Category Archives: Legal

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Blockchain Loyalty Programs

“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”
― Mark Twain

Under current taxation regimes, cryptocurrencies are treated as property by the IRS, which implies a host of existing rules and regulations regarding the reporting and taxation of property transactions.  This reporting and tax collection can be manually burdensome and is rarely automated given the current state of the technology. The IRS has recently started increased enforcement actions on cryptocurrency transactions. Blockchain and cryptocurrency enthusiasts have sought to apply some of the underlying technology and concepts in a variety of other ways to avoid these burdens.  One proposed use is in customer loyalty programs.

Customer loyalty programs can provide differentiation and sustain competitive advantages, particularly where the switching costs are low[1].  Customer loyalty programs have a long history with applications in the 1700s and 1800s with tokens and stamps that could be used by the customer for discounts on future purchases with the same supplier. Perhaps the modern stereotype is the frequent flyer mile. Originally acquired and used solely for air travel, these can now be acquired without using air transport and exchanged for a variety of other goods and services.  While typically not fungible beyond the partner ecosystem, customer loyalty tokens (e.g. frequent flyer miles) are sometimes seen as alternative currencies by both the creators and users. The analogy with cryptocurrency schemes as an alternative currency seems obvious.

Most consumers don’t think about taxation of their frequent flyer miles; and, most would typically assume that they are not taxable.  This, unfortunately, ain’t always so. The IRS has issued limited guidance on the taxation of frequent flyer miles with IRS announcement 2002-18 stating they would not pursue a tax enforcement program on frequent flyer miles – and not that these were not taxable. This relief does not apply to travel or other promotional benefits that are converted to cash, to compensation that is paid in the form of travel or other promotional benefits, or in other circumstances where these benefits are used for tax avoidance purposes. And there are a couple of court cases[2] where the value asserted in a frequent flyer miles transaction has exceeded de minimus limits and resulted in the issuance of 1099-MISC income statements with tax impacts. There are many variants in customer loyalty programs and opinions on the practicality of heir taxability[3]. Unexpected tax enforcement against consumers of loyalty program tokens would significantly impact the value of such programs.  No consumer-facing company wants to give its customers promotional tokens that result in tax problems from unexpected liabilities or reporting concerns.

Considering the potential for increased tax enforcement against cryptocurrency transactions, proponents of blockchain-based customer loyalty programs should consider how closely their proposed loyalty programs match the original concept of discounts against future purchases with the same supplier vs fungible alternative currency.

For companies considering a blockchain-based loyalty program there are additional considerations. FINCEN has recently issued guidance involving convertible virtual currencies.   While this guidance seems directed to virtual currency exchanges, it is not clear that businesses exchanging virtual currencies for goods and services are exempt. If applicable, then the business would need to comply with state money transmission regulations. This gives companies considering blockchain-based loyalty programs added incentives for restricting the program to match the original concept of discounts against future purchases with the same supplier vs fungible alternative currency.

Blockchain-based customer loyalty programs are not impossible; however, due diligence needs to be undertaken with the applicable regulations, to ensure the loyalty program is designed appropriately.

[1] A. Nastasiou, M. Vandenbosch, “Competing with loyalty: How to design successful customer loyalty reward programs”, Business Horizons Vol 62, Is 2. March-April 2019 pp 2017-214.

[2] See e.g., Shankar v Commissioner 143 T.C. No 5 (2014), Hirsch v Citibank (S.D.N.Y) Case 1:12-cv-01124-DAB-JLC (2016)

[3] J. A. Mankin, J.J. Jewell, “Frequent Flyer Miles as company scrip: implications on taxation” Business Studies Journal, Vol 7, No. 1, 2015

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Blockchain Terminology

Tokens may be used to safeguard sensitive data involving, for example, bank accounts, financial statements, medical records, criminal records, driver’s licenses, loan applications, stock trades, voter registrations, and other types of personally identifiable information (PII)

Initial Coin Offering (ICO) –In an ICO, a quantity of cryptocurrency is sold in the form of “tokens” (“coins”) to speculators or investors, in exchange for legal tender or other cryptocurrencies. The tokens sold are promoted as future functional units of currency if or when the ICO’s funding goal is met and the project launches. In some cases, like Ethereum, the tokens are required to use the system for its purposes.

Stablecoins are cryptocurrencies designed to minimize the volatility of the price of the stablecoin, relative to some “stable” asset or basket of assets.

Backed Stablecoins are redeemable in commodities (such as precious or industrial metals).

Currency backed stable coins are pegged to one or more fiat currencies (e.g. US Dollar, Euro etc.)

Cryptocurrency backed stable coins are issued with cryptocurrencies as collateral, which is conceptually similar to fiat-backed stablecoins; the significant difference between the two designs is that while fiat collateralization typically happens off the blockchain, the cryptocurrency or crypto asset used to back this type of stablecoins is done on the blockchain, using smart contracts in a more decentralized fashion.

Colored coins are a class of methods for associating real world assets (e.g. a deed for a house, stocks, bonds or futures) with blocks on the blockchain network. 

Mining– process of generating a new block on the blockchain – typically includes a PoW assertion.

Mining pool– a collection of miners who have pooled their resources together in order to mine a cryptocurrency

Single mining pool– A mining pool that mines a single cryptocurrency.

Multipool mining– mining poll that mines multiple cryptocurrencies

Orphan blocks– a successfully completed PoW that was not accepted by the consensus protocol – discarded (waste) in bitcoin

Stale blocks– a block that is abandoned because the mining node already received a solution from some of other node.

Uncle blocks– an orphan block; in Etherium, orphan (uncle) blocks can earn ether.

Genesis blocks– the first block on the blockchain.

Just as a Mint creates new currency notes and coins, minting on a blockchain expands the size of the cryptocurrency in circulation and supported by the blockchain.

To Burn a crypto currency asset is to destroy it – reduces the size of the cryptocurrency in circulation and supported by the blockchain.

Fiat currency is an object (like a paper bill or metal coin) that has been established as money, often by a government

A Digital Currency is a type of currency designed to be used in the digital form. A cryptocurrency is a digital currency.

On a permission less network, anyone who meets certain technical requirements can access the network or operate a node.

On a permissioned network, an entity controls access to the network and oversees who can operate a node.

Blockchain Governance is the approach to decision making taken by the decentralized nodes on a blockchain.

A non-fungible token (NFT) is a special type of cryptographic token which represents something unique; non-fungible tokens are thus not interchangeable. This is in contrast to cryptocurrencies like bitcoin, and many network or utility tokens that are fungible in nature.

A cryptocurrency wallet is a device (e.g. usb stick), physical medium, program or a service which stores the public and/or private keys and can be used to track ownership, receive or spend cryptocurrencies. The cryptocurrency itself is not in the wallet. In case of bitcoin and cryptocurrencies derived from it, the cryptocurrency is decentrally stored and maintained in a publicly available ledger called the blockchain. A public key allows for other wallets to make payments to the wallet’s account(address), whereas a private key enables the spending of cryptocurrency from that address.