How Tax Efficient are Security Tokens?
More businesses have issued new types of tokens which present different tax implications for holders. A security token offering represents a taxable event. Purchasers of security tokens must take into account the regulatory changes taking place not only for conventional cryptocurrencies but also security tokens.
What are Security Tokens?
Security token offerings are the regulated version of an ICO (Initial Coin Offering). An STO involves acquisition of legal rights in a physical or digital asset through the purchase of a token. An increasing number of companies find STOs to be a cheaper method of raising funds than raising funds through an IPO (Initial Public Offering).
Existing laws are clear that capital raised through a security offering is not considered as taxable income. This means that issuers of security tokens are not subject to tax liability from the sale of tokens. Traders are liable for taxes upon the sale of the tokens and capital gains made from the tokens.
IRS Treatment of Security Tokens
Security Token Offerings represent economic rights. Proactive traders of security tokens consider the categorisation of their tokens. The IRS may deem tokens as inventory. The lack of regulation in the space makes it very difficult to ascertain this.
The IRS is unclear about the economic rights that an STO represents.However, the IRS is clear on its classification of security tokens as property. While this may not seem like a big deal from the outside looking in, it complicates the tax filing process for many security token holders. The IRS provided guidance in 2014, stating that digital tokens are property for the purpose of US federal income tax. The result of this is that many issuers of security tokens deem utility tokens as the sale of inventory.
This means that there is a transfer of value where a security token transaction takes place. Traders may calculate the cost basis of security token transfers in pursuance of tax laws. A qualified accountant makes it easier to file taxes in accordance with applicable laws. Their job can be much easier with records of transactions.
Economic Substance of Transactions
The economic substance of a transaction affects how a security token is deemed as a sale of inventory. One needs to determine the “it” being transferred through the digital token. This affects how the asset is treated by the IRS.
The IRS may consider economic rights under different categories: equity, debt, and shared asset ownership. Case law sets the precedent on how to categorise economic rights.
In order to determine whether a security token is debt or equity, the following factors (among others) may be considered:
- The title given to the set of rights
- Fixed maturity date
- Principal payments
- Interest payments
- The right to enforce payment of principal and interest
- Participation in management
- Contribution relative to regular corporate creditors
- Intent of the parties
- Identity of creditors and stockholders
A tax partnership may exist where parties share the economic risks and rewards of a trade or business. The law may treat a partner as the owners of a proportion of each asset or interest in the partnership. This may enable an issuer of a security token to use a wider variety of approaches to define their relationships with investors for tax purposes but the complexities of compliance may increase.
Alternative Tax Jurisdictions
Some issuers of security tokens may utilise special purpose corporate vehicles to avoid the complexities of partnerships. Following the sale or contribution of security tokens to a corporation in a low-tax foreign jurisdiction, investors may purchase security tokens.
While the IRS is still trying to figure out the best approach to taxation of security tokens, Switzerland’s tax authorities have gained headway in scoping out their regulatory classification of security tokens.
Stamp duty is not applied to security tokens in Switzerland. This is due in part to the fact that share capital does not increase upon the sale of a security token. Switzerland does not classify tokens as securities.
The law does not subject purchasers of security tokens in Switzerland to VAT as such activities are considered as financing transactions which are not qualified as a consideration under Swiss law. Thus, the operation is exempt from VAT.
When it comes to taxation of security token offerings, regulatory uncertainty is moderately high in US. Many investors remain unclear about the application of laws to their holdings. Carrying out purchases and filing of taxes in good faith can help to reduce the risks of non-compliance and attendant consequences. Investors would do well to file their returns on cryptocurrency taxes even if they are worried about making mistakes. Failure to file taxes can expose one to criminal penalties. Seeking the assistance of a CPA can go a long way in reducing the risks of such exposures.