Latest Pronouncements From OECD, EU & G20 Allow Fintech To Flourish: Expert Take

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Last week marked the 10-year anniversary of Bear Stearns’ infamous collapse at the dawn of the global financial crisis caused by highly leveraged mortgage-back-security lending and related transactions – an event which allowed for today’s crypto economy to emerge. It was also the week the topic of cryptocurrencies, Blockchain technology and digital taxation received considerable coordinated attention from global Intergovernmental organizations, regulators, legislators and central banks who discussed their impact on financial stability and potential uses in tax evasion and illegal activities during the G20 meeting in Buenos Aires, Argentina.

During the meeting, world’s economic leaders agreed that cryptocurrencies and Blockchain technology, given its borderless and intangible nature, are fundamentally reshaping the global cross-border financial connectedness, and its increasing ability to automate cognitive tasks. The G20 settled on characterizing cryptocurrencies as property, thereby setting the stage for cryptocurrencies to be adapted as a new digital-asset-class.   They committed to implementing Financial Action Task Force (FATF)’s anti-money laundering (AML) and terrorist financing standards as they apply to crypto-assets to mitigate concerns over security, consumer protection, and financial crime.  As well as to abide by Organization for Economic Cooperation and Development (OECD)’s Base Erosion and Profit Shifting (BEPS) framework, study international nexus and profit allocation concepts for taxing the digital economy (BEPS Action 1) and come up with a new approach by 2020, as agreed upon by 113 countries. They also established a July 2018 deadline for proposals for cryptocurrency regulations.

Digital tax measures proposed by the European Union

With a long-term solution to taxing digital firms postponed to 2020, the EU Commission took the lead on proposing two new digital tax rules that will be submitted to the Council for adoption and to the European Parliament for consultation.

The first one suggests a common reform of the EU’s corporate tax rules to enable member states to tax digital profits that are generated in their territory, even if a company does not have a physical presence there. A digital platform will be deemed to have a taxable nexus, ‘digital presence’ or a virtual permanent establishment in a member state if it fulfils one of the following criteria. It exceeds a threshold of seven mln euro in annual revenues in a member state or has more than 100,000 users there in a taxable year, it has over 3,000 business contracts for digital services that are created between the company and business users in a taxable year. This proposal resembles a concept of nexus by Internet “cookies,” which differs from the physical presence nexus test as defined under OECD Model Tax Conventions.

Commission’s second proposal imposes a temporary interim tax of three percent to companies with total annual worldwide revenues of 750 mln euro and EU revenues of 50 mln euro on certain digital revenues created from selling online advertising space, digital intermediary activities which allow users to interact with other users and which can facilitate the sale of goods and services between them, selling data generated from user-provided information. This interim tax will be repealed once a long-term solution is jointly agreed upon by the OECD.

Crypto-asset lending firms emerge

With the fintech friendly announcements from OECD, EU, G20 and increased interest in crypto-assets by institutional investors, a new type of Fintech business- crypto-asset lending has been surfacing all over the world.

It’s a similar business to securities lending, which utilizes long-term stock holdings of institutional lenders, such as mutual funds, pension funds, insurance companies, exchange-traded funds and sovereign wealth funds, that would otherwise sit idle by temporarily lending them out on a collateralized basis and investing the cash in safe, short-term investments for a modest return.

Borrowers, typically hedge funds, use the securities to cover short positions, to hedge positions or to take advantage of arbitrage opportunities. They post securities as collateral that is usually 102-105 percent of the market value of the securities, with a promise to both return the shares, the same type and amount of securities, on demand and cover any dividends paid out in the meantime. If the shares are liquid and easy to borrow, the lender gets a modest fee for its cooperation and keeps an agreed-upon percentage of the interest earned on the collateral.

In the 1990s and 2000s, the demand for securities lending grew with the expansion of global securities markets and the exponential increase in short-selling by hedge funds. In 2007, there was an estimated $5.5 tln worth of securities on loan through various lending programs. But during the financial meltdown when securities prices fell precipitously, widespread abuses by securities lending agents came to light that led to disastrous losses for institutional securities lenders.

Market demand from institutional crypto-asset owners such as hedge funds and miners are fueling different types of crypto-asset lending businesses to emerge. Including U.S. mutual fund giant Fidelity Investments, with $6.3 tln under administration, which has entered the crypto-mining business because, a company official said, ‘‘we can see that the evolution of Bitcoin and Blockchain technology is setting the investment industry up for disruption.”

Some crypto-asset lenders are offering fiat currency loans to accredited investors who purchase a token to become members of their firms. These loans do not require a credit check or much paperwork but are expensive. Borrowers put up as much as 200 percent in crypto-asset collateral, for fiat currency loans issued at interest rates ranging from 10 percent to 25 percent.  

Other companies are peer-to-peer lenders where the platform matches lenders to borrowers in return for a fee.  

Crypto-asset-lending firms, backed by Blockchain technology, designed to reduce fraud, are exploring ways to offer the loans that make automatic interest payments via smart contracts.   These companies are nevertheless subject to similar risks associated with securities-lending and more.

Crypto-asset valuation

A crypto-assets’ value, which will serve as the collateral to a loan, is determined based on the demand for the cryptocurrency or token which may be highly volatile and illiquid as well as the financial performance of the token issuing company. Currently, there isn’t a standardized way of determining a crypto-assets value, because different exchanges are trading the same crypto-assets at different prices. This makes margin call monitoring especially difficult to implement for crypto-asset lending firms.

Blockchain technology

The crypto-asset lending firms are established on Ethereum (ETH) or Bitcoin (BTC) platforms which are in its early stages of development, and their application is of experimental nature. These platforms are vulnerable to computer viruses, physical or electronic break-ins, attacks or other disruptions of a similar nature (Hacks) as well as hard forks.

Regulatory & Tax

Global regulators, legislators and central bankers have committed to devising effective AML/KYC regulations for crypto-assets by July 2018.  It is not known whether they will come up with a coordinated approach to regulations for cross-border crypto-asset lending transactions as it pertains to registering securities interests in crypto-assets and their treatment under bankruptcy laws by the upcoming deadline.

Furthermore, it should be noted that the Internal Revenue Service (IRS) guidance on crypto taxation does not address crypto-asset loans or hard forks. In the event IRS treats crypto-asset lending transactions or hard forks as tax realization events, the resulting US tax obligations along with the applicable penalties for failing to file applicable tax returns could make the crypto-asset loans all the more expensive. Borrowers, including offshore hedge funds, are urged to take in to consideration the uncertain US tax treatment of their crypto-asset financing transactions and if need be, take advantage of the IRS Offshore Voluntary Disclosure Program before it ends by September 2018. On March 23 the IRS reminded taxpayers to report their virtual currency transactions or face applicable civil, as well as the criminal penalties for non-compliance.  

The views and interpretations in this article are those of the author and do not necessarily represent the views of Cointelegraph.

Selva Ozelli, Esq., CPA is an international tax attorney and CPA who frequently writes about tax, legal and accounting issues for Tax Notes, Bloomberg BNA, other publications and the OECD.

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