Compliance weekly – 23 May 2022

Crypto-Asset Reporting Framework and OECD CRS Amendments

The rising acceptance of crypto-assets for investments and financial activities in recent years has attracted attention from the tax authorities. Crypto-assets can be stored and exchanged without involvement from traditional financial intermediaries and without any central administrator having total transparency, either with transactions or holdings. Consequently, there are concerns that the expanding use of crypto-assets could undercut existing international tax transparency rules, including the Common Reporting Standard (CRS). 

The Organization for Economic Cooperation and Development (OECD) released a document concerning a global tax transparency framework to provide for the reporting and exchange of information with respect to crypto-assets, i.e. the Crypto-Asset Reporting Framework (CARF), which contains CRS modifications for the automatic transfer of financial account information between jurisdictions. The objective of CARF is to establish a framework that enables tax administrations to gather and share tax-relevant data on specific crypto-asset transactions.

The CARF’s guidelines and commentaries are based around four building blocks:

  • scope of crypto-assets to be covered;
  • reporting requirements;
  • intermediaries in scope; and
  • due diligence procedures.

Scope of crypto-assets to be covered.  Crypto-Assets, as defined by the CARF, are those that can be owned and transferred in a decentralized manner, i.e. without the use of traditional financial intermediaries, including non-fungible tokens (NFTs), stablecoins, and derivatives issued in the form of a crypto-asset. The definition is meant to ensure that all assets covered under the new tax reporting framework also fall within scope of AML/KYC obligations. Future asset class development based on related technology is also included.  The CARF also identifies crypto-assets that pose a low risk of tax evasion and therefore are excluded from reporting. The first type is Closed Loop Crypto-Assets, which are designed to be redeemed for goods or services inside a specific, constrained ecosystem. The second is Central Bank Digital Currencies (CBDCs), which reflect a claim in fiat currency on an issuing central bank or monetary authority.

Reporting requirements. Four types of transactions are proposed to be reportable under CARF: exchanges between Crypto-Assets and fiat currencies, exchanges between one or more forms of Crypto-Assets, Reportable Retail Payment Transactions, and Crypto-Asset transfers. Transactions will be recorded on an aggregate basis per Crypto-Asset type, distinguishing outward and inward flows, and differentiating Crypto-to-Crypto and Crypto-to-fiat. Reporting entities will also be required to categorize transfers by transfer type (e.g. airdrops, income derived from staking or a loan), in instances where they have such knowledge.

Intermediaries in scope. It is proposed that those intermediaries that, as a business, facilitate the exchange between Crypto-Assets and fiat currencies and/or provide exchange transactions in relevant Crypto-Assets, for or on behalf of customers, be considered Reporting Crypto-Asset Service Providers under CARF. Intermediaries are expected to have the most comprehensive access to the value of crypto-assets and the exchange transactions conducted.

Due diligence procedures. The CARF contains the due diligence procedures that Reporting Crypto-Asset Service Providers must follow when identifying their users, determining the relevant tax jurisdictions for reporting purposes, and collecting the relevant information necessary to comply with the CARF’s reporting requirements. The purpose of the due diligence requirements is to enable Reporting Crypto-Asset Service Providers to determine the identity and tax residence of their individual and entity users, as well as the natural persons controlling certain entity users, in an efficient and reliable manner.  

Due diligence procedures are based on the CRS self-certification process and existing AML/KYC standards. To minimize the constraints on Reporting Crypto-Asset Service Providers, especially when they are also subject to CRS duties as Financial Institutions, the due diligence procedures will be aligned with the CRS due diligence regulations to the degree practical and reasonable.

Amendments to the Common Reporting Standard (CRS)

The OECD has also proposed changing the CRS to include new, digital financial products as an alternative to holding money or financial assets in an account that is subjected to CRS reporting. In this regard, the proposal broadens the scope of CRS reporting to include digital money products including Central Bank Digital Currencies (CBDCs). In light of the CARF, the recommendations include revisions to the definitions of Financial Asset and Investment Entity to ensure that derivatives referencing Crypto-Assets and kept in custodial accounts, as well as investment entities investing in Crypto-Assets, are covered by CRS.  Simultaneously, the plan includes new rules to enable an efficient interaction between the CRS and the CARF, namely, to prevent instances of duplicative reporting.

