Four tax considerations to heed before launching an ICO

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Initial coin offerings (ICOs) are unquestionably the hottest trend in corporate fundraising, with companies having raised over US$3 billion in 2017. That is more than in all previous years combined, despite bans on ICOs in mainland China and South Korea.

Cautionary remarks to investors are being made by officials in many countries, in addition to warnings made by crypto-currency executives. Navigating the ICO trend is complex for many reasons, not least because most jurisdictions have not yet decided how to regulate or tax token issuers or investors.

What are ICOs?

ICOs, also called token sales, are used to raise funds for a new company, similar to the way new companies raise funds with initial public offerings (IPOs). Instead of granting investors shares of the new company, ICOs give investors crypto-currency tokens. These do not convey an equity share; instead, for example, the tokens can be traded, used to buy something from the company, or grant a right to access a platform.

Individual or company may have great business ideas and rush into an ICO without knowing the right questions to ask, especially around the tax implications. Careful consideration on tax issues should be done to mitigate the risk of tax errors; or otherwise, it may render the venture uneconomical. 

1. Don’t make a bad choice for the country of ICO issuance

Despite a common misconception, it is inaccurate to say that some jurisdictions “don’t tax” ICOs. However, the goal of an ICO to achieve a zero or very low tax rate at issuance and even during subsequent trading and operations is not a fantasy. In reality, while most countries have not written clear regulations around ICOs, many have made official statements that provide clues to what the regulation coming may be.

This fluid situation may create opportunities for carefully planned ICOs. The objective is to have a proper structure for fundraising that reduces corporate and indirect tax leakage, and the choice of jurisdiction/domicile for the ICO-issuing entity is all-important. It should be an appropriate domicile for regulatory purposes as well as being tax efficient.

Hong Kong is one such example of a jurisdiction with no specific ICO tax rules and as a result, general tax principles and case law provide guidance. Although most of the ICOs are for the purposes of fundraising, different from a conventional IPOs which confer equity interest to the subscribers of the shares, ICOs may give rise to different rights and obligations to the investors.

  • Examples of questions to consider when determining how tax authorities will decide how to treat an ICO

    • What are the motives/intentions of the taxpayer?
    • How will the ICO proceeds be used?
    • What are the rights and obligations of the parties?
    • What is the location of the people performing relevant activities?
    • What is the accounting treatment of the ICO proceeds?

    Normally, documentation such as a whitepaper, token sales memorandum and other legal agreements are a starting point in determining the answers to these questions, but ultimately a court or tax authority will make the tax decision with the benefit of hindsight.

2. Don’t rush through your planning for corporate structure and transfer pricing

As important as choosing the domicile is deciding the corporate structure, particularly where there are different entities within the corporate group that undertake different activities such as token issuance, platform development, sales/marketing, support functions, etc. 

The objective is to reduce tax leakage on dividends and capital gain from future divestment, and to mitigate the risk of creating a taxable presence in countries when certain development and other ancillary activities may take place.  

  • Factors to consider

    • The tax residency and citizenship of the founders/shareholders
    • The location of business substance of the overall enterprise 
    • The contractual model of engaging service providers
    • The post-ICO value-creating activities performed by the respective entities
    • The relationship between related parties

3. Don’t underestimate the complex, critical nature of taxes on intellectual property

The most common purpose of an ICO is platform development, and more often than not, intellectual property (IP) is created. In those cases, the objective is to maximize the use of available tax incentives for research and development (R&D), and assuming the IP ownership is retained, to minimize tax leakage on profits from its future use.

  • Relevant considerations when determining a tax-efficient IP structure

    • The type and nature of IP being developed
    • The location where the IP’s development, enhancement, maintenance, protection and exploitation (DEMPE) takes place, as well as the location of the entity controlling the DEMPE functions
    • The legal ownership of the IP and any contractual rights to it
    • R&D incentives/IP tax regimes
    • Treatment of royalties, including withholding tax and availability of tax treaty benefits

4. Try to look far enough ahead to make judgments about “routine” tax requirements

ICOs often result in the distribution to investors of another crypto-currency, such as Ethereum or Bitcoin. ICO planners need to consider how the subsequent fair value movement of such crypto-currency might be taxed.

  • Questions to answer

    • Will expenses incurred on the development activities be tax deductible?
    • How will related parties’ transactions be arranged, priced and documented?
    • Will future development activities, if undertaken in different jurisdictions, create taxable presence/permanent establishment?
    • Will the company’s activities trigger any indirect tax obligations such as goods and services tax or value-added tax?
    • What will be the tax filing/compliance requirements for any entities within the corporate group? 

All these ongoing taxation requirements will affect not only the administrative obligations to the taxpayer, but also the tax costs of doing business.

Because ICOs are new and as yet mostly unregulated fundraising vehicles, the tax considerations for them are actually more complex and require advisors with deep insights into the tax administrations of not only the founders’ country and the country of ICO issuance, but also many other countries where the founders or investors may have a residence or presence.

While IPOs continue to be larger than ICOs, the significant impact the ICO trend is having on the financial services landscape continues to provide fintech and investors with opportunities to be explored.