Awaken + Fenwick Legal Opinion

This article discusses the U.S. federal income tax consequences of "wrapping" crypto-assets. Wrapping – as further discussed below – is a common occurrence whereby a tokenized representation of an underlying crypto-asset is created. The U.S. Internal Revenue Service ("IRS") has not provided any guidance to date on the tax treatment of wrapping assets. That said, current law provides a clear framework for the proper tax treatment of wrapping and unwrapping tokens (which applies in equal force to tokens being bridged, and to tokens representing underlying interests in token pools, as discussed below). As discussed below, the wrapping of a crypto-asset should not result in a taxable event under current U.S. federal income tax law.

Background

Crypto-assets¹ can be wrapped. Wrapping a crypto-asset results in a tokenized representation of the wrapped crypto-asset – what we will call a Receipt Token. A Receipt Token is often (but not always) pegged at a 1:1 ratio to the underlying asset, and tracks the value of the underlying token. A Receipt Token can, in some cases, enable a token's value to be utilized on a different blockchain. A Receipt Token may also represent an underlying interest in a liquidity pool or a staking pool. In either case, it is merely a tokenized form of another token.

An example is illustrative. Consider token A, which is native to the Alpha Blockchain. One may wish to transact in a certain token A on the Beta Blockchain. One might thus lock the A token on the Alpha blockchain, and then mint a Receipt Token that can be transmitted on the Beta Blockchain.

Although a new token has been minted, that token is merely a reflection of the underlying A token that is locked up on the Alpha Blockchain. As another example, one might wish to stake an A token in a staking pool.² One might thus put an A into a staking pool, and receive a Receipt Token we could call Staked A. The Staked A here represents only the A in the staking pool, and can be freely transmitted.

In each case, the holder of the A token does not relinquish beneficial ownership of the A token. Further, the holder retains all benefits of burdens of the A tokens. Possession of the Receipt Token is simply evidence and a direct reflection of its ownership of the underlying token. The Receipt Token holder retains all upside and downside risks associated with the underlying token. In the case of our hypothetical A token, if the price of the A token were to go up, the Receipt Token holder alone would benefit from the increased value of the A token underlying the Receipt Token. And if the price of A were to fall, the Receipt Token holder alone would bear the losses of such decline in the value of the A token underlying the Receipt Token. Moreover, if there were a failure of the Alpha Blockchain or other systems such that A was no longer accessible, the Receipt Token holder would bear such loss and would have no recourse against any party.

The Receipt Token is freely transferable; it can be sold or exchanged, or purchased on the open market. A sale or exchange would represent a shifting of ownership of the underlying A tokens. And in each case, the sale or exchange of the underlying A tokens could only be directed or caused by the actions of the Receipt Token holder. The Receipt Tokens can also be exchanged (or redeemed) for the underlying A tokens. In the example above, that would mean the token could be redeemed for the locked A token on the Alpha blockchain, or could be redeemed for the corresponding A tokens held in the staking pool. In that light, the minting of a Receipt Token does not itself create any value, any more than the printing of a car's title creates any more value to the car itself. It is merely a reflection of ownership – nothing more.

Analysis

The wrapping of a crypto-asset should not result in a taxable event under current U.S. federal income tax law.³

Threshold Matters. We first look at which tax rules apply generally to crypto-assets. The IRS has consistently treated crypto-assets as property for all applicable tax purposes.⁴ That is, for the purposes of U.S. tax law, crypto-assets are not currency and therefore are not subject to the special tax rules for currency. Thus, we must look to the generally applicable rules for property to determine whether wrapping causes a taxable event. Under general U.S. tax rules, a taxable event occurs when there is a sale or other disposition (referred to here as an "exchange") of property in consideration for cash or for other property that is materially different in like or kind from the exchanged property.⁵ There are two separate prongs to this analysis. First, we must consider whether wrapping is an exchange at all. Second, we must consider whether, if it is deemed to be an exchange, wrapping is an exchange for property materially different in like or kind.

