When a U.S. corporation issues tokens in an Initial Coin Offering (ICO), the proceeds are subject to tax with only limited, narrow exceptions. The taxation of U.S. corporations explains, at least in part, the use of offshore jurisdictions and foreign foundations for ICOs. Foreign corporations that issue tokens aren’t subject to U.S. tax, unless they have a taxable presence in the United States.
Given the massive changes in international tax with the tax reform, U.S. shareholders have to pay special attention to avoid falling into any traps! Instead of considering the international issues for foreign corporations issuing into the U.S. market or for U.S. shareholders of foreign corporations issuing tokens, I instead consider the tax treatment of a U.S. corporation issuing new digital tokens.
In contrast to issuing debt or equity, tokens are taxable. But creative and persistent issuers may have hope to at least mitigate the tax liability.
Explosion of ICOs
Capital raising through initial coin offerings (ICOs) is giving venture capital investing a run for its money, at least for early stage financing. New coin sales have raised over $3 billion this year alone. With so many new potential ICO projects, the market has tightened and competition has increased for new ICOs.
Nevertheless, money continues to flow into the sector. When planning an ICO, the issuer should understand how it will be taxed on the ICO proceeds. Investors interested in limiting the use of their money to pay tax liabilities will want to pay close attention as well. And read on to learn what an ICO shares in common with the narrow walking path connecting the Italian Cinque Terre.
Varieties of Tokens
Given the unrelenting upward trajectory of Bitcoin prices, news on Bitcoin has proliferated exponentially. But there are hundreds, if not thousands of other digital tokens on the market. Before delving into the tax considerations of an ICO, first consider the varieties of digital assets, which for my purposes I will divide into three groups: Digital Gold, Digital Goods and Digital Stock.
- The most familiar and the most successful: Bitcoin, Litecoin, Zcash, Bitcoin Cash, Monero, Dash. Holders use these tokens to store value and purchase goods or services. (Although the most popular use is investors buying these tokens as speculative investments!) The creators designed these tokens to store value and to trade over a decentralized network. See this link for a more complete description of the attributes of several of the more popular offerings in this group.
- Tokens in this category tend not to have traditional ICOs because they operate over a decentralized network. However, sometimes, such as in the case of Zcash, the creators of the digital asset retain a percentage of the tokens as a reward for the founders.
- After the launch, no central authority controls these assets. The supply of future tokens is limited, so the token is deflationary. The software is open source and a decentralized network of developers continues modifying the protocol. A decentralized network of nodes validates all transfers. Successful validators (known as “miners”) of transactions receive a reward in cryptocurrency.
Digital Goods, a.k.a. Utility Tokens
- The past two years has seen an explosion of “utility tokens” in the form of token sales, ICOs, pre-sales, SAFTs and other offerings. Developers design utility tokens to perform some software function. Typically, a utility token allows the user to consume products or services offered on a platform created by the issuer. Sometimes, holding the token gives the holder voting rights or other attributes that create an incentive to hold. The issuer sells the tokens in a token sale or ICO and uses the proceeds to develop the platform.
- There is a raging debate among securities lawyers (and the SEC) about whether a utility token is a security. However, as we shall see, this debate has little impact on the tax treatment of token sales.
- Tokens that provide equity exposure or equity-like features are far less common in the ICO market than utility tokens. This is partly due to the desire to avoid securities regulation. However, such tokens do exist (at least in proposed form). These tokens entitle the holders, on a contractual basis, to shareholder or equity rights, including the right to participate in profits or a shareholder vote. At its simplest, a token would simply represent a share of stock.
- Other digital shares have hybrid features. One example is the proposed tZERO token. A subsidiary of Overstock, tZERO will be a new exchange that will enable trading in tokenized equity. The proposed terms for the token are that holders will receive a percentage of tZERO revenue and will be able to use the token to pay for tZERO fees or services.
Is My ICO Really Taxable?
The tax treatment of an offering of Bitcoin or one of its alternatives is simple: it is taxable. A company that creates a new Bitcoin alternative can deduct its costs in developing the new token, not unlike a miner deducting its mining expenses. But the creator of a new Bitcoin alternative will be taxed on its net income from the sale of the token. When a creator keeps a reserve of new tokens, the creator is only taxed when it sells the tokens on the open market.
Digital Goods: Deferral
Like digital gold, the sale of utility tokens is also taxable. But in this case, the plot thickens because the creator of a utility token has promised to provide future services or goods. Because of this promise, one might view the sale of a utility token as similar to a gift card or advance payment for goods or services.
