Crypto Logistics: Common CEX Pitfalls, Regulation and Taxation Considerations.
From the collapse of FTX to SEC’s lawsuits against Binance and Coinbase, the recent events surrounding the major centralized crypto exchanges (“CEX’s”) gave rise a host of operational and legal considerations, and a stream of endless related discussions. While it would appear that the US is desperately trying to exile crypto from its shores, many other jurisdictions have actively embraced the tech and the industry, and their numbers are only growing. It is thus essential that one daring to explore this industry learns to navigate the world of blockchain asset logistics in the modern day of geopolitics, sanctions, and regulation by enforcement.
Before diving any further into legal and operational details, let us take a look at what shapes and forms do CEX’s come in as they are the main platforms connecting digital assets to fiat.
A. CEX BREAKDOWN BY TIER
CEX rankings are rather fluid and mostly based on trading volumes that pass through the CEX. For ease of reference, and as part of Crypto Twitter folks, they are usually broken down into 4 Tiers. Most of current Tier 1-2 exchanges have similar know you customer (“KYC”) and AML requirements, have legal roots in respectable jurisdictions and the rating breakdown for them comes from actual volumes. As we get into Tier 3 and 4 exchanges, things start to change. There are less, if any, formal KYC and AML compliance safeguards, the CEX entities are generally being formed in off-shore jurisdictions and are not registered (or in formal legal compliance) outside thereof. Below are some of the examples of CEX’s that make up each tier.
1. Tier 1
Tier 1 exchanges are the largest by volume and liquidity, most reputable and well-regulated exchanges in the market. They are typically subject to strict regulatory requirements, such as anti-money laundering /combating the financing of terrorism (“AML/CTF”) compliance and customer due diligence. This generally makes them safer and more secure to use. However, Tier 1 exchanges can also be expensive to use as they often charge high fees for withdrawals. They also require KYC and actively report to and otherwise cooperate with local authorities for e.g. tax purposes. Nevertheless, they are the priority choice for fiat on-ramping and off-ramping as they are the most integrated with the banks and trigger far less scrutiny of funds from the banking side.
Coinbase was founded in 2012 and is headquartered in San Francisco, California. It is the largest, most popular and best-established crypto exchange in the US and offers two versions: the standard version and Coinbase Pro. Coinbase Pro has a larger selection of tradeable assets and tools, and a fee structure that is more geared for trading. The standard version fees on the other hand are the highest in the industry. CB is generally known for its user-friendly interface, high liquidity and ease of fiat-to-crypto-to-fiat ramping. As a publicly traded and FDIC insured entity, one would assume that it also offers the protections of a legitimate US business. It is a member of the Financial Industry Regulatory Authority (“FINRA”). Coinbase requires users to complete a KYC verification process and has repeatedly emphasized its attempts to be a legally compliant company. Additionally, Coinbase closely cooperates with US law enforcement agencies and has been known to turn over user data to the authorities and to freeze user accounts for suspicious activity. As more fully discussed below, Coinbase is currently involved as a defendant in litigation against the SEC for alleged securities laws violations.
Binance is the largest crypto exchange in the world by trading volume. Founded in China in 2017, it has since changed several jurisdictions. It offers a wide range of features and trading pairs, including spot trading, margin trading, futures trading, and staking. While Binance touts its regulatory compliance and significant KYC/AML procedures, recent events have shown that the later were to some extent an easily bypassable veil. Because of that, as well as certain services it offers, e.g. futures trading, Binance has been unsuccessful in securing operational licenses in several major jurisdictions. By way of example, Binance services are not available in the US, where it is currently litigating a case against the SEC involving a host of allegations related to securities laws violations, as more fully described below. Similarly, it has recently failed to secure the necessary licensing in the Netherlands and was forced to withdraw from the Dutch market.
Founded in 2011 and is headquartered in San Francisco, California, Kraken is another popular exchange. Like CB and the rest of US exchanges, Kraken requires users to complete a KYC verification process in order to create an account and start trading. Kraken is generally a well-established exchange with good reputation for security, lower fees and altcoin selection. In addition to its high liquidity and volume, Kraken is the only US exchange that offers margin trading.
