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ICOs, Cryptocurrency, and Tokenization: Legal Issues


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An Overview of ICO's, tokenization, regulation both nationally and internationally, and tax considerations.

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ICOs, Cryptocurrency, and Tokenization: Legal Issues

  1. 1. CROWDFUNDING/CRYPTO/ICOS 2018 IRS Circular 230 Disclosure: To ensure compliance with the requirements imposed by the IRS, we inform you that any tax advice contained in this communication, including any attachment to this communication, is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to any other person any transaction or matter addressed herein. Roger Royse Royse Law Firm, PC Skype: roger.royse Twitter @rroyse00 ICO’S, CRYPTOCURRENCY AND TOKENIZATION: LEGAL ISSUES
  2. 2. Disclaimer No information contained in this presentation is to be construed as legal advice. No information contained in this presentation is intended or related to any particular factual situation. Nothing herein forms an attorney-client relationship. If legal advice or other expert assistance is required, the services of a competent professional should be sought.
  3. 3. • Crypto currency • SEC – Must register “securities” with SEC pursuant to Section 5 of Securities Act unless exemption under 4(a)(2) or Regulation D • IRS – Convertible Virtual Currency, • “Virtual currency is a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value.” Notice 2014-21 • CFTC – Virtual currencies are “’goods’ exchanged in a market for a uniform quality and values” CFTC v. McDonnell. • Virtual currencies are within common definition of commodities, as well as the CEA’s broad definition which includes “all other goods and articles… and services, rights, and interest… in which contracts for future delivery are presently or in the future dealt in. • FinCEN – Virtual currency exchangers and administrators are money transmitters and must comply with Bank Secrecy Act and its implementing regulations, Amendments to Bank Secrecy Act Regulations; Definitions and Other Regulations Relating to Money Services Business, 76 FR No. 140 Crypto Currency
  4. 4. • Coinbase Action: The IRS sought to collect the personal information of individuals trading on the Coinbase Platform to investigate whether individuals were not reporting, under-reporting, or self-reporting their taxable gains through the trading of Bitcoin on the Coinbase Platform. • The Court allowed in part the IRS’s request for information for those accounts “with at least the equivalent of $20,000 in any one transaction type (buy, sell, send, or receive) in any one year during the 2013-2015 period” • Voluntary Compliance for individuals who did not report • Domestic Voluntary Disclosure • Offshore Voluntary Disclosure Program Internal Revenue Service
  5. 5. • “Tokens” or “coins” are, in essence, digital coupons used by new cryptocurrency startups to raise funds for their operations. • Depending on the company or platform distributing the Token, a Token could have numerous different purposes. 1. Utility on Platform 2. Licensing Rights 3. Voting Power 4. Ownership • Tokens call themselves “Utility tokens” • SEC chairman Jay Clayton during U.S. Senate hearing “I believe every ICO I’ve seen is a security” • “Merely calling a token a “utility” token or structuring it provide some utility does not prevent the token from being a security.” What is a “Token”?
  6. 6. • SEC Chairman and CFTC Chairman’s February Testimony before the Committee of Banking, Housing, and Urban Affairs: “…structures of ICOs that I have seen involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.” • SEC Chairman Clayton: Market professionals and gatekeepers must act responsibly and hold themselves to high standards. In the ICO space "they can do better”. • SEC warned against ICO Sponsors not making adequate disclosures and cautioned market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. • Family Resemblance test (Reeves) • Multi factor test applied to notes • Howey Test • An investment of money, in a common enterprise, with a reasonable expectation of profits, and to be derived from the entrepreneurial or managerial efforts of others. • The Risk Capital Test • The sale of membership to a country club was a security; substance over form • Investors were risking their capital in expectation of receiving the benefits of club membership, which was in the control of the issuers of the membership Is my token a security?
  7. 7. • The SEC’s Cyber Unit - Division of Enforcement • focused on misconduct involving distributed ledger technology and ICOs, the spread of false information through electronic and social media, brokerage account takeovers, hacking to obtain nonpublic information and threats to trading platforms and works closely with the SEC’s cross- divisional Distributed Ledger Technology Working Group • DAO Token – model described by one of the DAO founders as similar to “buying shares in a company and getting…dividends” • Holders of DAO Token had an expectation of profits derived from managerial efforts of others • Munchee - restaurant meal reviews • SEC halted cease and desist – unregistered securities • ICO targeted investors, who had an expectation of future profits, rather than users of the products, with intention to use proceeds to develop application and future “ecosystem”, which would increase the value the MUN token • Marketing materials stated additional development and ecosystem would increase the price of the MUN token and could trade on secondary market within 30 day after ICO Enforcement Actions
