Bitcoin ETFs: The known and unknown

Editor: Robert Venables, CPA, J.D., LL.M.

Recently, digital asset products have begun to secure approval from the SEC for investment by retail investors. As with the digital asset industry itself, the pioneer products center around bitcoin. Although the SEC is expected to expand approval to a broader range of digital asset products, including other currency-based and non-currency-based types of digital assets, the marketplace’s current focus is on bitcoin exchange-traded funds (ETFs).

A bitcoin ETF will be classified as a widely held fixed investment trust (WHFIT) under Regs. Sec. 1.671-5 if it meets the requirements for treatment as an investment trust under Regs. Sec. 301.7701-4(c). The most prominent of these requirements is that there must be “no power under the trust agreement to vary the investment of the certificate holders” (Regs. Sec. 301.7701-4(c)(1)). Usually, such a trust will also consist of “a single class of ownership interests,” but multiple classes of ownership interests can be permissible if necessary “to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interest is incidental to that purpose” (id.).

In addition to these requirements, Regs. Sec. 1.671-5(b)(22) specifies that the trust must be a U.S. person, the beneficial owners of the trust are treated as owners, and at least one interest in the trust must be held by a middleman (a trust interest holder (TIH)), other than a qualified intermediary, who, at any time during the calendar year, holds an interest in a WHFIT on behalf of, or for the account of, another TIH, or who otherwise acts in a capacity as an intermediary for the account of another person. In practice, this means that a bitcoin ETF will hold only two assets — bitcoin itself and cash, which will be used either to buy more bitcoin or pay expenses incurred by the trust.

Meeting the requirements to be treated as a WHFIT is desirable for a bitcoin ETF for two reasons. The first is that WHFITs do not have their own tax filing requirements; such entities are disregarded and merely required to provide information reports to the owners.

The second is that proper tax reporting becomes the burden of the owner (assuming all required information is reported to the owners by the WHFIT), which is particularly useful in an emerging industry such as digital assets, where proper reporting of unusual items can be trickier than in more established asset classes.

Tax issues to consider

Bitcoin WHFITs and their owners may have several tax issues to consider that are common to investment activities, unique to digital assets, or both. These issues include in-kind contributions; inkind distributions; sales by a WHFIT to pay expenses; and transactions exclusive to digital assets, such as forks, airdrops, and staking.

In-kind contributions: With respect to in-kind contributions, investors may seek to contribute appreciated assets to a vehicle such as a WHFIT. This will typically be done as a seeding project or to allow the investor to continue holding the appreciated position with fewer self-custodial responsibilities in exchange for being assessed a share of trust expenses. Because a WHFIT’s portfolio must be fixed for the life of the trust and a bitcoin ETF is a singleasset vehicle, investors contributing in kind can avoid the diversification rule applicable to investment companies and investment partnerships under Secs. 351 and 721, respectively, because investors do not benefit from diversification. It is worth noting that in-kind contributions will only be taken when a WHFIT is forming or expanding its holdings. After issuance to owners, WHFIT units represent a fractional share of the underlying bitcoin that is held by the trust.

In-kind distributions: With respect to in-kind distributions, these can be used by investors seeking to withdraw from the WHFIT rather than having to sell the trust units to a third party. Such in-kind distributions will decrease the total amount of bitcoin held by the WHFIT. Regs. Sec. 1.671-5(c)(2) permits an in-kind distribution if the information provided to WHFIT unit holders includes the amount of bitcoin that was distributed to the recipients of the in-kind distribution. This informs WHFIT unit holders who are not recipients of the in-kind distribution that they should not reduce their holdings by what would otherwise be their share of the in-kind distribution. In other words, redemptions from a WHFIT must be treated as special allocations.

Sales to pay expenses: WHFITs also must consider whether sales of assets to pay trust expenses will be considered de minimis under Regs. Sec. 1.671-5. WHFITs for which total sales proceeds are less than 5% of the trust’s net asset value meet the de minimis test (Regs. Sec. 1.671-5(c) (2)(iv)(D)). WHFITs meeting the de minimis test are permitted to provide abbreviated data on asset dispositions consisting of information required for owners to calculate their share of trust proceeds received from the dispositions. In contrast, WHFITs not meeting the de minimis test must provide the owners more detailed information on each individual disposition. In practice, most WHFITs will not sell a significant amount of their assets to pay trust expenses, but it is still important for annual reporting purposes to verify that the de minimis test is met.

Transactions unique to digital assets: A fourth major consideration for a bitcoin ETF taxed as a WHFIT will be how to address digital asset transactions such as forks, airdrops, and staking. Fortunately, the proper reporting of many of these types of issues will become clearer once the scope of ETFs expands to include other digital assets such as those using a proof-of-stake or other consensus protocols. However, these unique digital asset transactions are worth mentioning, given that bitcoin has experienced hard forks in the past, and there is no guarantee this will not occur again in the future. Transactions where a WHFIT would receive additional amounts of the same asset would be little cause for concern. For example, if a digital asset is staked and the rewards for staking such a digital asset are more of that same digital asset, the WHFIT would simply report receipt of that income and the increase in the amount of the asset held by the trust to the owners.

However, transactions such as hard forks (which result in the creation and distribution of new, different tokens) and staking rewards received in the form of a gas token present a unique situation for a digital-asset-holding WHFIT. These scenarios create a second asset, which would threaten their status as a WHFIT. Little, if any, guidance exists on how to address this unique circumstance. Currently, the best practice is for the WHFIT to decline taking possession of the new asset, if possible. This is most easily done when a barrier to “dominion and control” as described in Rev. Rul. 2019-24 exists. Otherwise, the WHFIT should immediately dispose of the extraneous asset. WHFITs facing this scenario should be mindful that disposing of extraneous assets could cause them to fail the de minimis test inadvertently.

Key considerations until guidance appears

As with other digital asset products, bitcoin ETFs are in their infancy, and new legislation and guidance may provide clarity and reform. For the time being, the issues described here are key considerations for tax advisers and their clients investing in digital assets.

Editor Notes

Robert Venables, CPA, J.D., LL.M., is a tax partner with Cohen & Co. Ltd. in Fairlawn, Ohio.

For additional information about these items, contact Venables at rvenables@cohencpa.com.

Contributors are members of or associated with Cohen & Co. Ltd.