2. Tier 2
Tier 2 exchanges are smaller in volumes and liquidity than Tier 1 exchanges, but are generally safe from security and regulation perspectives. This makes them a riskier for operations as well as for use as fiat on- and off-ramps. From this Tier down, it is highly likely that the bank receiving incoming funds will trigger a review process and inquire into the source of funds. This Tier includes e.g. Gemini due to its lower volume and Huobi Global for regulatory reasons.
3. Tiers 3 & 4
Tier 3 and 4 exchanges are the least reputable and regulated exchanges in the market. They are generally registered and operate in offshore jurisdictions, have hardly, if any, KYC/AML requirements, and may have a poor track record of fund security. They also offer minimal, if any customer service. Some notable examples of Tier 3 exchanges are Bybit, KuCoin, MEXC and Gate.io. While not directly illegal or unsafe, these exchanges do not satisfy the regulatory requirements necessary for safe and secure operations in conjunction with the US and EU banking systems. Many of Tier 4 exchanges are essentially honeypot scams that commonly refuse withdrawals and/or freeze assets under a plethora of false reasons without any recourse. Transactions involving these exchanges should be avoided at all costs in lieu of other logistical options as they are not only unsafe, but will certainly trigger scrutiny should funds even make it out of the trap.
B. GENERAL AND LEGAL CONSIDERATIONS
Having reviewed the general makeup of the CEX family, let’s consider some aspects of dealing with them. These may vary from tier to tier, but the general makeup and patterns remain common across the board.
1. User Account Bans and Restrictions by CEX’s
First and foremost, it is important to understand that CEX’s can and do frequently ban users, freeze assets or restrict and otherwise limit users’ ability to trade, deposit and withdraw funds. While Tier 1-2 CEX’s generally do so in response to suspicious activity or significant law and TOS violations, Tier 3-4 exchanges can operate in a more unpredictable and arbitrary fashion. Furthermore, while most Tier 1 and 2 exchanges offer decent customer service and avenues to review and appeal account bans and restrictions, Tier 3-4 exchanges often lack customer support and any appellate procedures altogether.
Let’s take a look at some exemplary issues that may cause a user account to get banned or restricted:
- Suspicious activity: Centralized exchanges may ban users if they engage in suspicious activity, such as making large, frequent deposits or withdrawals without making trades on the exchange. Recently a pattern has emerged of larger CEX’s imposing restrictions on accounts which trade in large volumes until additional KYC/AML inquiries are made and asset origins are provided.
- Violation of Terms of Service (“TOS”): CEX’s may also ban users if they violate the exchange's TOS. By way of example and not limitation, this may include engaging in fraud or by using the exchange to promote illegal activities.
- Complaints from other users: While rare to occur, CEX’s may ban users if they receive external complaints, such as if the user is accused of harassment or of scamming other users.
- Government regulations: Centralized exchanges may also be required to ban or restrict users by government regulations as they apply to specific jurisdictions. An example of this would be the commonly known restrictions imposed by Binance on US users and effectuated via IP address tracking. Similarly, US domestic CEX’s are required to ban users who are located in sanctioned countries.
- No explanation bans, asset freezes and restrictions: These hardly occur on Tier 1-3 exchanges, but are fairly common on less credible CEX’s.
Here are some considerations to reduce the risk of being banned or getting restrictions imposed on user account by the CEX:
- Read and understand the exchange's terms of service: Before you create an account on a centralized crypto exchange, read and understand the exchange's terms of service. This will help you to avoid violating the exchange's rules and regulations.
- Be careful with your activity: When you use a centralized crypto exchange, be careful with your activity. Do not engage in any suspicious activity, such as making large, frequent deposits or withdrawals, or engage in frequent transactions between Tier 1-2 CEX’s and Tier 3-4 CEX’s.
- Report suspicious activity: If you see suspicious activity, report it to the exchange. This will help the exchange to protect its users and to prevent fraud.
- Be respectful of other users and CEX employees: Be respectful of other users when you use a centralized crypto exchange. Do not engage in any harassment or scamming.
2. Banking with CEX’s
In light of recent CEX troubles, it should come as no surprise that CEX’s should not be used for long term storage of funds beyond those being in active trading use. This applies even to the largest Tier 1 CEX’s as they may still be subject to severe regulatory enforcement, fraud and liquidity issues.
a) Fiat On-Ramp and Off-Ramp
There are a number of different crypto fiat on-ramp and off-ramp options available in the EU and US. Each option has its own set of pros and cons, and the best option will ultimately depend on individual needs and jurisdiction.
