ICOs: trade-offs between securities and tax law?

Initial Coin Offerings (ICOs) have been a defining feature of the 2017 cryptocurrency market. While there has been recent regulatory guidance on the securities law consequences of ICOs, the interplay with tax law remains mostly unexplored.

Although ICOs have been embraced by entrepreneurs looking to raise capital for innovative projects, the regulatory treatment of ICOs across the world remains patchy and unclear. Some jurisdictions (including major markets the US and China) have sought to regulate ICOs more closely and potentially put an end to the “wild west” days of 2016 and 2017.

In particular, much attention has been given over to the US Securities and Exchange Commission’s (SEC) moves to regulate some ICOs on basis that the cryptocurrencies and tokens issued may be securities (and thus subject to heavy regulation). While the SEC is not applying this as a hard-and-fast rule to all ICOs, it should flag to those considering an ICO to ensure that have careful regard to the legal and regulatory issues an ICO can raise. Complying with US securities regulations can be onerous, and so the “default” position among some ICO players has been to move toward characterising the tokens issued via an ICO as something akin to an intangible good or a bundle of rights, so as to move outside tough securities laws.

However, there may be unconsidered tax trade-offs to this approach.

When an entity raises funds through a conventional IPO or capital raising, the funds received from that process are typically understood as debt or equity. The receipt of debt or equity via such a process typically isn’t taxable, as the amount is not characterised as income —partially on the basis that the issuer of the debt or equity expects to get something back in return for their investment. However, if a strong line against a token being a security is taken during an ICO, the end result is that the ICO may function instead as a “pre-sale” of a intangible good or bundle of rights, either of which may be income taxable in many jurisdictions around the world (not even considering the potential Value Added Tax (VAT) consequences!).

Parallels can be seen in the approach regulators have begun to take in relation to other more standard crowd-funding arrangements. Where the ‘investor’ in an arrangement has limited rights to receive something from the issuing entity in exchange for their funds, the crowd-funding arrangement is not an issue of debt or equity. Some regulators have provided guidance suggesting that consequently, this amount could be “income” on which income tax would have to be paid (with, for example, the federal income tax rate in the USA being 35%).

Additionally, when you consider that the bulk of expenses in developing a project may arrive in later years after the team and technology has been built out — and thus be unable to be offset against the income tax due on the initial amount raised via an ICO, it starts to become apparent that characterising an ICO token as something other than a security isn’t the panacea it may first appear!

Lupercal Capital is an independent cryptocurrency advisory firm. If you are a cryptocurrency startup or considering an Initial Coin Offering (ICO), we’d love to talk with you.