Wrapping is Not an Exchange for Tax Purposes.

The U.S. Internal Revenue Service has, in published guidance, stated that the owner of property for tax purposes is the person who bears the economic burdens and benefits of ownership of that property.⁶ Thus, for there to be an exchange of property in the first instance, a person must transfer the economic burdens and benefits of ownership of their property to another person. (For this purpose, the term "person" is broad, it could be an individual, a corporation, or any other taxpayer). Courts look to many factors in making this determination, but they generally consider: (i) the parties' intent (e.g., whether the parties intended to make an exchange or if one party wanted to lend property to another); (ii) which party is entitled to profits from the use of the property; (iii) which party bears the risk of loss; (iv) the extent of control, if any, afforded to a purported purchaser of the property; (v) which party has the rights of possession and use of the property; (vi) which party is liable for taxes on the property, if any; and (vii) which party pays for the property.⁷

To that end, Receipt Tokens function like other "receipts" (i.e., documents that represent title), such as a bill of lading, an American depositary receipt ("ADR"), or a coat check ticket. A bill of lading functions as a receipt for shipping goods and does not evidence or effect a sale or other disposition of property. An ADR is a receipt issued by a custodian, usually a bank, representing rights to a deposited asset (often stock in a foreign corporation) that would be difficult for a U.S. person to hold directly. The holder of an ADR may redeem it for the underlying asset at any time, and the bank or custodian may not dispose of the underlying asset. And under IRS guidance, the owner ADR is treated as the owner of the underlying asset for tax purposes.⁸ A coat check ticket would be analyzed under the same reasoning. And thus, the issuance (or redemption) of an ADR or a coat check ticket is not a sale or disposition of the property represented by the ADR or coat check ticket.

This analysis applies squarely in the context of Receipt Tokens. When a holder of A tokens wraps his A tokens and thereby mints Receipt Tokens, there is no transfer of the benefits and burdens of owning the underlying A tokens. The situation is no different than a person printing out a certificate of title for a house, or the creation of an ADR described above. For this reason, the wrapping of A tokens should not be seen as giving rise to an "exchange" that results in a taxable event.

Even if Wrapping Is an Exchange, Receipt Tokens Are Not Materially Different than the Underlying Crypto-assets.

Even if an exchange were deemed to occur on the creation of a Receipt Token through wrapping (and to be clear - it does not), well-established tax law requires more for that exchange to be taxable. IRS regulations state that the exchange must be of property that differs "materially either in kind or in extent."⁹ In a seminal case on this question, the U.S. Supreme Court held that there was a taxable event because the property that the petitioner received in exchange for its property (a debt instrument relating to a bundle of mortgages) had different obligors and was secured by different underlying mortgages.¹⁰ Thus, for there to be an exchange, the tax law requires an exchange of properties with "legally distinct entitlements."

A Receipt Token does not represent a legally distinct entitlement from the underlying crypto-asset that it represents (that is, token A). Much in the same way that a person can sell her coat check ticket or an ADR to a willing purchaser, so too can holders of Receipt Tokens sell the Receipt Token as a way of effecting the sale of the underlying crypto-assets represented by that token. But that does not change the fact that what was really sold in that transaction was the benefits and burdens of owning the underlying A token. Thus, minting a Receipt Token, even if treated as received in exchange for an A token, is not an exchange for "property that differs materially either in kind or extent" – the test applied under established caselaw – from the underlying A tokens. That is, the mere act of wrapping should not be an exchange of property that differs materially in kind or extent and accordingly, no taxable event.

Conclusion

In summary, neither minting nor redeeming a Receipt Token involves an exchange of property and thus, such activities do not amount to a taxable event. And furthermore, even if minting or redeeming a Receipt Token is incorrectly treated as an exchange, the Receipt Token is not property that differs materially in kind or extent, and therefore no taxable event occurs.