This can make a difference for issuers of utility tokens that use accrual rather than cash accounting. Under accrual accounting, a company defers advance payments in its financial statements until it delivers the good or service. This raises the question: can the issuer of a utility token defer income from an ICO?
An issuer of a utility coin may reflect a deferred liability in its financial statements. This delays the recognition of revenue and therefore reflects a conservatism in financial accounting. But the tax treatment of advanced payments diverges from accounting. Deferred income is anathema to the IRS. The tax man always wants to accelerate income.
Although the IRS at times resisted allowed deferral for advance payments, in 2004 it issued a revenue procedure permitting a one-year deferral of advance payments. That revenue procedure will become part of the tax code under the proposed tax reform winding its way through Congress now. To qualify for tax deferral, the issuer must defer the recognition of income in its applicable financial statement.
For example, assume NewToken raises $20 million in the sale of utility tokens in 2017. In its financial statements, it recognizes only 10% of the revenue, or $2 million, in 2017. NewToken defers the remaining revenue because it has a future liability to deliver a product or service. If the revenue from the token sale qualifies as an advanced payment for tax purposes, NewToken can defer $18 million of revenue from the token sale until 2018.
It’s unclear if ICOs constitute an advanced payment similar to a gift card. Is a utility token really like a gift card? There are differences. For example, the value of a utility token may fluctuate in a secondary market, whereas a gift card always entitles the holder to a fixed amount in U.S. dollars. Regardless, the potential for deferral exists. That could be very important for an ICO, as deferral provides the issuer a minimum of 12 months, and as long as 24 months, to spend the proceeds on deductible expenses.
If a token provides the holder with all the rights of a shareholder, the token should be treated as stock for tax purposes. The proceeds from a sale of stock are exempt from taxation. Therefore, the proceeds from the sale of a token that is functionally equivalent to stock should also be tax-free. But this raises challenging tax compliance issues. For example, how do you identify the shareholders to report dividends and capital gains?
What if the token promises the holder a share of the profit from a particular division or subsidiary of the issuer? This is similar to “tracking stock” that corporations sometimes issue with respect to a subsidiary or division. When properly structured, tracking stock is respected as stock, even when it only relates to the profits of a particular subsidiary or division. Just as in the case of tracking stock, if properly structured, a “tracking token” may qualify for tax-free treatment. But again, the compliance issues would be very challenging.
The taxation of digital assets with hybrid features is less favorable. A hybrid digital asset combines an equity feature with a utility feature. It’s possible that, for tax purposes, the hybrid token could be separated into its two component parts.
Sometimes, a single financial transaction is separated into different parts that are taxed differently. For example, borrowers sometimes issue stock warrants to their lender. The stock warrant is a “sweetener” to entice lenders to lend to risky companies. For tax purposes, this is called an “investment unit.” When a lender receives a stock warrant, it allocates part of its investment to the loan and part to the warrant.
Perhaps, like an investment unit, the hybrid token could be separated into two parts for tax purposes. In an ICO, the buyer would purchase a utility token and a share of stock. However, when we analyze the transaction, there is little basis for such a separation.
At least in the case of the tZERO token, the utility portion cannot be physically separated from the rest of the token. Once the tZERO token is used to pay for a fee or service on the platform, it is consumed.
Unfortunately, the blended features of this hybrid token do not bode well for its tax treatment. Yes, tZERO has equity characteristics because the holder shares in profits. But it’s not “stock” of a corporation for tax purposes. Because it is so difficult to separate the two aspects of the token, it’s likely to be taxable in its entirety.
Narrow Path to Tax-Free Treatment
In the end, the path to tax-free treatment for security tokens is … extremely narrow. Indeed, given the uncertainties of tax treatment and amount at stake, all of the available tax strategies for taxpayers have some degree of peril. I’m reminded of the narrow walking path (shown in the picture below with the author’s daughter) connecting the beautiful seaside villages of the Italian Cinque Terre. There’s little room for error but the path can be rewarding!
To be tax free, the tokens need to be functionally equivalent to stock. Another possibility is that a token represents equity in a partnership. But that seems to raise a tax compliance nightmare.
A partnership needs to identify all of its partners so that each partner can report its share of partnership income. How would the business deliver K-1s to holders on a global decentralized blockchain? Moreover, if a partnership is publicly traded, it may be treated as a corporation for tax purposes. Unfortunately, tax issues present challenging issues for structuring tax-free ICOs!