(1) Crypto fiat on-ramp options
- Bank transfer: This is the most common way to buy crypto. It is a convenient and relatively low-cost option. However, as mentioned above, it can take several days for the funds to clear, which can be inconvenient for emergencies.
- Credit card: This is another convenient option, and it allows buying crypto instantly. However, not all CEX’s offer this option and many credit cards either do not support crypto purchases altogether or consider them cash advance transactions subject to high fees.
- PayPal: PayPal has become a popular payment processor which allows buying crypto with user’s PayPal balance. This is a convenient option, but PayPal fees can be high.
- Crypto ATM: Crypto ATMs are becoming increasingly common, providing an easy cash buy and sell avenue. This may be a convenient option from an anonymity perspective. However, crypto ATM fees can be high and there are few countries that currently have these services.
(2) Crypto fiat off-ramp options
- Bank transfer: As with on-ramping, this is the most common way to sell crypto. It is a convenient and relatively low-cost option. Depending on the parties involved and jurisdiction, the time for funds to clear with the bank may be instant in the case of Coinbase and large US banks or days in other scenarios.
- PayPal: PayPal is a popular payment processor that allows you to sell crypto and receive the funds in your PayPal balance. This is a convenient option, but PayPal fees can be high.
- Crypto ATM: Same considerations as with on-ramping apply here as well.
- OTC: Most anonymous, shadiest, old school back-alley way of transacting. A frequent choice of anonymity nerds and jurisdictions where crypto is less than legal.
b) Legal considerations
The legal status of crypto in the EU and US is still evolving. In the EU, crypto is currently considered a financial instrument, and it is subject to certain regulations, including the upcoming MiCa, as discussed in more detailed below. In the US, crypto assets are not currently considered securities by law, yet they are subject to severe regulation by enforcement from the SEC, which has as recently as this month named a host major assets securities.
It is important to be aware of the legal considerations when using crypto fiat on-ramp and off-ramp options. In particular, you should make sure that you are using a reputable exchange that complies with all applicable laws and regulations.
c) Asset Cooldown Periods
This aspect often gets overlooked, yet it is very important to understand how a CEX of choice handles incoming deposits and withdrawals, particularly fiat related transactions. Specifically, cooldown periods. By way of example, Coinbase places a 7-day withdrawal restriction on incoming automated clearing house (“ACH”) fiat deposits. Another consideration here is the time it takes to confirm incoming on-chain asset deposit. While clearing times for major CEX’s are generally under an hour, exchanges below Tier 3 frequently take 24hrs or more to confirm the deposit. It is thus necessary to plan CEX logistics and routing ahead of time so not to get trapped.
CURRENT REGULATORY REGIME
The overarching legal landscape for cryptocurrencies is constantly evolving, as governments and regulators around the world grapple with how to best address this new asset class. In the United States, the Securities and Exchange Commission (SEC) has taken the lead in regulating cryptocurrencies, classifying some as securities and others as commodities. The Commodity Futures Trading Commission (CFTC) has also played a role in regulating cryptocurrency derivatives. In the meantime, a new piece of legislation - The Digital Asset Market Structure bill – has been proposed in order to bridge the antiquated securities laws and new tech.
In the European Union, the Markets in Crypto-Assets (MiCA) regulation is currently being finalized. MiCA would establish a comprehensive regulatory framework for cryptocurrencies in the EU, including requirements for licensing, AML/CTF compliance, and investor protection.
Other jurisdictions around the world are also developing their own crypto regulations. For example, China has been well known for its bans on cryptocurrency trading and mining, while UAE and Japan have established relatively friendly regulatory environments for cryptocurrencies.
The legal landscape for cryptocurrencies is still in its early stages, but it is clear that governments and regulators around the world are taking this asset class seriously. As cryptocurrencies become more mainstream, it is likely that we will see even more regulation in the years to come. In the meantime, let’s take a closer look at the two regulatory frameworks currently under consideration in the US and EU.
1. The McHenry-Thompson Digital Asset Market Structure Bill
a) Background on DAMS
It has been the topic of endless discussions and controversies that the current regulatory regime in the Unites States for crypto is undefined and is currently being driven by the SEC and CFTC through a series of regulation by enforcement actions. The Digital Asset Market Structure bill (hereinafter “DAMS” or “the Bill”) is a proposed piece of legislation that would create a new - predictable - regulatory framework for digital assets. The Bill was introduced by Representatives Patrick McHenry (R-NC) and Glenn Thompson (R-PA) on June 2, 2023.
