Expert Blog is Cointelegraph’s new series of articles by crypto industry leaders. It covers everything from Blockchain technology and cryptocurrencies to ICO regulation and investment analysis. If you want to become our guest author and get published on Cointelegraph, please send us an email at [email protected]
Initial Coin Offering (ICO) is a new way of fundraising enabled by digital currencies and Blockchain technology where participants invest fiat currencies and receive ‘‘tokens,’’ digital assets in return.
ICOs are widely seen as an innovative fintech alternative to traditional initial public offering of stock (IPO) as a means for start-up businesses to raise capital. A person, project or company in need of capital creates a new kind of digital coin and sells a tranche of them for fiat currencies on a digital trading platform or exchange.
Prior to an ICO, a business would typically release a “whitepaper” which provides investors with an explanation of their proposed project, the rights behind the virtual tokens they would be issuing, the risks of the investment and details of the ICO itself.
The rights behind the digital tokens can vary considerably, and many tokens are not intended to grant the investor an ownership stake in the business, unlike stock.
Currently, there isn’t a standardized way of preparing a whitepaper in comparison to regulated prospectuses for IPOs.
ICO’s token valuation
With the exception of hedge fund managers who indiscriminately assess ICO tokens for their long and short selling prospects, the underlying motivation of an ICO investor is the expectation that the token’s value would uptick after the ICO, and the investor would sell it to make a tidy profit.
A token’s value is determined based on (1) the demand for the token which may be denominated in a highly volatile virtual currency (2) the underlying company’s financial performance. Currently, there isn’t a standardized way of determining a token’s value. ICO investors trade these tokens at a profit or loss.
The Ethereum (ETH) ICO platform is public and open-source and features smart contract functionality. It is still in its early stages of development, and its application is of experimental nature.
Vitalik Buterin, co-founder of ETH, cautioned that there are flaws, technical intricacies of ETH Blockchain networks that support ICOs arising from the centralization problem, which could take up to two to five years to solve. Buterin expects 90 percent of ETH-based ICOs to fail.
Despite information technology (IT) network security measures, software applications, computer hardware, the Internet, Blockchain platforms supporting the ICOs, are also vulnerable to computer viruses, physical or electronic break-ins, attacks or other disruptions of a similar nature (Hacks).
The revelation of the technical vulnerabilities of the ETH-based platform and the risk of Hacks could add operational, technological risks for ICOs.
This year has been the year of ICOs for countries like Russia, China and Japan. To date ICOs raised $3 bln, averaging 20 new virtual coin offerings a month, that produced an average investment return of 1,320 percent, 293 times S&P 500 return of 4.5 percent during the third quarter of 2017.
There have been many new uses for ICOs, including municipality-funding applications in Japan. But Joseph Lubin, co-founder of ETH, cautioned that some of the ICOs have been plain old scams.
In the US, the Department of Justice (DOJ) and the Federal Bureau of Investigations (FBI) began clamping down on fraudulent virtual currency transactions after the FBI issued a first of its kind report analyzing the likelihood and consequences of illegal activities involving virtual currencies in April of 2012. Less than a year later, in March of 2013 the Financial Crimes Enforcement Network (FinCEN) enacted registration requirements for money service businesses (MSB) dealing in virtual currencies before the first ICO launched in July of the same year.
With the known ICO related risks in mind, global regulators, legislators and central bankers have been working on devising effective regulatory measures to mitigate concerns over security, consumer protection and financial crime.
The first country to regulate ICOs was the US Securities Exchange Commission (SEC), which on July 25, 2017, issued a landmark opinion concerning digital assets stating that ICOs can sometimes be considered securities — and as such are subject to strict laws and regulations.
Putting the new SEC law to use: (1) the SEC brought charges against two companies and their operator for defrauding investors in a pair of fraudulent ICOs and (2) ICO token holders served Tezos with two potentially groundbreaking class action lawsuits alleging that its $232 mln ICO violated US securities laws and misled investors.
Since SEC’s ICO pronouncement, twenty-eight countries have proposed or enacted ICO legislation in an uncoordinated fashion. Some countries mimicked the SEC in regulating ICOs as a security. Other countries like China abruptly banned ICOs and shut down all virtual currency exchanges.
Other US laws applicable to ICOs in addition to SEC laws
With the enactment of ICO regulations, institutional investors have become increasingly interested in investing in them. Here are other US laws they should take into consideration in addition to the SEC laws when evaluating an ICO for investment.
- CFTC on ICO Tokens: Commodity Futures Trading Commission (CFTC) regulates virtual currencies/tokens as commodities. A commissioner explained, “crypto-tokens offered in a pre-sale can transform. They may start their life as a security regulated under SEC from a capital-raising perspective but then at some point – maybe possibly quickly or even immediately – turn into a commodity.” This is how many understand the simple agreement for future tokens (SAFT) concept because no bright-line rule determines which types of tokens are securities and which are not. Instead, what qualifies as a security can only be determined by a facts-and-circumstances-driven analysis of particular tokens.
- FinCEN on Foreign Virtual Currency Businesses: According to a spokesman for FinCEN, “A foreign virtual currency business may have to register with FinCEN depending on several factors. If the foreign virtual currency company is registered with, and functionally regulated or examined by the SEC, CFTC or if it engages in activities that, if conducted in the US would require it to register with the SEC or CFTC, then it would not have to register as an MSB with FinCEN. If it does not satisfy this condition, the answer depends on how it operates, on behalf of whom and where its customer base is located based on a facts-and-circumstances-driven analysis.”
- IRS on Foreign Virtual Currency Businesses: A foreign virtual currency business may be subject to US tax laws because virtual currencies are characterized as property according to Notice 2014-21, gains of which are subject to federal taxation and tax reporting requirements under Information Reporting and Backup Withholding, Foreign Account Tax Compliance Act (FATCA), Country-by-Country Reporting (CbCR). The IRS may claim jurisdiction over a foreign virtual currency business that lacks any physical presence in the US, so long as they do substantial business in the US based on a facts-and-circumstances-driven analysis. According to the new chief of the IRS Criminal Investigation division, “in 2018: (1) the Nationally Coordinated Investigations Unit, and (2) the International Tax Enforcement Group will be increasingly focused on the cross-border use of virtual currencies.”
As regulations fall on ICOs around the world, it opens the doors for institutional investors to partake in ICOs of companies that may have a global footprint from a business, technological and legal structure standpoint. This requires sophisticated evaluation of all ICO related risks in all jurisdictions the company operates. “ICO companies, their executives and institutional investors should carefully take into consideration the ever-changing regulatory landscape around the world and implement a good compliance program. An ICO company needs to comply with various countries regulations including money-laundering regulations and anti-bribery laws, while minimizing risk,’’ advised John Kearney of MyComplianceOffice.
Disclaimer: This article is adapted with permission from Tax Management Memorandum, 58 TM Memorandum 418, 10/16/17. Copyright 2017 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com.
Selva Ozelli, Esq., CPA is an international tax attorney and CPA who frequently writes about tax, legal and accounting issues for TaxNotes, Bloomberg BNA, other publications and the OECD.