As blockchain and cryptocurrency continue the transition from early adopters to mainstream traditional finance, it’s important to consider how IRS might apply traditional subpart F anti-deferral rules to the blockchain and cryptocurrency space. Even as the U.S. regulatory environment has improved under the Trump administration (as evidenced by reduced enforcement activities), it’s important to note that many existing and new cryptocurrency, NFT, and web3 projects have been or will be structured offshore due to a lack of regulatory clarity and stability in the U.S. And while an offshore structure may facilitate investment and token issuance from a regulatory standpoint, it may also bring additional tax benefits to stakeholders who can understand and proactively plan for subpart F considerations. 

Notice 2014-21

For U.S. federal income tax purposes, most digital assets remain classified simply as property under Notice 2014-21. Under this guidance, a taxpayer realizes gain or loss on the exchange of digital assets.  The character of the gain or loss depends on whether the digital asset is capital or ordinary in the taxpayer’s hands. The notice treats digital assets held as inventory explicitly as ordinary assets while all other assets generally are implied to be capital in nature. In practice, this means that digital asset disposal in the context of brokerage and reselling, token mining, minting new tokens, and creating NFTs would generate ordinary income, while disposals or exchanges in other contexts would result in capital gains or losses.

Token Disposals by Controlled Foreign Corporations and Foreign Personal Holding Company Income

The ordinary versus capital question is particularly important for controlled foreign corporations (CFCs).  Many CFCs operating in the blockchain space will be capitalized with digital assets, earn digital assets in their operations, and use digital assets to pay contractor fees and other expenses. The use of digital assets to pay expenses is considered a disposal of property for U.S. federal income tax purposes, and where such gain is capital, the disposing CFC will often have foreign personal holding company income (FPHCI) or loss. Moreover, CFCs in this position will often be limited in the deductions that can be allocated to the capital gain/FPHCI. Alternatively, even where payment of expenses in digital assets results in a capital loss, such loss may not be allocable against the CFCs tested income for GILTI purposes. Finally, unlike federal taxation of domestic corporations, which includes a capital loss carryback and carryover mechanism, the calculation of FPHCI for CFCs does not include the ability to carry back or carry over capital losses to offset potential subpart F income in other years. Excess capital losses at the CFC level, therefore, may end up permanently trapped and never able to offset corresponding subpart F income in other years.

Token Disposals for Miners, Minters, Validators, and Resellers

As discussed above, where a digital asset is considered ordinary, for example, as inventory, then a taxpayer may end up with ordinary gain or loss on the disposal of the digital asset. For example, where a CFC is engaged in the business of minting new NFTs, then the disposal of one of these NFTs, in whatever context, would generate ordinary, rather than capital income and, therefore, may not constitute FPHCI. However, the determination of ordinary versus capital treatment is made on an asset-by-asset basis. So, in the above example, if the CFC NFT producer mints and sells an NFT in exchange for ETH tokens, and then uses the ETH tokens to pay a contractor for services, then the exchange of the NFT for ETH may be considered ordinary, but the subsequent exchange of the ETH for the services of the contractor would be considered capital.  This result could lead to possible subpart F inclusion on any gain on disposal of the ETH, as the CFC NFT producer is not in the business of producing ETH and ETH is not considered inventory to the CFC NFT producer.

In the digital asset space, where business is often conducted entirely in digital assets and the value of these assets can fluctuate significantly over short periods of time, careful attention should be paid to managing inadvertent capital gains and losses on the use of capital assets for payment of ordinary expenses. It’s imperative to partner with international tax and digital asset specialists to assist in these types of analyses as well as plan mitigation strategies.

U.S. Effectively Connected Income (ECI) Considerations for Miners, Minters, Validators, and Resellers

It is important to remember that general U.S. ECI considerations apply to CFCs in the business of mining, minting, validating, and reselling digital assets, which may subject their income to U.S. federal income tax, even where it is not otherwise subpart F income. For example, where an NFT producer is organized in a foreign jurisdiction but operates exclusively, or predominantly through U.S.-based employees, that CFC may be considered to have a U.S. trade or business under Internal Revenue Code Sec. 864, and the income of that CFC may be considered U.S. ECI, and subject to U.S. federal income tax (and possibly state income tax as well). Where it is intended that the CFC’s income be considered non-ECI, careful attention should be paid to the substance that the CFC has in its local jurisdiction, and the activities that are conducted in the U.S.

Staking Income Versus Validator Income

As proof of stake (PoS) blockchain projects gain popularity and momentum as a flexible and lower-cost alternative to proof of work blockchains, taxpayers may find themselves in possession of pools of PoS tokens that they may ultimately re-deploy for staking or establishing a validator node in order to take advantage of additional income producing potential. In PoS blockchains, validators compete via a lottery system operated by the network, to be selected to solve a cryptographic puzzle by way of specialized computer equipment and software (Validator Node), publish a new block to the network and earn validator rewards (collectively Validator Income).  Validators must have tokens "staked" (locked up on the network as collateral) with their Validator Node to participate.  Individual token holders are encouraged to stake their tokens with one or more validators via rewards of new tokens issued directly by the network (Staking Income), to the staked token holder based on the amount of tokens and length of time staked, regardless of which Validator Node they’ve staked with. Note that Validator Rewards and Staking Rewards are different income streams earned for different actions.  At present, IRS guidance on staking (and validation) income is limited to Rev. Rul. 2023-33, which provides that cash method taxpayers recognize taxable income on staking rewards at the time they have control over these staking rewards. Although not explicitly indicated by IRS, some taxpayers take the position that staking income is a passive income stream, akin to interest income. Where a CFC stakes PoS tokens (without running a validator node), there is a risk that IRS could take the position that staking income is passive, FPHCI. There may be a stronger position that the income earned from running a Validator Node, which requires more technical capability and day-to-day management would not constitute FPHCI (and would instead constitute tested income subject to the GILTI rules, rather than FPHCI subject to subpart F rules).  It is recommended that where staking and PoS validation activities are conducted within a CFC structure, taxpayers consult proactively with tax professionals with strong backgrounds in the taxation of digital assets and international tax.  

The Takeaway

As the transition from early adopters to mainstream traditional finance continues to evolve, blockchain and cryptocurrency producers, resellers, brokers, and investors need to consider how IRS might apply traditional subpart F anti-deferral rules to the blockchain and cryptocurrency space where offshore structures are used. Depending on the structure, token disposals need to be tested for tax purposes as either ordinary income or capital gain, especially in the CFC realm.