The goal of DAMS is to provide clarity, fill regulatory gaps, and foster innovation while providing adequate consumer protections. The bill attempts to accomplish this by:
- Defining digital assets
- Distinguishing between securities and commodities
- Creating a new self-regulatory organization for the digital asset industry
- Providing investors with new protections, such as disclosure requirements and customer protection
Before we dive in further, it is important to note that, while novel for the current US framework, the bill is not going to revise the entirety thereof or recreate the existing securities laws. It is a fair attempt to try and bridge the gap between the current regulatory structure and the new technological developments. Thus, its reach and design is fairly limited and contains notable areas of concern.
b) Key Areas of Significance
One of the most important features of DAMS is the creation of a new exemption for the initial sale of digital assets. This exemption would be similar to the crowdfunding exemption that was created by the JOBS Act. Accordingly, the DAMS exemption would allow blockchain developers to raise funds through initial coin offerings (ICOs) while still providing investor protections.
Another important feature of DAMS is the definition of a “decentralized network.” A decentralized network is one that is not controlled by any single entity. DAMS would provide specific criteria for determining whether a network is decentralized. Once a network is determined to be decentralized, it would be subject to different regulations than centralized networks.
In addition to the creation of a new exemption and the definition of a decentralized network, DAMS also includes a number of other significant features. These features include:
- Definition of digital assets: DAMS defines digital assets as "fungible tokens that are created using distributed ledger technology and that are not securities or commodities." Notably, this definition excludes non-fungible tokens (NFTs).
- Distinguishing between securities and commodities: DAMS would distinguish between securities and commodities by using the Howey test. The Howey test is a legal test that is used to determine whether an investment is a security. Under the Howey test, an investment is a security if it is an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.
- Creating a new self-regulatory organization: DAMS would create a new self-regulatory organization (SRO) for the digital asset industry. The SRO would be responsible for developing and enforcing rules for the digital asset industry.
- Providing investors with new protections: DAMS would provide investors with new protections, such as disclosure requirements and customer protection. Disclosure requirements would require issuers to provide investors with information about the digital assets they are offering. Customer protection would include measures to protect investors from fraud and abuse.
- A provision that software that simply creates a digital asset does not qualify as an issuer.
- A safe harbor for issuance in the form of airdrops and network participation rewards.
c) Potential Areas of Concern
While DAMS is a well-accepted and a welcome piece of legislation, it does raise certain concerns, including inter alia:
- That it is meant to fit a round peg into a square hole, e.g. trying to adapt archaic securities laws to modern tech instead of a well-due overhaul of the underlying framework.
- The requirement that issuers not substantially change their networks for three months after they are deemed to be decentralized. This could prevent issuers from making necessary changes to their networks.
- The requirement that issuers not own or control more than 20% of the network's outstanding tokens. This could prevent issuers from raising enough capital to launch their networks.
- The requirement that investors comply with certain anonymity and KYC requirements in order to participate in crowdfunding offerings. This could discourage some investors from participating in crowdfunding offerings.
- That this is a Republican-backed bill that still needs to win over Democrat support, which may go against the general Democrat agenda.
d) Final Thoughts
DAMS is a significant piece of legislation that, despite it drawbacks, could have a major positive impact on the digital asset industry in the United States. However, the Bill is still in its early stages, needs to build up support and is likely to be further modified before it is passed into law.
2. Recent Litigations
On June 2, 2023, the U.S. Securities and Exchange Commission (SEC) filed a lawsuit against Binance, BAM/Binance.US entities, CZ and his personal corporate affiliates, alleging a host of securities laws violations by operating an unregistered digital asset exchange and failing to register as a broker-dealer. The SEC's complaint further alleges that Binance, the world's largest cryptocurrency exchange, allowed U.S. customers to trade digital assets without registering with the SEC as a securities exchange or broker-dealer. The SEC also alleges that Binance failed to implement adequate AML and KYC procedures, which allowed Binance to be used by criminals to launder money and finance terrorist activities. The SEC's complaint alleges that CZ, Binance's founder and CEO, personally aided and abetted Binance's violations of securities laws. The SEC alleges that CZ was aware of Binance's violations but did nothing to stop them. Specifically, The SEC's complaint alleges that Binance and CZ violated the following securities laws: (A) the Securities Act of 1933, which prohibits the offer and sale of securities without registration or an exemption from registration; and (B) the Securities Exchange Act of 1934, which prohibits fraud and manipulation in connection with the purchase or sale of securities.
