such reporting?
Interestingly, little thought has been given to writing about the tax reporting of crypto transactions to non-U.S. customers, which occurs on a separate Form 1042-S.
The reason for this is straightforward. Discussions have mostly centred on the trading of cryptocurrencies, and proceeds from the sale of property generally escape U.S. tax and corresponding tax reporting for non-U.S. customers.
But as the use cases for crypto assets evolve and we encounter payments arising from such transactions as staking, crypto lending and even dividend-paying tokens, the calculus as to the applicability of tax reporting on crypto transactions to non-U.S. customers changes.
Crypto exchanges, brokers and custodians may need to begin a conversation about the potential Form 1042-S reporting obligations as well, even as the parameters of domestic tax reporting remain unsettled.
1. Can a non-U.S. person be subject to tax on crypto payments?
As the conversation begins, there will be more questions than answers.
Looking at the baseline rules on when a non-U.S. customer is taxed on investment income or becomes subject to Form 1042-S reporting, however, may provide a point of departure.
Under U.S. tax rules, non-U.S. investors who do not otherwise engage in a U.S. trade or business may be subject to U.S. withholding tax and Form 1042-S reporting on payments that meet the twin criteria of being what is called fixed, determinable, annual, or periodic (FDAP) income and being “U.S. sourced”.
FDAP income, on the large, includes dividends, interest, royalties, compensation for services and essentially all types of income except for gains from the sale of property. Some specific types of income are excepted, such as interest or original issue discount from obligations that mature in 183 days or less. Other types of income such as bank deposit interest or portfolio interest may be exempt from withholding tax but remain reportable on a Form 1042-S.
In its tax guidance, the IRS has indicated that crypto mining income is taxable on receipt as ordinary income as are cryptocurrencies received in an airdrop. There is no guidance on the tax classification of rewards received from “staking” cryptocurrencies or earnings received through crypto lending platforms much less on dividend-paying tokens.
However, given the IRS’s position with respect to mining rewards, there is a good probability that the tax agency would treat these various rewards or earnings also as taxable income upon receipt.
An institution that is currently filing a Form 1099-MISC to a U.S. customer for staking rewards earned by a customer is in effect taking a position that such rewards are taxable income. If these crypto rewards and earnings are indeed income, they would likely also be treated as FDAP income given the broad definition of FDAP.
2. Determining source for tax purposes
The question as to whether U.S. withholding taxes and Form 1042-S reporting are applicable when such rewards, fees or dividends are paid to a non-U.S. customer may turn on the “source” of such payments from a U.S. tax perspective.
One way of thinking about “U.S. source” is to think of it as a criterion for determining whether the income has sufficient “nexus” to the U.S. to be taxed by the U.S. The general precept under U.S. tax rules is that while U.S. residents are taxable on their worldwide income, nonresident investors are generally taxed only on U.S. sourced amounts.
Different source rules apply to different types of income. Dividends, for example, are sourced to the place where the issuer is organised. Interest is sourced to the residence of the borrower. Royalties and rents are sourced generally to the location where the property giving rise to the royalties or rent is being used. Services income are sourced based on where the services are performed.
No rules currently exist for the sourcing of crypto-related payments, of course, but a way to begin the conversation about sourcing is to look at specific crypto payments and determine whether they may be analogous to other income payments for which there are existing sourcing rules.
This is not an easy endeavour given the unique nature of crypto assets, but at least some initial questions can be posed. In this blog, we begin a discussion on staking rewards. In a subsequent blog, we will turn to crypto lending and dividend-paying tokens.
3. Staking
a) Consensus protocols
A cryptocurrency is essentially a distributed ledger that is kept synchronised across a network of multiple computers or nodes. Instead of a centralised intermediary that keeps the ledger, the ledger is maintained and updated at each of the network nodes.
For this to function, the nodes require a consensus protocol for agreeing on ledger updates and discouraging false transactions since there is no central authority to assess what is genuine or not.
