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Legal, Tax and AccountingImpacting your Domestic or
International ICO
Presenters Listed at End
November 2, 2017
General Agenda
• It all starts with the Business Model!
•Analysis of Token(s) (and White Paper Analysis)
•Securities Law Issues
•Domestic and International Tax and Accounting
•Financial Services Regulation (and others)
•Other Regulatory/Privacy and Security for On-going Business
2
Common Questions
• Is your token a security? And is it always a security?
• If a token is not a security, what else might it be?
• If your token is a security, how can it be legally issued?
• What can happen if securities tokens are issued without registration or an exemption or with misleading disclosure?
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Common Questions
• Resales of securities tokens by purchasers?
• Is your company an “investment company”?
• What do we need to consider with taxes for a domestic ICO?
• What are the U.S. tax considerations with doing a foreign ICO?
• How are Tokens and Crypto-Currencies Accounted for?
4
Common Questions
• Could your structure be defined as a “money servicer” business (MSB)?
• When do I need to do be compliant for AML/KYC/OFAC?
• What is the regulatory landscape on the State level?
• Is your token a commodity?
• What about international options like “sand boxes” or foundations or other not-for-profits?
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The SEC’s DAO Report (July 2017)
• Participants sent ether to the DAO in exchange for DAO tokens that permitted the participants to vote on the projects the DAO would fund
o Participants would share in the “rewards” if those projects were successful
o A DAO founder referred to buying DAO tokens as being similar to buying shares in a company and getting dividends
• The DAO organizers and supporters were geographically dispersed. “Curators” screened investment proposals.
• There were no restrictions on the resale of DAO tokens
• Roughly $150M raised. Security vulnerabilities in the DAO resulted in funds being stolen from the DAO, and ultimately a “hard fork” of the Ethereum Blockchain was used to restore the stolen funds
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The SEC’s DAO Report (July 2017): Legal Analysis
• Analysis of DAO tokens as “securities”
o Focused on the definition of the term “investment contract” under 1933 Act, as interpreted by SEC v. W.J. Howey Co., 328 U.S. 293 (1946), and its progeny
• Analysis of DAO Platforms (web-based platforms that supported secondary trading in DAO tokens) as securities “exchanges”
o Reviewed Section 3(a)(1) of the 1934 Act and related exemptions
• Status of the DAO as an “investment company”
o Did not analyze, but appears to have been an investment company under Section 3(a) of Investment Company Act of 1940 (ICA)
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Selected Other Applicable Securities Laws
• Notes are securities unless they bear a strong “family resemblance” to certain types of notes that are not securities (e.g., certain commercial and consumer loans)
• State Securities Laws
o Most follow Howey
o Seventeen states, including California, apply some version of the “risk capital” test in addition to or in lieu of Howey
• Foreign jurisdictions
o Some are following the SEC’s lead (some tokens are securities): Singapore, Canada, Hong Kong, Malaysia, Gibraltar (sort of) (and see Isle of Man)
o China and South Korea: “moratorium on ICOs”, China called for a repayment of proceeds from completed offerings (but are they really?)
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Securities Analysis
• Consider the “Big 3” (as to laws of each applicable jurisdiction):
o Is the token a “security”? Or a “derivative, commodity, etc.”?
o Is the platform an “exchange”?
o Is the company an “investment company”?
• May be able to structure token/SAFT characteristics to achieve desired status
• Ultimately must structure offering to comply with applicable requirements
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Is the Token a Security?
• Apply Howey
o Investment of money (or other valuable consideration)
o Common enterprise
Some circuits require horizontal commonality - investors pool their money or assets together to invest in a project
Some circuits look at vertical commonality (some strict, some broad) – an investor’s fortunes are tied to the fortunes of the promoter/manager (strict) or are dependent on the promoter/manager (broad)
o Expectation of profits – profit need not be the only motivation, but it generally must be the principal motivation (e.g., not principally motivated by the desire to use or consume the interest acquired)
o [primarily? substantially? predominantly?] through the efforts of others - Courts vary in their formulations of this prong (Howey said “solely,” but later cases broadened it)
Some courts have said this prong is met where the efforts of others are the “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise” or where profits are to be derived from “the entrepreneurial or managerial efforts of others.”
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Is the Token a Security?
• States – most states apply Howey, but California and sixteen other states apply some version of the “risk capital” test, either in addition to or in lieu of Howey
o Compared to Howey, the risk capital test generally focuses more on whether the sale proceeds will be used as capital to develop the enterprise that is selling the contract and generally does not require that the investment be profit-seeking.
o The risk capital test is often associated with a California case in which golf club developers sold club membership interests, with the proceeds to be used to develop the club. The court held the membership interests represented “risk capital” and were securities, even though purchasers were seeking the benefits of membership, rather than profits.
o Consider stage of development and use of funds
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Is the Token a Security?
