How Structuring Can Help Manage Your ICO Tax Exposure

With Bitcoin and other cryptocurrencies hitting new highs, Initial Coin Offerings or Token Generation Events (which we’ll refer collectively to as ICOs in this article) continue to attract attention as a means of raising funding to finance new crypto projects.

While regulators are still largely playing catch-up with the latest cryptocurrency trends, increasing scrutiny is being applied to the crypto world, and regulators are moving to apply legal frameworks to ICOs and crypto projects, including moves to ensure the crypto industry is paying tax and complying with securities law.

Previous articles by Lupercal have identified some of the key regulatory considerations for ICOs. At a high level, we see three regulatory areas that must be addressed by a project considering an ICO:

1. anti money-laundering/counter terror-financing law;
2. corporations and finance regulations, which often involves determining whether ICO tokens constitute securities; and
3. the tax treatment of ICO proceeds.

Complying with these regulations can be costly and complex. The corporate tax outcomes alone could potentially result in over 30% of ICO proceeds being owed to a tax authority (in addition to Value Added Tax (VAT) that could apply at rates of 20–25% or more on parts of the proceeds!).

Tax and ICOs

At a high-level, there are two key taxes that can impact an ICO: income tax, imposed on the ‘income’ of an entity, and VAT, imposed on supplies made by an entity.

VAT

VAT systems effectively create a tax liability where an entity makes certain kinds of ‘supplies’. Many ‘supplies’ the average person makes are familiar: they include goods (such as a Coke) or services (such as a car mechanic fixing broken suspension). But VAT can apply to a much wider range of ‘supplies’ than is commonly thought: insurance products, certain kinds of financial derivative products, and some vouchers for example.

While most regulators have not yet published their formal position on the VAT treatment of tokens or coins issued by ICO projects, there is a real chance that ICO tokens sales could constitute supplies and be subject to VAT (rates vary, but are around 20% on average).

VAT is a ‘high compliance cost’ tax as the VAT treatment of ICO tokens may be different in each jurisdiction. Without considering the impact of VAT, you may wake up one morning to a large VAT bill from a country half-way across the world.

Income and international tax

Income tax rules vary across jurisdictions, but as a general rule, corporate income tax is effectively imposed on the ‘net income’ (or profit) enjoyed by an entity in a particular jurisdiction.

As we previously explained here, it may be that the proceeds raised from certain ICOs are taxable income under many jurisdictions’ corporate tax rules. This could mean that entities face a significant income tax bill shortly after their ICO (corporate tax rates vary but can be over 30%).

Our previous article explains how corporate tax may work in many jurisdictions on a domestic income tax basis. However, the global nature of ICO projects — which may involve a team spread across the world and purchasers located in nearly every country — means that principles of ‘international tax’ (a complex area of the already niche tax field) will likely come into play for an ICO project.

In general, tax is imposed by a particular country on either:

• a residency basis, i.e. on an entity’s ‘global’ income (all its income regardless of the source of that income); or
• a source basis, i.e. country-by-country where the income is generated.

These rules effectively add another ‘condition’, to whether an amount is taxable income in a particular country. In simple terms, this means that a country imposes corporate tax when an amount is income and that income has a ‘source’ in that country, or that income is generated by entities that are ‘residents’ of that country.

If neither of those rules are satisfied, a country typically won’t impose income tax on proceeds — in this case, international tax rules effectively assume that such income will be taxable elsewhere and is a question for another country. The application of tax treaties entered into between various jurisdictions may further complicated the matter.

ICOs and international tax structuring

Assuming that ICO proceeds are ‘taxable income’, international tax principles potentially add another set of tax consideration for ICO entities. These principles can be central to managing the global tax exposure of many multinational entities.

Many ICO projects are actively exploring or reconsidering the location of their token-issuing entity to manage potential tax outcomes, in part because of the tax residency considerations.

Of particular interest to ICO projects is the use of ‘tax neutral’ jurisdictions as the location of the ICO issuing entity, with a separate service/development entity located where the other project members are based (which is often in a relatively ‘high tax’ jurisdiction such as the United States, Canada or Australia). Another alternative that some operations have explored is to relocate their entire ICO group altogether.

In simple terms, if entities are resident in a jurisdiction that does not impose tax, they are not taxed on all of their global income (tax is only payable in certain jurisdictions on a ‘source’ basis — that is, in certain jurisdictions where the income was generated, but the application of the source principle to international ICOs has not been tested so it remains somewhat unclear whether/to what extent it would apply to ICO proceeds).

At a very high level, the potential impact of adopting a structure where the ICO issuer in based in a tax neutral jurisdiction, as compared to a higher tax jurisdiction, is illustrated below.

