Although it’s inaccurate to say that the Chinese character for “crisis” combines the characters for danger and opportunity, the thought has resonated since President Kennedy repeatedly used this trope in his presidential campaign speeches. Cryptocurrency investors and traders whose digital assets have become trapped on one of the several platforms that suspended redemptions or declared bankruptcy now have a hopeful prospect in such events—a silver lining, as it were—in being able to accelerate tax losses on these assets as a result of the January 4, 2023, decision of the US Bankruptcy Court for the Southern District of New York in the Chapter 11 cases of Celsius Network LLC and its affiliates (collectively, “Celsius”).1
The court delivered a consequential adverse ruling against cryptocurrency traders and investors that had placed their digital assets on the Celsius platform. Specifically, the court held that digital assets held in Celsius’ customer accounts belonged to Celsius, in effect rendering the account holders unsecured creditors. The decision addressed digital assets held in the Celsius high-interest “Earn” program, which allowed the account holders to deposit their digital assets into accounts on the Celsius platform and earn substantial yields from the deposits. Under the program, the assets on the platform were intermingled and invested by Celsius, and generated returns shared with the depositors. The Earn program held 77% of assets on the platform, with a market value of approximately $4.2 billion as of the bankruptcy filing.
The holding in Celsius, supra, that the deposit of digital assets onto a lending platform is a sale of such assets in exchange for a promise to deliver identical assets in the future, should result in a disposition of such assets for federal income tax purposes. Under Treasury Regulation § 1.1001-1(a), however, a taxable sale only occurs when a taxpayer exchanges property, here the digital assets, “for other property differing materially in kind or extent.” The promise of Celsius to return identical property most likely meant that the deposit of the cryptocurrencies did not result in the depositors receiving a promise to be given property that “differed materially in kind and extent” at the time of the transfer. When this promise was broken, however, the depositors should be considered to have incurred a loss.
A. The Open Transaction Doctrine and Securities Lending Transactions
The digital asset deposits made by the Celsius account holders bear a strong resemblance to securities lending transactions, but with cryptocurrencies instead of securities.2 In each case, the lender/depositor is transferring away property in exchange for a promise to receive back identical property in the future. Thus, the rules governing securities lending transactions may be applicable to deposits of digital assets onto platforms such as the Celsius high-interest “Earn” program.3 To the extent that the deposits of cryptocurrency are treated as analogous to a securities lending transaction, authorities support the conclusion that under the tax accounting rules for these types of lending programs, a loss should be available when the platform fails to deliver back the loaned property, in this case, the cryptocurrency.
The first step in the analysis is determining how should the initial transfer be characterized. In General Counsel Memoranda 39648 (July 20, 1987), the Internal Revenue Service (the “IRS”) set forth its position that when there is a transfer of securities for a promise to return identical securities, “it is clear that the transaction . . . results in a disposition rather than a loan of securities.”4 The IRS’s conclusion seems further warranted when the borrower has the right to hypothecate the securities (or cryptocurrency), as in the Celsius case. In this case, the borrower can transfer securities to a third party who can exercise full dominion and control over the assets and who has no way of knowing that the securities in its hands came from the original lender. It would be anomalous on these facts to conclude that no disposition occurred.
The fact that a disposition occurred, however, is not sufficient to determine whether gain or loss is recognized. The next inquiry is to determine whether the digital asset lender had received property that differs “materially in kind or extent” within the meaning of Treasury Regulation § 1.001-1(a). An initial sub-issue is when the question is asked. In the GCM, the IRS concluded that the disposition is not judged for differences in kind or extent at the time of the initial transfer of the property. Instead, “the transaction remains open and the income tax consequences [are] not to be determined until the borrower satisfies his obligation to the lender.”5 If the borrower (the digital asset platform) “satisfies his obligation under the contract by delivering to the lender securities of the same principal amount and of the same issue as the securities borrowed, the transaction is a nontaxable exchange.”6
So what happens if the digital asset borrower, Celsius in our case, does not deliver back the cryptocurrency that it had borrowed? It should follow that if the lender demands his property back in accordance with the terms under which he lent it, and the counterparty does not deliver identical property to the property that was placed on the platform, the open transaction doctrine should cease to apply from and after that time. The open transaction doctrine does not require a re-evaluation of the year in which the first part of the transaction occurred. So, a sale or exchange of the cryptocurrency should be deemed have occurred at the time of the failure to return.
B. Character of the Loss
A trader or investor in cryptocurrency should treat fungible or non-fungible coins as capital assets. The IRS has already stated that gains and losses from dispositions of digital assets (that are capital assets in the hands of the taxpayer) are capital gains and losses.7 As discussed above, the deposit of the cryptocurrencies on to the Celsius platform may be treated as a comparable to a securities lending transaction and, thus, treated as a disposition for federal income tax purposes. No gain or loss would be recognized in connection with such a disposition, however, because the open transaction doctrine would have applied. However, when the open transaction doctrine ceases to apply, the depositor should recognize a capital loss. When the open transaction doctrine ceases to apply because the borrower completely failed in its obligation to return the property, the digital asset lender should have a zero amount realized. This analysis would permit the digital asset lender to claim a capital loss for its basis in the cryptocurrency that was lost in the bankruptcy.
C. Interaction with Existing IRS Guidance
In a recent Chief Counsel Advice memorandum, the IRS concluded that taxpayers could not claim either abandonment losses or a worthlessness deduction for substantially impaired positions in cryptocurrencies.8 Such deductions are of dubious value for many taxpayers in any event due to the suspension of miscellaneous itemized deductions. The capital loss opportunity provided by the Celsius decision may allow a taxpayer to avoid having to attempt to claim a loss under either of these theories. Although the limitations on capital losses make such losses less attractive than ordinary losses, the ability to claim such losses is a significant improvement over nondeductible losses.
Mark (212 506 2499; firstname.lastname@example.org) and Kyoolee (212 506 2687; email@example.com) are tax lawyers with the New York office of Mayer Brown LLP. They do a substantial amount of work on the tax issues associated with cryptocurrency and non-fungible token (“NFT”) trading.
(1) The securities lending agreement must be in writing;
(2) The agreement must provide for a return to the lender of securities that are identical to the securities borrowed;
(3) The borrower must be required to pay amounts equivalent to all interest, dividends or other distributions (as applicable) which the owner of the securities is entitled to receive during the term of the securities loan; and
(4) The securities loan must not reduce the lender’s opportunity for gain or risk of loss by specifically providing that the lender may terminate the securities loan upon not more than five business days’ notice.
3 Code § 1058 contains statutory rules for the treatment of securities lending transactions. These rules do not apply to digital assets because digital assets are commodities and not securities. IRS Notice 2014-21, 2014-16 IRB 938. Accordingly, the Code § 1058 rules will not be discussed in text.
8 CCA 202302011. We analyzed the prior guidance in our January 2023 Legal Update: https://www.mayerbrown.com/en/perspectives-events/publications/2023/01/the-january-effect-the-us-internal-revenue-service-rules-on-cryptocurrency-loss-harvesting.