The SEC's complaint alleges that Binance raised over $1.8 billion from U.S. investors through the sale of digital tokens, but failed to register with the SEC as a securities exchange or broker-dealer. The SEC also alleges that Binance failed to implement adequate AML and KYC procedures, which allowed Binance to be used by criminals to launder money and finance terrorist activities. Binance and CZ have denied the allegations in the SEC's complaint and are actively onboarding top legal counsel in preparation to fight the lawsuit.
On June 7, 2023The Securities and Exchange Commission (SEC) filed a lawsuit against Coinbase alleging that the exchange violated securities laws by operating as an unregistered exchange, broker-dealer, and clearing agency. The SEC also alleges that Coinbase offered unregistered, nonexempt securities through its delegated staking program and specifically names a host of altcoins as securities. Coinbase has denied the allegations and said it will fight the lawsuit. The case is still in its early stages, but it is bound to have a significant impact on the industry because of, inter alia, the SEC’s low-key attempt to slip in a precedent for group-tagging tokens as securities. Unlike the suit against Binance/CZ, the suit against Coinbase is much “milder” towards the defendant and more administrative in nature as it does not entail corresponding criminal allegations or proceedings. This lawsuit centers on two main issues: market structure and delegated staking.
(1) Market structure: The SEC alleges that Coinbase violated the 1934 Securities Exchange Act by failing to register as a national exchange, broker-dealer, and clearing agency. The 1934 Act requires that these functions be separated to protect investors. Exchanges are responsible for bringing together buyers and sellers of securities, while broker-dealers execute trades on behalf of customers and clearing agencies settle trades between buyers and sellers.
The SEC alleges that Coinbase operates as an unregistered exchange because it facilitates the trading of securities on its platform. The SEC also alleges that Coinbase operates as an unregistered broker-dealer because it executes trades on behalf of customers and clears trades between buyers and sellers.
(2) Delegated staking: Coinbase's delegated staking program allows users to stake their cryptocurrency on the Coinbase platform and earn rewards. The SEC alleges that Coinbase's delegated staking program is an unregistered securities offering because it meets the four Howey test criteria:
- 1. An investment of money;
- 2. In a common enterprise;
- 3. With a reasonable expectation of profits to be derived from the efforts of others;
- 4. With the investment being in a scheme to operate and manage a profit-making enterprise.
The SEC alleges that users who stake their assets with Coinbase are making an investment of money because they are giving up their cryptocurrency in exchange for the promise of future rewards. The SEC also alleges that users who stake their cryptocurrency with Coinbase are participating in a common enterprise because they are all working together to validate blockchain transactions and earn rewards. The SEC further alleges that users who stake their cryptocurrency with Coinbase have a reasonable expectation of profits because they are relying on Coinbase to manage the staking process and earn rewards. Finally, the SEC alleges that users who stake their cryptocurrency with Coinbase are investing in a scheme to operate and manage a profit-making enterprise because Coinbase is using the staking rewards to generate revenue. While most of the allegations are routine and administrative, this lawsuit deserves significant attention, and a good job by Coinbase counsel refuting the allegations, because the SEC is attempting to implicitly create a precedent for future use in naming a host of major tokens as securities.
EUROPEAN UNION – MiCA
The European Commission presented the MiCA proposal on 24 September 2020. It is part of the larger digital finance package, which aims to develop a European approach that fosters technological development and ensures financial stability and consumer protection. In addition to the MiCA proposal, the package contains a digital finance strategy, a Digital Operational Resilience Act (DORA), that covers crypto-asset service providers as well, and a proposal on distributed ledger technology (DLT) pilot regime for wholesale uses.
This package bridges a gap in existing EU legislation by ensuring that the current legal framework does not pose obstacles to the use of new digital financial instruments and, at the same time, ensures that such new technologies and products fall within the scope of financial regulation and operational risk management arrangements of firms active in the EU. Thus, the package aims to support innovation and the uptake of new financial technologies while providing for an appropriate level of consumer and investor protection.