Cryptocurrencies like Bitcoin utilise a proof of work (PoW) consensus protocol.
In a PoW model, participants known as “miners” solve complicated maths puzzles to earn the right to validate a block of transaction. The miners receive mining rewards for this work, generally in coin issued by the blockchain or in transaction fees.
But PoW is not the only consensus protocol. Increasingly, there are blockchains that utilise an alternative consensus protocol known as proof of stake (PoS). Ethereum, the second largest cryptocurrency by market capitalisation, is currently transitioning from PoW to PoS.
For a cryptocurrency that uses PoS, holders of the cryptocurrency put up as a “stake” a certain portion of their holdings to obtain a chance at validating transactions on the blockchain. These forgers, upon validating a transaction block, receive staking rewards.
b) Classifying staking rewards
Unlike miners, however, forgers do not need to solve complex mathematical problems with computers or computer farms, but the staked coins can be forfeited in cases of malfeasance and may be subject to restrictions for a time.
While mining rewards may take on the character of services income, it is not clear if this would extend to the relatively “passive” task of staking, even though forgers do perform the validation function. But if staking rewards were classified as a type of service income, presumably the services would be performed where the forger is resident, and a non-U.S. forger would obtain non-U.S. source treatment on staking rewards.
But does this change when staking occurs through a U.S. crypto exchange, brokerage, or custodian? Since staking generally requires the participant to hold and stake a minimum threshold of the cryptocurrency (Ethereum requires a validator to stake 32 ETH, equivalent to over US$50,000 based on mid-March 2021 prices), individual investors often access staking rewards by delegating their units of cryptocurrency to an exchange or broker that pools the units from multiple investors in order to effect staking.
The staking rewards are then apportioned to the investors participating in the staking “pool,” with the exchange or broker facilitating the staking taking a “commission”.
Do the activities of the exchange or broker in this context change the sourcing of the staking rewards? That is, if the exchange or broker is U.S.-based, does this now mean any “services” performed are performed in the U.S. and the staking rewards should be U.S.-sourced?
c) Alternative classification possibilities
These questions are likely just the beginning. If staking rewards are not treated as services income, a host of other questions arise, assuming it is in the end treated as some sort of taxable income.
For example, might the IRS treat staking rewards more in the nature of passive income such as interest or dividends where we look to the U.S. or non-U.S. status of the payor? In that case, if a crypto network distributes staking rewards, is it even possible to determine source? And again, does an intermediary pooling staking rewards change the payor analysis? That is, is the intermediary now the payor? Perhaps this depends on how the staking platform operated by the intermediary is structured?
Or could staking rewards be a sort of guarantee fee? In this case, some of the issues with services analysis discussed above would likely arise as well.
Staking might in the end require its own sourcing rule.
One possible rule would be for the IRS to simply source staking rewards as a matter of policy to the residence of the payee. This occurs, for example, for payments on notional principal contracts or swaps. The payee-residence sourcing approach avoids the sourcing morass on something like crypto assets, which is global in nature.
From a revenue standpoint, it would mean that the U.S. tax authority would settle for the result that U.S. residents would be taxed in the U.S. on their staking rewards and non-U.S. residents would not.
4. Thinking beyond domestic reporting
As use cases expand and the technology behind cryptocurrencies and tokens continues to evolve, the cross-border aspects of the crypto-related payments will need to be addressed.
Institutions that facilitate various crypto transactions will need to consider the tax classification of a crypto transaction payment and begin to unravel its source from a tax perspective.
To a large extent, we are still trying to parse out the parameters for domestic Form 1099 reporting for crypto transactions. The IRS also has yet to issue Form 1099 information reporting regulations on crypto transactions, although it has indicated this is forthcoming.
But given the rapid changes in the evolution of crypto transactions, it may be time to at least begin a conversation on the corresponding Form 1042-S tax reporting of crypto payments, if only to begin to assess the scope of the issue in the context of specific crypto platforms and products.
We will consider earnings from crypto lending and dividend-paying tokens in a separate blog.