Illustrative potential tax impact of ICO issuers in high tax v tax neutral jurisdictions

But residency is the tip of a (very, very) large iceberg of structuring considerations. Poorly thought-out, ill-advised, and poorly implemented structures can cause many problems.

Complexities of Structuring — still the preserve of multinationals?

Traditionally, international tax structuring was the preserve of major multinationals and high-net-worth individuals. Effective international structures are complex, and require teams of very specialised, expensive lawyers and accountants.

Major leaks such as Lux Leaks, the Panama Papers and Paradise Papers have brought international tax structuring arrangements to the forefront of public debate.

Complexities of Tax Structuring — why doesn’t everyone do it?

While the basic operation of tax structures is more widely known than it used to be, it is no less complex. Recent regulatory changes have made the area much more complicated than it once was.

ICO projects thinking of simply using an ‘off-the-shelf’ structure to achieve desired tax outcomes should carefully consider their options before jumping on such ‘solutions’. A structure that operates for one entity is often unlikely to work for another. Knowing how to apply international tax law relies on a detailed, particular knowledge of the intricacies of tax law across key jurisdictions and a deep understanding of the commercial operation of the project.

As many multinationals are currently finding as a result of the Panama Papers and Paradise Papers, the commercial drivers of a project, location of the relevant entities, and type of product/service being supplied will all combine to uniquely impact the tax outcome for each individual ICO project.

In short, whether an ‘on paper’ structure is valid can depend on the circumstances of the entity that adopts it — it is often a much more complex exercise than it can seem.

Government/regulation attention on ICOs

As most readers will be aware, many OECD governments around the world have sought to address certain structures that lead to ‘tax avoidance’ outcomes for those that employ them.

Whether a specific structure is seen as legitimate or not often turns on the nature, type and location of the ICO project’s activities. In many cases, having an ill-advised or poorly implemented ICO structure may actually be worse than not having an ‘optimised’ structure — many countries impose penalties and interest for tax offences that can far exceed any perceived tax ‘saving’.

Corporate vs. non-corporate entities

In addition to the international tax aspects raised above, determining the type of entities (corporate or otherwise) involved in the ICO project adds another dimension to ICO structures.

For instance, some ICO projects have sought to use not-for-profit entities as the issuer of ICO tokens as, on the face of it, these entities are exempt from corporate income tax, and so may avoid an income tax liability following tokens being issued.

This approach isn’t without issues though, as the founders of the Tezos project are currently discovering: the Foundation that raised USD 232 million for their project is still considering whether to fund their litigation fees for the three class-action lawsuits facing Tezos in the United States.

Founders and project executives of ICO project that use not-for-profit and charitable entities may find that onerous compliance and regulatory considerations constrain their ability to develop the project as they see fit. Importantly, how the foundation’s legal documentation is drafted can be key to how its funds can be used.

Conclusion — So, is structuring an option for ICOs?

Yes, structuring is definitely an option and an important consideration for ICOs. But deciding on an ICO group structure should not be taken lightly and should be driven by the underlying commercial operations of the project.

Key things to consider…

Many ICO projects have experienced the post-ICO low of receiving a large upfront tax bill after the success of their project and so are drawn to complex and seemingly ‘efficient’ structures to manage their potential tax obligations.

However, deciding on a structure for your ICO is a tricky and involved task that typically requires experienced advisors. Every ICO project will have unique circumstances, such as the location of the team and where fundraising will occur. Often, the longer an ICO project progresses without advice, the harder and more expensive it becomes to implement or resolve anything.

It can be tempting to run pre-ICO structuring cheaply, but cheap solutions are often bad solutions. As projects like Tezos highlight, setting up corporate arrangements right from the start can save huge amounts of money and headache in the long run.

Many structuring options come with trade-offs around risk, financial, commercial, legal, or tax positions. It is a good idea to discuss these trade-offs and considerations before choosing the right approach for your ICO.

It may be that the right structure for your ICO is not international and does not involve residency considerations — there are further options that can be explored for an ICO project. Structures that use different entity types can be an effective means of ensuring that the ICO ‘lump sum’ is amortised or recognised over a longer period as the entity incurs more development expenditure, for example.

Next Steps

Getting good advice as soon as possible when considering an ICO could significantly impact the long-term future of your project.

Lupercal Capital (lupercalcapital.com) and its network of specialist advisers have worked with many ICO projects to guide them through complex commercial and financial considerations of running an ICO.

We also advise investors and purchasers on which crypto projects have addressed key commercial and financial issues, and set themselves up for long-term success.

Please contact us at [email protected] if you would like to talk with one of our experienced advisers on how we can help you.