INTRODUCTION

Initial coin offerings ("I.C.O.'s") offer blockchain-based1 companies a new way to raise capital.2 Companies, both in the U.S. and outside the U.S., have been raising capital using blockchain technology since 2016. For example, in 2016 Overstock raised $2 million through the sale of digital preferred stock on a blockchain platform, as part of a larger capital raise.

Some issuers use I.C.O. proceeds to fund the development of a service on a blockchain (e.g., a crypto-asset exchange), others to purchase a property (e.g., real property or even stock in a corporation). In 2019, investors were offered the opportunity to invest in Elon Musk's SpaceX venture via a new token product — USPX. A special purpose vehicle ("S.P.V."), Unicorn Tokenization Corp., was formed for this purpose. It bought shares of SpaceX on a secondary market and offered investors to purchase tokens representing shares in the S.P.V. Token holders were granted economic rights proportionally equivalent to the underlying SpaceX shares.

As these means of raising funds gained popularity around the world, questions arose. The S.E.C. ruled that some tokens are securities, so that an offer to the public in the U.S. is subject to Federal securities laws.3 Tax questions also arose, but not all questions have been answered. Specifically, no guidance exists with respect to the proper characterization of a token, and U.S. investors are not assured of the tax consequences of their investments. Nor are they advised on how they should be reported.

No "one answer fits all" can exist in these circumstances, as each token is different. The rights and powers embedded in each token are specific to the offered token and are described in the I.C.O. documentation. Some tokens are sold as an equivalent of a stock (e.g., USPX tokens, which were therefore not offered to U.S. investors), making them an instrument that is relatively clear for most U.S. tax purposes, although some uncertainties remain. For example, is a token holder considered a "shareholder" for purposes of meeting the requirements to be treated as a real estate investment trust ("R.E.I.T.")?4 Others tokens are not clearly presented to buyers as an equivalent of stock, and those raise more questions when it comes to determining their U.S. tax characterization.

TOKENS ARE PROPERTY. BUT ARE THEY EQUITY?

It seems that tokens are a type of cryptocurrency. The I.R.S. ruled that Bitcoin and other virtual currencies are treated like property and that a transaction using such property is a taxable event.5 However, the I.R.S. has not addressed when certain tokens that hold equity-like characteristics (e.g., voting rights, rights to participation payments, or redemption rights) will be treated as equity for tax purposes. Not all tokens offer such equity-like characteristics. Some tokens offer merely the future right to participate in a service, or receive a product, developed by the issuer. The I.R.S. has not addressed the U.S. tax treatment of these tokens.

Additionally, this could affect the issuing company. Will the I.C.O. proceeds be taxable to the issuer? Will payments, if any, made to token holders be a deductible expense or could it be viewed as a dividend payment? How will the Foreign Account Tax Compliance Act ("F.A.T.C.A.") apply to the issuing entity?

"I.R.S. has amended Form 1040, U.S. Individual Tax Return, to include a question as to whether the taxpayer received, sold, sent, exchanged, or otherwise acquired a financial interest in any virtual currency."

The classification of tokens is important, especially since the I.R.S. has amended Form 1040, U.S. Individual Tax Return, to include a question as to whether the taxpayer received, sold, sent, exchanged, or otherwise acquired a financial interest in any virtual currency. In the absence of guidance as to the tax characterization of a token, the specific characteristics of a particular token must be examined based on generally accepted tax principals.

Separately, FinCEN has advised that "virtual currency held in an offshore account is not a foreign account that needs to be reported on [the] FBAR [i.e., Report of Foreign Bank and Financial Accounts]." Nevertheless, FinCEN and the I.R.S. are continuing to study the question of whether offshore virtual currency should be incorporated into F.B.A.R. reporting requirements.

GENERAL TAX PRINCIPALS: DEBT V. EQUITY

The well-developed standards of the debt v. equity treatment of a corporate instrument can be looked to when performing the required analysis of the character of a particular token. Debt and equity are two major forms of capital with different rights, risks, and rewards for the holder and the issuing corporation. As one court noted, the "vital" difference between stock and debt is the status it confers on the owner: The shareholder is "an adventurer in the corporate business; he takes the risk, and profits from success," whereas the creditor, "in compensation for not sharing the profits, is to be paid independently of the risk of success, and gets a right to dip into capital when the payment date arrives."6

Because companies and investors are often incentivized to treat junior funding as equity or debt, the I.R.S. has often disagreed with a taxpayer's conclusion and re-characterized the instrument. As a result, prior to the 1969 enactment of Code §385,7 courts devised a variety of tests to determine whether shareholders' or creditors' funding of a corporation in which they own interests should be treated as stock or as debt.

The most widely cited opinion in the debt v. equity area, issued by the Third Circuit, mentioned 16 different factors to be considered in discerning the substance of a shareholder's or creditor's interest as either debt or equity:

  • Intent of the parties to fund via debt or equity
  • Whether identity exists between the "creditor" and the entity's shareholder base
  • Extent of participation in management by the holder of the instrument
  • Ability of the corporation to obtain funds from outside sources
  • "Thinness" of capital structure in relation to debt
  • Risk involved
  • Formal indicia of the arrangement
  • Relative position of obliges as to other creditors regarding payment of interest and principal (i.e., is there any subordination involved)
  • Voting power of the instrument holder
  • Provision of a fixed rate of interest
  • Contingency of the obligation to repay
  • Source of interest payments
  • Presence or absence of a fixed maturity date
  • Provision for redemption by the corporation
  • Provision for redemption at the option of the holder
  • Timing of the advance with reference to the organization of the corporation8

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Footnotes

1. "Blockchain" refers to the technology that allows decentralized ledger. See our Blockchain 101 article.

2. While many refer to coins and token interchangeably, in fact, they are different. A coin is native to its blockchain (Bitcoin, Litecoin, Ether, Neo, to name a few) and can be used as a (crypto)currency outside its native blockchain, while a token is generally created on an existing blockchain. For example, a token can be built on the Ethereum platform. This token is known as the ERC-20 token.

3. S.E.C. Release No. 81207 in relation to their investigation of The DAO token offering.

4. It is largely believed that the answer is yes; however, a legal opinion is generally obtained by the issuer prior to electing to be treated as a R.E.I.T.

5. I.R.S. Notice 2014-21.

6. Commr. v. O.P.P. Holding Corp., 76 F.2d 11, 12 (2d Cir. 1935).

7. Enacted in 1969 as part of P.L. 91-172, Sec. 415(a).

8. Fin Hay Realty Co. v. U.S., 398 F.2d 694 (3rd Cir. 1968).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.