by Crystal Stranger, Co-Founder of PeaCounts
Across various blockchain conferences, many potential investors have come to me with the same quandary: that they wouldn't want to invest in a U.S.-based initial coin or token offering (ICO). The reason they give is that the Securities and Exchange Commission (SEC) considers all ICOs to be securities and with a utility token, this is the death of investment.
You could establish a company abroad. In reality, however, it's not that simple. For starters, even companies formed with an international home base face the risk of SEC securities sanctions. There can be legitimate reasons to settle abroad if the business model has other markets as primary sources of income, or if there is beneficial ICO legislation. For companies that intend to do business in the U.S., it can be simpler to form domestically as the new corporate tax regime is competitive. Many of the choices I see businesses make in this area are misguided, however, and based more on trends than on legitimate business decisions.
ICO Islands
When it comes to favorable jurisdictions in which to set up shop, there seems to always be a flavor of the week. One week, it will be the Cayman Islands. The next could be Malta, Bermuda, or Gibraltar. The race is on among tax-favored domiciles to offer corporations the most attractive regulatory environment. At first glance, this would seem to be a smart strategy, as forming a business abroad puts the company out of other governments' reach, right? Not exactly.
If your company's substantial presence is not in the jurisdiction legally formed in, establishing a business there is for naught. If the bulk of work is done in the U.S., the primary market is the U.S., one of the heads of the company lives in the U.S., or investment is sought in the U.S., then the U.S. securities laws still apply.
To get around these regulations, some companies have added language to their websites stating that they do not allow U.S. investments. This still does not solve the problem at hand, though and seems downright silly. Why are you present in the U.S. if no part of your business strategy is here other than to raise investment? It's unlikely the SEC and Department of Justice (DOJ) will find this a logical excuse to avoid their jurisdiction.
Foreign-based firms, especially those formed in tax havens such as the Cayman Islands, are asking for trouble if they run a token sale. Firstly, forming outside the US then running a token sale aimed at US investors can make a company seem shady from the outset. Moreover, as some locations are singled out as havens for abusive tax structures ownership of entities in these jurisdictions can lead to more intense governmental scrutiny, especially in the post-Panama Papers world.
Many European countries have blacklisted known tax havens and apply a harsh tax regime on income from these locales.
Malta may be the best choice with the three ICO laws passed this week that set up a new regulatory framework and legitimize companies that wish to offer utility tokens. The process to be approved involves legitimate hurdles intended to prove a company and project is based on solid footing. These investor protections are welcome in the industry, although they may also sideline some smaller projects that cannot meet Malta's standards.
Recourse for Investors
For investors, it is essential that they have legal support in the event some aspect of the business is mishandled. For companies based in many of these island paradises, there is no recourse if the founders of the company decide to buy a superyacht with the ICO funds instead of developing the underlying business.
With these considerations in mind, some prefer to invest in companies formed in Switzerland or the U.S. where there are clear laws in place to protect investors. The very same legislation that has investors so scared about the US with regards to ICOs serves as a bulwark should founders turn out to be less than honest about their business intentions.
Security Token Offerings
A new category of token sales is security token offerings (STOs). With this token class, you are granted limited voting rights and a share in future profits. Security tokens are thus likely to fill a void in the ICO industry as it's currently challenging to get the message out to investors without paying for marketing methods that invalidate a token offering's utility status. Even with an STO, specific marketing practices could still be considered deceptive marketing, resulting in the security raise being illegal.
Calling the sale a security offering make it seem that the issuers are taking steps toward regulatory self-compliance. This should certainly help with cleaning up the ICO world's image as the financial Wild West and could lead to faster, positive ICO legislation. In a traditional crowdfunding round, it is more beneficial for small investors to purchase a token than a share because the token is more liquid and can be exchanged for fungible currency.
Considering the global nature of the cryptocurrency world, utility token offerings need to be immensely cautious, though.
As Jed Grant, CEO of KYC3, has said, "when two peers in two different jurisdictions have a utility in one jurisdiction and security in another, there is an irreconcilable difference. Buying a security after issuance isn't an issue. But people could use exchange listings."
In some situations, it makes sense to do an STO in the US as this structure harmonizes neatly with the SEC's Regulation D offering and crowdfunding regulations for making an SEC-compliant sale.
Venture Fund Token Issues
Tax issues related to venture funds, decentralized autonomous organizations (DAOs) or other types of tokenized investment pools present another set of concerns for investors. If venture funds are formed as U.S.-based companies, these token holding structures may be a good fit for U.S. investors though they are suboptimal for foreign investors who face a 30% withholding from any distributions, requiring them to file US taxes as a non-resident.
If formed outside of the U.S., U.S. tax law labels this a passive foreign investment company, meaning U.S.-based investors may get hit with a tax rate on income as high as 80%. It would be possible to form both a U.S. and international tokenized fund, but then the arbitrage between both would be challenging to maintain as would finding market makers to support liquidity in each.
As regulation presently stands, there is no easy solution for venture fund token issues. Once security tokens begin to be traded on exchanges, it will be more difficult to limit who is allowed to purchase these tokens. In such an instance, how can a company make sure the proper withholding is made or tax forms are sent out? For companies paving the way toward tokenized venture funds, this oversight is certain to present a challenge.
About Author, Crystal Stranger
Crystal Stranger, EA, author of The Small Business Tax Guide, has more than 14 years of tax experience, with a focus in international tax. She has been writing about cryptocurrency tax and regulatory issues since 2014. Wanting to help her tax clients who have struggled with regulatory compliance, she founded PeaCounts, a blockchain accounting software company that is building a revolutionary new payroll system using the token PEA. This new, transparent payroll will promote fair wages and eliminate the need for black market labor.