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On April 10, 2019, U.S. Representatives Warren Davidson (R-OH) and Darren Soto (D-FL) ‎reintroduced the Token Taxonomy Act1‎ (“TTA”) in the effort to amend the Securities Act of ‎‎1933 and the Securities Exchange Act of 1934 to exclude “digital tokens” from the definition of ‎a security and provide tax certainty on such assets. As currently drafted, “digital tokens” under ‎the TTA are fundamentally digital units on a distributed blockchain that do not represent “a ‎financial interest in a company or partnership”.2‎ ‎ Reps. Davidson and Soto first introduced the ‎TTA in December 2018; however, this previous attempt to pass the bill was unsuccessful because ‎the 115th Congress failed to make a decision prior to the end of its session. ‎Reps. Davidson and ‎Soto, along with other proponents, hope that the passage of the TTA will provide legal and ‎regulatory clarity for businesses, entrepreneurs, and regulators alike with respect to digital tokens.‎

While interest in blockchain, distributed ledger technologies, and cryptocurrencies has ‎grown exponentially in the last several years—both nationally and globally—regulators, including ‎the U.S. Securities and Exchange Commission (“SEC”), have encountered challenges keeping ‎pace with the rapidly growing industry.‎ 3‎ This is particularly pressing for digital tokens designed ‎for end-use as a medium of exchange or store of value. For example, if a digital token sale ‎and/or the method of token distribution is undertaken with an expectation profit or growth in ‎value of the token, according to recent SEC guidance (see below), such sale would generally be ‎deemed as a sale of a security. As a result, the token issuer would be subject to prescribed ‎requirements promulgated by the SEC for such transactions, raising compliance costs and ‎undercutting the transferability of the underlying asset. As a result, there is an open debate on ‎whether it is best for regulators to treat digital tokens, such as cryptocurrencies, as securities, or ‎rather consider them as another type of asset, such as a currency, a commodity, or a newly ‎created class. The TTA seeks to slot digital tokens into a new class. ‎

On April 3, 2019, the SEC’s Division of Corporation Finance issued a Statement with a ‎‎“Framework for ‘Investment Contract’ Analysis of Digital Assets”4‎ ‎(the “Framework”) to ‎provide guidance on how the SEC plans to determine whether a digital asset is a security.5‎ ‎ The ‎Framework, while not a formal rule, goes a step further from the SEC’s prior statements that the ‎Howey test ‎ for investment contracts should be applied to sales or offerings of digital tokens, ‎coins, or other assets. Under the Howey test6, an “investment contract” exists when there is the (1) ‎investment of money in a (2) common enterprise (3) with a reasonable expectation of profits to be ‎derived from the efforts of others.‎

The Framework provides that the “first prong of the Howey test is typically satisfied in an ‎offer and sale of a digital assert because the digital asset is purchased or otherwise acquired in ‎exchange for value, whether in the form of real (or fiat) currency, another digital asset, or other ‎type of consideration,” and that the second “common enterprise” prong “typically exists.” ‎According to the SEC, the main issue is generally with the final prong, “whether a purchaser has ‎a reasonable expectation of profits (or other financial returns) derived from the efforts of others.” ‎In short, the Framework provides that the SEC will generally find a “reliance on the efforts of ‎others” if the blockchain has any feature that is centrally controlled by the entity offering or ‎selling the digital asset (or by a group of third parties affiliated with that entity). ‎

Accordingly, it is no surprise that the question of whether or not a digital token is deemed a ‎securityhas tremendous implications on any issuer of digital tokens, particularly ones aiming to ‎create a functioning cryptocurrency. To this end, the TTA would provide clarity to some of ‎currently open-ended questions. ‎

Excludes “Digital Tokens” from the Definition of a Security

The TTA amends Section 2(a)(1) of the Security Act of 1933 to expressly exclude ‎‎“digital tokens” from the definition of a “security.” Additionally, “digital token” would mean a ‎‎“digital unit,” which is a representation of economic, proprietary, or access rights that is stored in ‎a computer-readable format.‎

U.S. Federal Income Tax Implications

The TTA would also allow the sale of digital assets to qualify for the benefits of Internal ‎Revenue Code Section 1031 “like-kind exchange” provision. This provision provides a limited ‎exclusion of capital gains of up to $600 from a sale or exchange of virtual currency from an ‎individual’s gross income so long as the sale or exchange is not for cash or cash equivalents.7

Jurisdiction & Federal Preemption ‎

Finally, the TTA further clarifies jurisdictional parameters in its effort to streamline ‎federal enforcement. For example, Section 6 of the TTA provides that “[n]othing this Act or the ‎amendments made by this Act shall be construed to limit the application of the Commodity ‎Exchange Act or the Federal Trade Commission Act.” More notably, to clarify any conflicting ‎state initiatives and regulatory rulings, the TTA preempts any state laws which would otherwise ‎overlap with TTA.‎

Conclusion

As businesses and investors continue to enter the crypto ecosystem, the need to establish ‎clear and comprehensive laws with respect to digital tokens is crucial. Rep. Soto noted in his ‎press release,8‎ ‎ “[t]his is an important first-step to promoting innovation and maximizing the ‎potential of virtual currencies for the U.S. economy, all while protecting customers and the ‎financial well-being of investors.” ‎

1. ‎See H.R. 2144 – Token Taxonomy Act of 2019 found here.‎
2. ‎Under the TTA, the term ‘digital token’ means “a digital unit— “(A) that 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 any single person or 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) that has a transaction history ‎that— “(i) is recorded in a distributed, digital ledger or digital data structure in which consensus is achieved through ‎a mathematically verifiable process; and“(ii) after consensus is reached, resists modification or tampering by any ‎single person or group of persons under common control;“(C) that is capable of being transferred between persons ‎without an intermediate custodian; and“(D) that is not a representation of a financial interest in a company or ‎partnership, including an ownership interest or revenue share.” Id.‎
3. For a more thorough discussion surrounding the issue of what constitutes a “security,” please refer to Locke Lord ‎QuickStudy: Staking its Claim: SEC Provides Comprehensive Guide for Blockchain, Digital Asset Securities.‎
4. See Framework for “Investment Contract” Analysis of Digital Assets. The Framework can be found here.‎
5. See SEC Clarifies How to Tell When a Token is a Security – A New Framework found here. ‎
6. See SEC v. W.J. Howey Co., 328 U.S. 293 (1946). ‎
7. See 26 U.S.C. § 1031 found here.‎
8. See Rep. Darren Soto’s Press Release entitled “Soto, Davidson Introduce Digital Token Taxonomy Package to ‎Address Blockchain Innovation Flight in America.” The Press Release can be found here.‎