Silver Linings Playbook: Celsius Bankruptcy Ruling Provides Cryptocurrency Tax Planning Opportunities – Fin Tech
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 main issue before the court was whether the investors and
traders continued to own the digital assets that they deposited
with Celsius, or whether they traded these assets away to Celsius
in exchange for an unsecured promise on the part of Celsius to
deliver identical assets in the future. To answer this question,
the court examined whether the Terms of Use for the Earn program
were “unambiguous with respect to whether [the account
holders] retained ownership or transferred ownership of
cryptocurrency assets by depositing the assets into Earn
Accounts.” The depositors argued that the Terms of Use were
ambiguous as to the ownership of the assets because it repeatedly
used the terms like “loan” or “lending,” which
suggested that the depositors retained ownership. The court
rejected this argument and stated that based on the transfer of
title clause, it was clear that the title to, and the ownership of,
the digital assets belonged to Celsius. Furthermore, nothing in the
Terms of Use suggested that the depositors retained a lien on the
digital assets. Therefore, the depositors did not have a secured
claim to the assets in their Earn accounts.
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.
Footnotes
1. In re Celsius Network LLC, Case No. 22-10964
(Bankr. S.D.N.Y. Jan. 4, 2023), Memorandum Opinion and Order
Regarding Ownership of Earn Account Assets, Docket No. 1822
(“the Decision”).
2. Code § 1058(b), coupled with the proposed
regulations issued thereunder, contains four requirements for a
transfer of securities to be treated as a securities lending
transaction:
(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.
4. This position reinforced a similar conclusion reached
earlier in General Counsel Memo 29205.
5. In tax parlance, this rule is referred to as the
“open transaction doctrine.”
6. Id.
7. Notice 2014-21, 2014-16 I.R.B. 938.
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.
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