Next Steps

On 22 March 2022, interested parties were invited to provide comments on the CARF and the proposed CRS amendments. Comments received by the OECD are now available, and a public consultation meeting was scheduled to be held on 23 May 2022. No date has been established for the proposed CARF standards to take effect, and it appears doubtful that during the financial year 2022, crypto-asset transactions would be required to be disclosed under the CARF standards. If adopted and passed into domestic law, it is possible that certain crypto-asset transactions made during the fiscal year 2023 might be subject to the proposed CARF requirements.

Key Points

FinTech, crypto and virtual assets businesses including recent models like DeFi, NFT, Web3, and Metaverse projects, are triggering significant regulatory changes worldwide, including additional reporting and compliance requirements, such as the proposed CARF and CRS amendments. Provenance is offering FATCA/CRS services and additional support, and is available to discuss and design CARF reporting infrastructures where applicable, which can and should be integrated with AML/KYC processes. Businesses which can anticipate and incorporate compliance in their internal processes at an early stage will have a competitive advantage and greatly reduce the cost of compliance later on.

Other Compliance News

We are still reviewing the cascading issues revealed by the LUNA/TERRA incident, but many of the following incidents, e.g. the loss incurred by Scream, a DeFi lending protocol, or the suspension of trading by BitPrime, a New Zealand cryptocurrency retailer, due to lack of liquidity, demonstrate the need to have robust valuation rules, data feeds, risk management systems, business continuity plans, etc. many of which are often lacking in the blockchain startup ecosystem. Indemnification and market integrity rules need to be quickly developed. The regulators are certainly looking into this, so the industry should as well! 

A federal magistrate judge approved a U.S. Department of Justice (DOJ) criminal complaint regarding a U.S. person transmitting over US$10 million in BTC to a sanctioned country. This shows that sanctions are a big issue for the digital assets industry and concerns should not be dismissed without proper controls and AML/CFT programs in place.

Five U.S. states ordered a metaverse casino with alleged ties to Russia to halt sale of NFTs. Flamingo Casino Club allegedly started operating from Russia in March 2022. It has since been fraudulently soliciting NFTs that purportedly convey ownership of a metaverse casino and the right to share in the profits. The project allegedly touted the validity of its operation by claiming to develop its metaverse casino through a partnership with the Flamingo Las Vegas, an established casino operating in Nevada. According to the regulators, this representation is simply false. This proves again the importance of investors carrying out due diligence on projects they support or are partnering with. 

Chainalysis, the blockchain data platform, announced a $170 million Series F financing.

South Korea’s Financial Services Commission (FSC) and the Financial Supervisory Service (FSS) launched emergency inspections into local crypto exchanges, according to industry sources.

A lawsuit against bZx DAO was filed in the Southern District of California, with 14 plaintiffs claiming to have lost funds in a hack of DeFi platform bZx are requesting the return of their funds. Plaintiffs allege the theft was possible because the protocol had not yet implemented security measures. Defendants include bZx protocol co-founders, several bZx investors, as well as the developer company. bZx DAO had already approved and published a compensation plan, which was deemed insufficient. The lawsuit argues that since the DAO has no legal entity attached, it falls under general partnership rules, with the partners jointly and severally liable to the plaintiffs. 

Nayms is the first crypto-native insurance marketplace to become fully-regulated in Bermuda, with a Class F license (previously part of the Bermuda Monetary Authority (BMA) Sandbox).

Coinbase launched Coinbase Institute, a global crypto-native think tank on decentralization, web3, and the future of finance.

About Provenance

As the virtual assets industry is on the brink of mainstream adoption, the demand for services in this space far exceeds the capabilities of the traditional compliance providers. The difficulty to date has been that industry veterans have had neither the benefit of practical examples of how regulators will assess the servicing of virtual assets, nor do they have in house expertise or experience to confidently risk asses virtual asset engagements and build out the controls to mitigate associated risks. Additionally, the volatility in the asset class causes trepidation in traditional investment circles. We have established service lines across the specialist functions of compliance, internal audit, risk and advisory, with a focus on enhancing compliance and risk management solutions available to Investment Funds, Managers, Service Providers, and other participants in the virtual asset sector. We collectively bring over 75 years of experience in traditional legal, accounting and compliance services to the financial services industry, with recognised industry leaders and pioneers in developing solutions for virtual asset ventures in Cayman Islands, BVI and across the globe.

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