In the current COVID-19 crisis, businesses across the country need access to capital and liquidity. Many businesses have found it difficult to obtain capital and liquidity through traditional financial institutions and conventional financing mechanisms. Though the government has stepped in to help, new loan programs enacted in the CARES Act are capped and the Paycheck Protection Program (PPP) has complex and burdensome rules that make it unusable for a large number of businesses. This has been particularly harmful to small businesses, who do not typically have the financial safety nets of larger businesses, such as extensive revolving lines of credit, robust cash reserves, or access to public capital markets.
Digital assets, such as bitcoin, ether, and XRP, have the potential to help solve this problem. As more and more businesses are becoming comfortable with dealing in digital assets, these instruments represent an untapped potential source of capital that can be deployed as short-term loans to businesses that require capital and liquidity to maintain operations, including payroll costs. The overall size of the digital asset market is approximately $269 billion USD (as of July 7, 2020) and experts conservatively estimate that $50 billion USD of digital assets would be available for lending.
However, this potential source of capital remains untapped due to the uncertainty surrounding its tax treatment. Current law largely is silent on the tax treatment of loans of digital assets, which the IRS refers to as “convertible virtual currencies.” We believe there is basis under current law to treat loans of convertible virtual currencies as non-taxable events, assuming further that the assets are loaned in units, returned in units, and callable on demand. However, there is sufficient uncertainty about whether the loan of convertible virtual currencies could be recast or treated as a deemed taxable sale, with the adverse effect that many in the industry with the ability to lend convertible virtual currencies refrain from doing so.
To free up this additional source of capital and liquidity, Congress needs to pass legislation that clarifies that loans of digital assets, aside from any interest or fees earned, should not be taxable transactions. Fortunately, there is precedent for this sort of congressional action. Beginning in the 1940s, as the securities market grew, there was increasing interest in loaning securities, in order to provide market participants liquidity to engage in trading activities inherent in healthy markets. However, because there was no clear guidance on how a securities loan would be taxed, more conservative market participants elected to stay out of the market. In 1978, Congress passed legislation that created Section 1058 of the tax code clarifying that securities lending would not be treated as a taxable exchange of the loaned securities.
Because convertible virtual currencies are not securities, Section 1058 does not apply to such loans. Congressional action is needed to provide similar clarity for loans of convertible virtual currencies. With this clarity, digital asset lenders will have the legal certainty needed to make capital, in the form of digital assets, available to businesses across the country. In this time of economic contraction, all available sources of capital and liquidity should be made available, and digital asset lenders are ready to play their part.