Last month, ProShares Trust launched an exchange-traded fund (ETF) to provide investors with exposure to Bitcoin (the Fund) with the ticker symbol BITO. It is the first of its kind. The Fund indirectly invests in Bitcoin through futures contracts traded on the Chicago Mercantile Exchange (CME). Significantly, the Fund intends to qualify as a Registered Investment Company (RIC) under Subchapter M of the Internal Revenue Code. It achieves this objective through a creative structure, which comes at the cost of increased complexity and potentially unfavorable treatment of its taxable shareholders. James C. Row, Founder of Entoro Capital, LLC, said: “We expect the BITO structure to become the norm as more funds expand into digital assets and investors should quantify its impact on them before investing. “
A fund must be registered under the Investment Companies Act 1940 and meet three elements to be considered a RIC.
- First, 90% of the gross income of the fund must come from a legal list (e.g. dividends, interest, loan repayments, gains from the disposal of shares or foreign currencies, income from qualified partnerships listed on the stock exchange, etc. .).
- Second, the fund must pass the asset diversification tests. At least 50% of the fund’s investments in value at the end of each quarter must be represented by cash, cash, government securities, securities of other RICs and other securities of which the fund holds less that certain thresholds. In addition, a maximum of 25% may be invested in the securities of the same issuer, the securities of issuers under the control of the fund or in partnerships listed on the stock exchange.
- Third, the fund must distribute at least 90% of the sum of its taxable income and tax-exempt income each year.
The big question
As always with cryptocurrency, “what is a Bitcoin? surfaces like the big question. All tax consequences flow from this answer. Bitcoin’s status as a security or currency determines the fund’s ability to respond to the elements of income and RIC diversification. Although Bitcoin has been identified as a commodity in other contexts, IRS guidelines to date simply state that Bitcoin should be considered personal property and not currency for federal tax purposes. Investing directly in Bitcoin and Bitcoin futures comes with significant risk for funds if they want RIC status.
The Fund avoids the issue by contributing up to 25% of its assets to a Cayman subsidiary that will engage in bitcoin futures trading. The structure transmutes revenues from trading bitcoin futures contracts into subpart F or GILTI inclusions and “ownership” into securities of a subsidiary issuer.
With respect to the income element, the foreign affiliate will be treated as a controlled foreign corporation (SEC). The CFC will block the recognition by the fund of income generated by future underlying Bitcoin trading operations. Income, however, will be subject to the anti-deferral regimes of Subpart F and GILTI, and actual distributions are mandatory on the part of the CFC to meet Treasury regulatory requirements. The fund expects that the gains will be included in its annual taxable income according to these rules. The main thing is that the income recognized in these plans takes the character of a dividend. Therefore, the Fund can be certain that the character of the income will satisfy the element of income.
With regard to the element of diversification, the CFC share will be considered as a security of an issuer controlled by the Fund. The Fund intends to adjust its investment in the subsidiary before the end of each quarter to meet the 25% limit. The remaining 75% will be invested in qualifying securities, including stocks of companies engaged in cryptocurrency-related activities such as mining. As a result, the Fund can be certain of how the economic investment in Bitcoin will rank when calculating the percentages tested to satisfy the element of diversification. Again, the structure transmutes an asset of uncertain properties into an element known to the RIC rules.
The rule of equivalent exchange
Alchemy requires an equivalent trade, and the structure is not without cost. The 25% limit for investing in the CFC means that the Fund must either engage in leveraged futures strategies or settle for exposure below one parity of the Fund’s investment. Bitcoin futures contracts. Leveraged futures strategies are complex, increase the cost of margin and increase the risk of malfunction. They approximate the results of larger investment positions and are imperfect to replicate the desired positions.
In addition, the subpart F and GILTI regimes are unilateral and impose an additional cost on the fund. They require the inclusion of gains in the income of the Fund, but they do not allow the Fund to deduct losses. For example, the CFC may lose $ 100 in year 1 and earn $ 100 in year 2. They will recognize an inclusion of $ 100 in year 2. The loss of $ 100 may result in ultimately be recognized as a capital loss at an indefinite future date when a shareholder disposes of the fund or the fund liquidates the SEC. Thus, a shareholder may pay tax on $ 100 of income despite the lack of growth in economic value during the two-year period.
Finally, the subpart F and GILTI inclusions are not qualified dividends subject to preferential rates. Taxable shareholders will likely recognize taxable income subject to ordinary rates, instead of the potential rates of long-term capital gains that could be achieved by acquiring and holding Bitcoin over a year.
The structure implemented by the Fund avoids the significant uncertainties that plague the blockchain fund community regarding the federal tax characterization and treatment of cryptocurrency investments. However, the creative structure employed is not without cost, due to its complexity and its interaction with the US international tax system. In addition to the financial impact, investors should consider that the laws and regulations regarding these international tax regimes change often. As such, the reporting and valuation principles underlying the Fund’s current strategy may one day change, which could make the Fund a taxable entity outside the RIC regime.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Ryan reneau is Senior Counsel in Chamberlain Hrdlicka’s San Antonio office. He focuses his practice on international tax planning, optimizing the business structure and the efficiency of transactions. Reneau can be contacted at [email protected] or (210) 278-5805.
Kevin sweeney is a shareholder in the Philadelphia office of Chamberlain Hrdlicka, specializing in civil and criminal tax litigation and litigation. He can be contacted at [email protected] or call (610) 772-2327.
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