As cryptocurrencies, such as Bitcoin and Ethereum, become more prevalent and developed as an asset class, the questions of if and how regulated investment companies (RICs) can gain exposure are becoming more common. In particular, there are a number of tax issues and complexities RICs and their advisers will need to consider before entering this asset class.
There are various ways RICs can gain exposure to this developing asset class. Below is a list of the more common methods:
Blockchain technology and cryptocurrency are still in their infancy stages. As a result, comprehensive accounting and tax guidance has been slow to develop. The IRS has issued some formal guidance, however, that directly impacts RICs and their shareholders. Most impactful was IRS Notice 2014-21, which classified virtual currency as property, as opposed to securities or currency. This determination has wide ranging tax implications for RICs ability to gain exposure to the asset class.
To receive the conduit tax treatment from which RICs may benefit, they must meet certain requirements aiming to limit the types of investment RICs can make. The 90% qualified income rule requires RICs to obtain at least 90% of their gross income from passive sources, including interest, dividends, gains from the sale of securities or foreign currency, payments from securities loaned and other income from securities. Classifying cryptocurrency as property, as opposed to securities or currency, excludes it from the definition of qualifying income.
The asset diversification rules, in addition to limiting a RIC’s ability to hold a highly concentrated portfolio, functionally require the RIC to invest primarily in securities as well. Direct exposure to cryptocurrency would result in non-qualifying assets for purposes of this test.
As a result of the above rules, essentially, RICs cannot directly invest in cryptocurrency. Unitized investment trusts such as Greyscale Bitcoin Investment Trust are typically Grantor Trusts for U.S. tax purposes, which result in the taxpayer being treated as directly holding the cryptocurrency. Similarly, due to the look-through requirements for derivatives (Rev Rule 2006-1), a RIC would be treated as investing directly in cryptocurrency when using a derivative contract. Look-through would also apply to any investment in private partnership and have the same result.
A RIC can create a non-RIC corporate subsidiary to hold these investments, converting the income from non-qualifying to qualifying. This strategy is commonly referred to as setting a blocker corporation and is often used so RICs can get exposure to other non-qualifying income sources, such as commodities or active trade or business income. The RIC is limited, however, to an investment in the subsidiary of 25% of the RIC’s assets.
Because a domestic subsidiary would be subject to U.S. corporate income tax, the most common approach is to a create foreign subsidiary in a low tax jurisdiction (such as the Cayman Islands). A foreign corporation that is 100% owned by a U.S. corporation would be a Controlled Foreign Corporation (CFC) and then subject to the tax rules of that regime. The RIC would be required to record as income any current earnings and profits in the year earned (referred to as Subpart F income). Net losses, however, would not flow through to the RIC. The character of any positive earnings and profits would be ordinary to the RIC.
Another opportunity would be to invest in a publicly traded partnership that investments primarily in cryptocurrency. The 2004 Jobs Act amended the income qualification rules to include income from Qualified Publicly Traded Partnerships (QPTPs) as qualifying. Given the nature of the income generated, it’s likely that a publicly traded partnership investing primarily in cryptocurrency would be classified as a QPTP. The 25% asset limitation above also applies to cumulative investment in QPTPs.
The possibility exists to combine these two approaches to increase the funds exposure. Furthermore, investment in corporations that derive their value from blockchain technology or investing directly in crypto is not subject to limitation as long as the entities are tax as corporations.
Combining these differing investments vehicles can allow a RIC to gain significant exposure to the digital asset class, while remaining compliant with the RIC qualification rules.
Contact Jay Laurila at jlaurila@cohenco.com or a member of your service team to discuss this topic further.
Cohen & Co is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.