• Utility token pre-sales (before network launch/minimum viable product)
o Is there utility/consumptive use at the time of the sale?
oAre purchasers hoping to make a profit from an increase in token value if/when the network is launched?
o Issue a SAFT – Simple Agreement for Future Tokens – as a security, and distribute the utility tokens when the network is launched/viable/has utility?
• Foreign Securities Analysis (and Reg S), as applicable
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If the Token is a Security
• Conducting the Token Generating Event (TGE):
o Register with the SEC ?
Time and expense
o Rely on federal registration exemptions (e.g., Regulation D, Regulation S, Reg A+, Rule 701 and Section 4(a)(2)) (may need to verify purchasers as “accredited investors”)
o State/foreign compliance, as applicable
o Even if sale not registered, federal and state anti-fraud rules apply. Disclose all material non-public information in an accurate and balanced manner
o Don’t pay parties who are not licensed broker-dealers to sell a securities token of SAFT
13
If the Token is a Security
• Resale Issues for unregistered offering:
o Federal Rule 144 resale safe harbor – for private company securities, 12-month holding period and affiliates may not be able to utilize the safe harbor
o Resellers must comply with state resale requirements (most states have an exemption for resales by non-affiliates)
o Even if a resale is legal, will there be a legal, liquid market/securities exchange?
o Section 12(g) – and Rule 12g
Register with the SEC if have assets at a year end >$10M and a class of equity securities held of record by 2,000 persons or more or by 500 or more who are not accredited investors
If register, have annual, quarterly, and periodic reporting, proxy statements, audit requirements, etc. Material time and expense requirements.
• State/foreign compliance (and Reg S requirements), as applicable
14
Domestic ICO
• Why is the tax scare about a domestic ICO?
oHow many years of expense can offset ICO revenue in computing tax over time?
oHow many years of R&D Credits can offset tax due on an ICO over time?
oAre accounting rules under GAAP and tax different for an ICO?
Why does it matter?
International ICO
• What is the US tax consideration with doing a foreign ICO?
• The following is relevant, but not part of the advice given by non-US counsel/tax advisors:
IP Transfer?
Cross License of IP?
Controlled Foreign Corporation rules?
Subpart F?
Transfer Pricing Rules and Regulations?
Will the foreign entity be considered to have a Permanent Establishment in the US?
How are Tokens and Crypto-Currencies Accounted for?
• What are the rules according to US GAAP?
• What are the rules according to IFRS?
• What are reasonable accounting positons?
• Does your token use and business model impact the accounting?
• Does the accounting impact the tax results?
Investment Company
• Investment company?
oPropose to engage in the business of holding or trading “securities” (e.g., an investment fund)
This includes companies whose business plan is to invest in securities issued by other blockchain based companies
o Investment companies are subject to a broad range of restrictions and requirements
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Selected Other Legal Issues
• Money Servicers/Transmitter Laws
• KYC / AML /OFAC
• Tax Laws – a particular token may not fit neatly into traditional categories
oTraditional equity and debt contributions generally not taxed
oUtility token sales may be treated as sales of inventory or services
oOther categorizations may apply
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Perspective: Selected Additional SEC and Other Enforcement Actions
• September 2017, SEC charged Maksim Zaslavskiy and his companies REcoin and DRC World (aka, Diamond Reserve Club) with defrauding investors
o Selling unregistered securities and, per the SEC, the tokens don't really exist and neither has real operations
• July 2017, BTC-e, a digital currency exchange, and Alexander Vinnik criminally charged with operating an unlicensed money service business, money laundering and other crimes
• June 2017, SEC alleged that an individual created an unregistered broker-dealer and did not register the firm with the SEC as required under the federal securities laws. Allegedly used sales representatives to cold call potential investors and sell securities in Bitcoin Store Inc. and Bar Works Inc.
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Money Servicer Business (MSB)
Any person doing business, whether or not on a regular basis or as an organized business concern, as a Currency Dealer or a Money Transmitter :
(1) Currency dealer or exchanger.
(2) Check casher.
(3) Issuer of traveler's checks, money orders or stored value.
(4) Seller or redeemer of traveler's checks, money orders or stored value.
(5) Money transmitter (FYI - The definition of a money transmitter does not differentiate between real currencies and convertible virtual currencies)
(6) U.S. Postal Service.
The term "money services business" does not include:
1. A bank, or
2. A person registered with, and regulated or examined by, the Securities and Exchange Commission or the Commodity Futures Trading Commission.
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Money Servicer Business (MSB) Con’t
FinCen (a bureau of the U.S. Department of the Treasury) has defined the participants in generic virtual currency arrangements:
1. User - a person that obtains virtual currency to purchase goods or services.
2. Exchanger - a person engaged as a business in the exchange of virtual currency for real currency, funds, or other virtual currency.