The Council adopted its negotiating mandate on MiCA on 24 November 2021. Trilogues between the co-legislators started on 31 March 2022 and ended in a provisional agreement reached on 30 June 2022. Today’s formal adoption of the regulation is the final step in the legislative process.
b) Key Areas of Significance
The MiCA regulation will have a significant impact on crypto users in the EU. Some of the key provisions of the regulation that will affect crypto users include:
- Licensing requirements: Under MiCA, crypto providers will be required to obtain a license from a national competent authority in order to operate in the EU. This will mean that crypto users will only be able to use crypto services that are provided by licensed providers.
- AML/CTF compliance: Crypto providers will be required to comply with AML/CTF regulations under MiCA. This will mean that crypto users will be subject to the same AML/CTF checks as other financial services users.
- Consumer protection: MiCA will provide increased consumer protection by requiring crypto providers to provide clear and concise information to consumers about the risks associated with crypto assets. This information will need to be provided in a way that is understandable to consumers.
- Market transparency: MiCA will increase market transparency by requiring crypto providers to provide regular reports on their activities to ESMA. These reports will include information on the number of users, the volume of trading, and the risks associated with the crypto assets that the provider offers.
- Innovation: MiCA is designed to promote innovation in the crypto sector by providing a clear regulatory framework for businesses to operate within. The regulation does not seek to stifle innovation, but rather to ensure that it takes place in a safe and orderly manner.
The MiCA regulation is a complex piece of legislation, and it is still under development. However, the overall impact of the regulation on crypto users is likely to be positive. The regulation will provide increased consumer protection and market transparency, and it will also promote innovation in the crypto sector.
c) Legal considerations
The MiCA regulation is a piece of EU law, and it will therefore be directly applicable in all EU member states. This means that crypto users in the EU will be subject to the same regulatory requirements, regardless of where they live. The MiCA regulation will also have extraterritorial effect. This means that crypto providers that offer services to EU users will need to comply with the regulation, even if they are not located in the EU.
d) Final Thoughts
The MiCA regulation is a significant development for the crypto industry. The regulation will provide much-needed clarity and certainty for businesses and users operating in the EU sector, and it will help to protect consumers from fraud and other risks. MiCA is also likely to have a significant impact on the global crypto market being the first comprehensive regulatory framework for crypto assets in a major market. As a result, it is likely to be used as a template for other jurisdictions.
Overall, the MiCA regulation is a positive development for the crypto industry. The regulation will help to ensure that the crypto market is fair, orderly, and transparent. It will also help to protect consumers from fraud and other risks.
Geopolitical sanctions are economic restrictions that are imposed by governments on individuals or entities in order to achieve a political or economic objective. These sanctions can have a significant impact on crypto users, as they can make it difficult or impossible to use crypto assets to interact with sanctioned entities.
In the US, the Office of Foreign Assets Control (OFAC) is responsible for administering sanctions. OFAC has issued a number of regulations that specifically target the use of crypto assets to evade sanctions. For example, OFAC’s regulations prohibit the use of crypto assets to:
- Transfer funds to or from sanctioned entities;
- Pay for goods or services from sanctioned entities;
- Invest in sanctioned entities.
The EU also has a number of sanctions that can affect crypto users. The European Union's (EU) Foreign Affairs Council is responsible for adopting sanctions. The EU has adopted a number of regulations that specifically target the use of crypto assets to evade sanctions. By way of example, the Article 5b(2) of Council Regulation (EU) No 833/2014 states that “It shall be prohibited to provide crypto-asset wallet, account or custody services to Russian nationals or natural persons residing in Russia, or legal persons, entities or bodies established in Russia”. Such restriction means that that no new services or accounts are allowed and existing services or accounts must be closed.
Crypto transactions can be traced and the use of crypto assets to evade sanctions is a serious offense. In the US, individuals or entities who violate OFAC's regulations can be subject to civil penalties of up to $250,000 per violation, or criminal penalties of up to 20 years in prison. In the EU, individuals or entities who violate the EU's regulations can be subject to fines of up to €5 million, or 10% of their annual turnover. Thus, it is imperative to be aware of the geopolitical sanctions that may apply when carrying out transactions or interacting with certain persons, entities and exchanges.
