Staking Income

Disclaimer

I've been asked several times recently about the appropriate tax treatment of Staking Income.  Staking Income arises from "staking" a validator with tokens to allow it to validate more transactions, for which the validator pays the party providing the tokens a fee.

As discussed below, I think there are enough issues here that funds should consider a small restructure to eliminate the risk.

NATURE OF THE ISSUE:

Usually the question is posed by a fund that has foreign and/or tax exempt investors who wants to be sure that receiving "Staking Income" does not result in those investors being allocated "Effectively Connected Income" ("ECI") or "Unrelated Business Taxable Income" ("UBTI").  If the validator is not operating in the US, the foreign investors don't have an issue, but the tax exempt ones are still at risk if the income is "business income".

The problem, as with most crypto questions is that there is no authoritative guidance.

UNCERTAIN LEGAL TREATMENT

While there is an argument that such income is so called "Fixed or Determinable, Annual or Periodical" ("FDAP") income (see, for example New York State Bar Association Report 725, page 28), which protects foreign investors from having to file US tax returns (although it subjects them to up to a 30% gross basis withholding tax on US source income) and should protect tax exempt investors from UBTI -- that argument is far from certain and in any case imposes an obligation on the fund to withhold tax from US source Staking Income allocated to foreign investors (taking into account uncertainty regarding which treaty provision applies).  See also PLR 8822061 which says income from Securities Lending transactions is "industrial or commercial profits" for purposes of the relevant treaty which would be bad for the tax exempt investors. 

RECOMMENDED STEPS

For 2018 transactions, probably the best you can do is claim that it's FDAP, ideally from foreign sources, but if not, accept the application of withholding tax to the portion allocated to foreign investors.

Going forward, I recommend Funds consider whether they should form a wholly owned special purpose corporate subsidiary ("SPV") to undertake the Staking activity.  The Fund could lend the tokens to SPV for a fixed rate of interest, which would clearly not be UBTI and should not be subject to withholding tax when allocated to foreign investors under the portfolio interest exception.  The interest rate on the loan would have to be at least the "Applicable Federal Rate" (currently 2.52%/year for short term loans), but it could be higher if the Staking income is expected to be higher.

To the extent that SPV has net income after deducting its interest expense (and after the 2017 tax act, that calculation is complicated), there would be some additional tax, but much better to pay that tax than to have investors form "blocker" corporations and subject 100% of their fund income to US corporate tax.  (If SPV would have a loss, the Fund may have to capitalize it with additional assets.)

There may be better solutions now or in the future, and should you discover those, you can unwind this approach, but in the meantime, there are benefits to certainty.

                             

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