INSIGHT: Dangers of Peer-to-Peer Cryptocurrency Exchanges

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By Crystal Stranger

When it comes to reporting requirements for owning cryptocurrencies, investors face a number of issues related to informational reporting, such as the foreign bank account rules for filing the FBAR report, and Form 8938 requirements under the Foreign Account Tax Compliance Act (FATCA), or the Form 5471 requirements if structured as a foreign corporation. But few tax professionals are talking about the informational returns required for payments made to other individuals made in cryptocurrency, or in exchange for other virtual currencies. There are a multitude of dangers related to transacting on peer-to-peer (P2P) exchanges that have been thrust upon unsuspecting investors. If investors don’t pay attention now, they could deeply regret it later.

When an investor makes a transaction on a P2P exchange, in most parts of the world they must verify they are meeting the anti-money laundering (AML) rules. Additionally, for U.S. persons, business transactions over $600 must be reported under informational reporting rules, as do payments made to foreign persons that may result in income for them. Obtaining the information necessary to fulfill these legal requirements can prove next to impossible, and many exchanges focus on the opposite, by offering anonymity to users.

According to Greg Nevano, deputy assistant director of the Illicit Trade, Travel, and Finance Division of U.S. Immigration and Customs Enforcement (ICE), “These illicit P2P exchangers position themselves as the money launderers of the cryptocurrency world. One type of P2P exchanger illegally generates revenue by charging a premium for allowing their customers to remain anonymous. Targeting these illicit P2P exchangers helps to open the door and pull back the veil of pseudo-anonymity provided by cryptocurrencies.” Nevano made his comments June 20 at a hearing before the U.S. House Subcommittee on Terrorism and Illicit Finance.

The trouble is that few, if any, of the exchanges are providing the information needed to properly prepare know your customer (KYC) verifications or file informational returns when needed. Government agencies such as the Internal Revenue Service and the Financial Crimes Enforcement Network (FinCEN) have issued no reasonable guidance on the matter, leading to further confusion among the taxpaying public. Considering that the penalties that can be assessed for not meeting these rules will in many cases be far higher than the profits received, this is an area investors need to know more about in order to protect their interests going forward.

Up until now, P2P exchanges have mainly been the fodder of funds and whales who frequently make over-the-counter (OTC) trades. But P2P exchanges are growing in popularity within the cryptocurrency world, with a number of new exchanges launching to the public or currently in the ICO stage. Ox protocol relays and Totle are examples of new companies launching with P2P exchange platforms that are doing nothing to protect investors. I asked David Bleznak, CEO of Totle, about the informational reporting requirements with P2P exchanges at the Crypto Invest Summit in Los Angeles this May, and based on his responses it was clear to me that nobody had brought up these issues before.

Dark Side of Anonymity

This is a hot area because decentralization is a core tenet of the beliefs of the crypto community, and many of the early investors who have profited heavily would prefer to trade in this manner. However, P2P trading carries a lot of risk also. When making an anonymous transaction, you obviously do not know from where the person paying the funds is getting their money. Thus there is a risk with anonymous transactions that they could be made in support of terrorism or other abhorrent acts.

“People who avoid exchanges do so for a reason, and OTC brokers and banks are moving in the direction where these transactions are not being made without KYC and AML protections in place; cryptocurrency can actually spell the end of black market,” says Bayo Akinmejiwa from Elliptic. “In cash, you burn money and the government can’t see what you do. Criminals however don’t understand how cryptocurrencies operate. Something like this with a registered transaction number and hash won’t go anywhere, and as such transactions made on most cryptocurrencies are fully traceable by investigators.”

This leads back to the tremendous danger that your clients may be putting themselves in when they don’t meet the KYC validation requirements and file the appropriate informational returns. Although the IRS and Department of Justice have not yet started going after these cases, it is likely they will make examples of a handful of large investors in the coming years. How to comply with the regulations is another open-ended question, however.

“Informational reporting can especially be a concern for atomic swaps,” said Jason H. Poole, an attorney from the Department of Justice, Tax Division, who spoke at the ABA Section of Taxation May Meeting in Washington, DC. Atomic swaps are a P2P cryptocurrency trade that happens without any exchange or other third party intermediary facilitating the transaction. These are fully anonymous trades, meaning that inherently the parties do not provide to each other the information required to meet the KYC, AML and informational reporting requirements.

Tax Considerations

IRS Notice 2014-21, the main guidance given to the cryptocurrency rules, makes clear that any payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property. Reporting for business transactions such as “rent, salaries, wages, premiums, annuities, and gains on compensation paid in cryptocurrency is also required.

Notice 2014-21 also provides detail about requirements for Form 1099-Misc for non-employee compensation and Form 1099-K that must be filed by Payment Settlement Entity (PSE). In the cryptocurrency space, Form 1099-K applies predominately to companies that operate as exchanges or sharing economy platforms. One thing to note if Form 1099-K does apply to your client’s company is that as of Dec. 31, 2017, it is no longer required to file Form 1099-K for certain individuals who have only a foreign address.

If tokens that are considered property are purchased from a non-U.S. person, there may be withholding requirements under tax code Section 1441 as well. This 30 percent withholding should be withheld on each transaction with a non-U.S. person that may subject this person to U.S. tax.

Does selling tokens in the U.S. subject a foreign person to U.S. tax? Under Section 1441(c)(2), it states that if the owner is unknown that withholding may be required on securities. As of right now it is still debatable which cryptocurrencies may be classified as securities, thus this withholding obligation is nearly impossible to determine.

With proper KYC and knowing the resident country of the recipient, there are a number of treaty positions that may make a substantial percentage of these transactions not subject to withholding. But if transactions are anonymous, how do you know if you are transacting with a foreign person at all, let alone with one who is required to file and pay taxes in the U.S.?

One of the exceptions to this rule is for payments made that are effectively connected to a trade or business within the U.S. So it would seem on the surface that by treating trading activities as self-employment income, this issue may be mitigated, as would be much of the gains treatment during the year. However, property paid as part of business transactions would clearly be reported on Form 1099-Misc. And as such there is still not the required KYC information provided from most existing P2P exchanges in order to complete these filings.

However, there are potential solutions on the way. I met up with Jed Grant, CEO of KYC3 at the Unchain conference in Hamburg. Grant is building a solution for KYC compliance that could be adopted by exchanges to collect and provide this information to investors.

His suggested solution was to, in his words, “mutualize peer mounted instances, meaning the stake holders running nodes, between the blockchain and off-chain storage. Define compliance the investors need to meet. Then the exchange can complete compliance and provide a certificate with every swap.”

Grant claims his product is “chain agnostic, meaning it could run equally well on any exchange.” This is certainly a product that is needed sooner rather than later.

But, in the meantime, until P2P exchanges have begun to provide these certifications, it would be wise to warn your clients to stay away from these types of transactions. And if clients have done this in the past, it may be worthwhile to voluntarily disclose this information on Form 8275 attached to their tax return, explaining the inability to file the required informational returns.

Crystal Stranger, EA, author of The Small Business Tax Guide, has over 14 years of tax experience, with a focus in international tax and has been writing about Cryptocurrency tax and regulatory issues since 2014. She is the founder of PeaCounts, a blockchain accounting software company building a new payroll system using the token PEA.

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