3. Administrator - a person engaged as a business in issuing (putting into circulation) a virtual currency, and who has the authority to redeem (to withdraw from circulation) such virtual currency.
An administrator or exchanger that (1) accepts and transmits a convertible virtual currency or (2) buys or sellsconvertible virtual currency for any reason is a money transmitter under FinCEN's regulations, unless a limitation to orexemption from the definition applies to the person.
Common exemptions claimed by Virtual Currency Exchangers/Administrators:
1. They are acting as a Payment Processors (Argument refuted through FinCEN guidance FIN-2014-R011)
2. They only accept and transmit funds integral to the sale of goods or the provision of services, other than moneytransmission services, by the person who is accepting and transmitting the funds.
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AML/KYC/CIP & OFAC
• Anti Money Laundering (AML): requires procedures and controls in place to identify the source of funds.
• Know Your Customers (KYC) Customer Identification Program (CIP) and The Office of Foreign Control (OFAC): Requires one to maintain a process to verify a customer’s identity and perform a check against the Specially Designated Nationals (“SDNs”) list as maintained by OFAC
Contained environments vs. Interactive Environments
• Interactive environments have coins moving from virtual currency wallets into the traditional banking system. Once the funds enter the traditional banking system it is hard for them to identify the source of the funds, it is believed that this problem will further drive exchanges to create controls around AML and KYC.
It’s a balance of Privacy and Identification. Need to think about the tools necessary to maintain compliance post
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State Level Regulation (New York)
New York implemented 23 CRR-NY 200 titled “Virtual Currencies”. NY requires anyone engaged in any“virtual currency business” activity to obtain a license. The regulation defines “virtual currency business” asan activity involving any one of the following types of conduct that takes place in New York or involves aNew York Resident:
(1) Receiving virtual currency for transmission or transmitting virtual currency, except where the transactionis undertaken for non-financial purposes and does not involve the transfer of more than a nominalamount of virtual currency;
(2) Storing, holding, or maintaining custody or control of virtual currency on behalf of others;
(3) Buying and selling virtual currency as a customer business;
(4) Performing exchange services as a customer business; or
(5) Controlling, administering, or issuing a virtual currency.
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State Level Regulation (New York)
Each licensee must maintain and enforce written compliance policies, including policies with respect to anti-fraud, AML, cyber security, privacy and information security and a customer identification program.
The AML and customer identification requirements given their own section of the regulation which require (at a minimum):
(i) Verification of the customer’s identity, to the extent reasonable and practicable,
(ii) Maintenance of records of the information used to verify such identity, including name, physical address, and other identifying information, and
(iii) A check of customers against the Specially Designated Nationals (“SDNs”) list maintained by OFAC. Enhanced due diligence may be required based on additional factors, such as for high risk customers, high-volume accounts, or accounts on which a suspicious activity report has been filed.
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Are Virtual Currencies Commodities?
• The CFTC has jurisdiction over a virtual currency when it is used in a derivatives contract, or if there is fraud or manipulation involving a virtual currency traded in interstate commerce. They do not oversee “spot” or cash market exchanges and transactions involving virtual currencies that do not utilize margin, leverage, or financing. But again here it is very beneficial to understand their view on virtual currencies.
• LabCFTC issued “A CFTC Primer on Virtual Currencies”. Here the CFTC reiterates they have previouslystated that virtual currencies are properly defined as commodities and point to the CommoditiesExchange Act’s language (CEA) which states in part “commodity” includes “all services, rights, andinterests . . . in which contracts for future delivery are presently or in the future dealt in.”
• There is no inconsistency between the SEC’s analysis and the CFTC’s determination that virtual currencies are commodities and that virtual tokens may be commodities or derivatives contracts depending on the particular facts and circumstances. The CFTC states they “look beyond form and consider the actual substance and purpose of an activity when applying the federal commodities laws and CFTC regulations”
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Presenters and contact information
• Jason Epstein, Chair of Blockchain and Digital Assets, Nelson Mullins
o [email protected] | 615.664.5364
• Craig Nazzaro, FinTech and Blockchain, Of Counsel, Nelson Mullins
o [email protected] | 404.322.6969
• John Jennings, Partner, Securities and ICOs, Nelson Mullins
o [email protected] | 864.373.2207
• Mitchell Kopelman, CPA, Partner-in-Charge, Business Tax, Technology & Biosciences, Aprio
o [email protected] | 404.898.8231
• Jagruti Solanki, Assurance Senior Manager, Technology & Biosciences and International, Aprio
o [email protected] | 770.353.3047
• Kurt Huntzinger, Assurance Partner, Technology & Biosciences and International, and Chief Risk Officer, Aprio
o [email protected] | 404.898.7548
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QUESTIONS