CRYPTO TAXATION CONSIDERATIONS
Cryptocurrency taxation is a complex and evolving topic. The rules for how cryptocurrencies are taxed vary depending on the jurisdiction, and there is still a lot of uncertainty around the issue. However, it is important to understand the basics of crypto taxation in their current application to major jurisdictions.
A. UNITED STATES
1. General Overview
The Internal Revenue Service (IRS) considers cryptocurrency to be property, and therefore, any gains or losses from cryptocurrency transactions are subject to capital gains taxes. This means that when you sell, trade, or otherwise dispose of cryptocurrency, you will need to calculate the difference between your cost basis (the amount you paid for the cryptocurrency) and the fair market value of the cryptocurrency at the time of the sale or trade. Any gain is taxable, and any loss can be used to offset other capital gains. Specifically:
- Cost basis: The cost basis of cryptocurrency is the amount you paid for it, plus any fees associated with the purchase.
- Fair market value: The fair market value of cryptocurrency is the price that it would sell for on an open market.
- Capital gains: Capital gains are the profits you make when you sell an asset for more than you paid for it.
- Capital losses: Capital losses are the losses you make when you sell an asset for less than you paid for it.
- Short-term gains: Short-term gains are capital gains that you realize on assets that you held for one year or less.
- Long-term gains: Long-term gains are capital gains that you realize on assets that you held for more than one year.
- Short-term losses: Short-term losses can be used to offset short-term gains.
- Long-term losses: Long-term losses can be used to offset long-term gains, or they can be carried forward indefinitely to offset future short-term or long-term gains.
The IRS taxes cryptocurrency gains and losses at the same rates as other capital gains and losses. The rates depend on your income and filing status. For example, in 2023, the top capital gains tax rate for single filers with taxable income of $518,400+ is 20%.
The IRS also requires cryptocurrency exchanges to report certain information about their customers to the IRS. This information includes the customer's name, address, and taxpayer identification number (TIN). The IRS will use this information to match transactions to tax returns and to identify taxpayers who may be underreporting their cryptocurrency gains.
2. Issued Guidance
The IRS has released a number of guidance on cryptocurrency taxation over the years, including:
- Notice 2014-21, which provides general guidance on the tax treatment of cryptocurrency.
- Revenue Ruling 2019-24, which provides guidance on the tax treatment of airdrops and forks.
- Cryptocurrency Frequently Asked Questions, which provides answers to frequently asked questions about cryptocurrency taxation.
The IRS has also announced that it will be cracking down on cryptocurrency tax evasion. In 2021, the IRS launched a new unit, the National Cryptocurrency Enforcement Team (NCET), to focus on investigating cryptocurrency-related tax crimes.
B. EUROPEAN UNION
Taxation of crypto assets in the EU is currently governed by a patchwork of national laws. There is no single EU-wide law on crypto taxation, and each member state has its own rules and regulations. This can make it difficult for taxpayers to comply with the law, and it can also create opportunities for tax avoidance. Some member states, such as Portugal, have relatively favorable tax regimes for crypto assets. Portugal does not impose capital gains tax on crypto assets if the assets in hold for more than 365 days, which makes it a popular destination for crypto investors. Other member states, such as Germany, have more restrictive tax regimes. Germany taxes crypto assets as property, which can result in high tax bills for investors looking to cash out under its jurisdiction.
Once fully enacted, the aforementioned MiCA will create a single EU-wide framework for crypto regulation, including taxation. In the meantime, taxpayers should be aware of the national laws in their own member state and comply with those laws.
As we can see, the regulatory and tax regimes for crypto are highly jurisdiction-specific and for the most part are as clear as mud with significant frameworks just starting to slowly be introduced. While the specifics of crypto regulation remain uncertain, it is clear that the technology is here to stay. As the industry matures, we can expect to see more comprehensive and harmonized regulations. CEX’s play a vital role in this ecosystem. They provide a platform for users to buy, sell, trade cryptocurrencies and provide the fiat on- and off-ramp logistics. However, not all CEXs are created equal, yet all of them are directly affected by the regulations, compliance and security concerns. It is thus imperative to be aware of the risks involved in trading cryptocurrencies and to develop careful planning for asset logistics using reputable exchanges.
Keep your finger on the pulse of global change through our research! Follow us on Twitter for the most convenient way to track all our updates and insights. Start your journey into the digital frontier with just one click.
Thank you for reading this research.
It's not a financial advice.
Follow us on Twitter: @ax1vc