  8. 8. o 506(b): No general solicitation/advertising o 506(c): solicitation/general advertising o Reg A+ o Reg S o Non-US Offering o Registration Statement How is it regulated as a security?
  9. 9. o 506(b): No general solicitation/advertising; accredited and 35 sophisticated unaccredited investors; preempt state law regulations o 506(c): Broad solicitation/general advertising; all accredited investors; issuer takes “reasonable steps” to verify accredited status; preempt state law regulations o Reg A o Tier 1: $20M in 12-month period; unlimited accredited and unaccredited investors; state laws not preempted (Blue Sky laws); unlimited accredited and unaccredited investors o Tier 2: $50M in 12-month period; unlimited accredited and unaccredited investors; solicitation okay for testing interest; all investors; state law regulations preempted o Reg S o Foreign Targeted o Non-US Offering o Registration Statement How is it regulated as a security?
  10. 10. • Community supported crowd sale of cryptocurrency tokens issued by startups based on private Blockchain technology • In 2017, 200 ICOs raised $3.9 billion (Coinschedule) • Status: $90 million; Bancor: $153 million; Filecoin: $257 million • Kik: $100 million (failed to raise revenue through advertising) • Creates liquidity and growth equity without giving up equity in a company • Tokens are sold in exchange for Bitcoin, Ether, or government fiat • No clear tax guidance • Regulatory Guidance: Canada, UK, Hong Kong, Thailand, Switzerland, Australia, Gibraltar, Singapore • Bans: China, South Korea, Macau Initial Coin Offering (“ICO”)
  11. 11. • SEC: tokens are usually securities • IRS: crypto is property • FinCEN: convertible virtual currency • CFTC: may be a commodity ICOs (cont.)
  12. 12. Issuer Law • Securities Law • Tax • AML/KYC • Anti Fraud • FINCEN • CFTC • FTC • Investment Company Act • Exchange Act $ Step 2: Build Platform Step 1: Pre-Sale $orCrypto SAFT Investors Step 3: ICO Tokens Investors The ICO: Crowdfunding on Steroids Team • Legal US • Tax US • Foreign Legal • Compliance • Marketing • KYC/AML • ICO Economies • Blockchain Technical Utility • Use of Token • Secondary Trading • Scarcity • Voting + Democratized
  13. 13. US Platform Co. Cayman ICO Co. Singapore ICO Foundation $ $ SAFT $ tokens Token Securities Compliance Step 1 Step 3: Cash to US Co. $ Step 2: ICO Issuance 1) 506 – All accredited 2) 506/Reg S foreign targeted offering 3) Non US offering 4) Foreign Utility Tokens – not a security 5) Reg A+ 6) Register with SEC 7) Sec 4(a)(2) private offering Resale Rule 144 (12 month holding) Section 12(g) Rule 12g3-2(b)
  14. 14. • Two kinds of Reg. A offerings, called “tiers”, with different qualities: Issue Tier 1 Tier 2 State law regulations? Not preempted; multistate coordinated review program to help Preempted Maximum amount raised? $20 M in 12 months, up to $6M of which from current holders $50 M in 12 months, up to $15M of which from current holders Per investor maximums? None Up to 10% of greater of non- accredited investor’s net worth or net income; unlimited for accredited Investor limitations Accredited and non-accredited okay Issuer limitations Cannot be public, shell company, bad actor, those failing certain SEC compliance rules Reg. A – Two Options (“Tiers”)
  15. 15. Issue Tier 1 Tier 2 Solicitation, advertising Testing for interest, soliciting OK, though notices needed and materials may be exhibits on SEC filing; potential to keep confidential SEC filings during this time Initial disclosures Financial statements for past two years, plus offering circular Same as tier 1, plus audited financials Disclosure to buyers? Circular or most recent Tier 2 report due to buyers by specific time before sale Ongoing disclosures File exit report at end of offering Yes, if 300+ holders; annual, semiannual, and current events. Limitation on need for full Exchange Act registration Securities restriction Unrestricted; affiliates have some limitations Allowed securities? Asset backed-securities banned Integration safe harbor Exists; allows non-US and crowd-funding to be separate Reg. A – Continued
  16. 16. Issue 506(b) 506(c) Reg. A Tier 2 State law regulations? Preempted Preempted Preempted Maximum amount raised? Unlimited Unlimited $50 M in 12 months, up to $15M of which from current holders Per investor maximums? Unlimited Unlimited Up to 10% of greater of unaccredited investor’s net worth or net income; unlimited for accredited Investor limitations Unlimited accredited, and 35 sophisticated non-accredited; self-certification standard Accredited only, and issuer must take steps to certify they are accredited Unlimited accredited (self- certified), unlimited non- accredited 506(b), 506(c), and Reg. A Tier 2
  17. 17. Issue 506(b) 506(c) Reg. A Tier 2 Issuer limitations No bad actors No bad actors Cannot be public, shell company, bad actor, those failing certain SEC compliance rules Solicitation, advertising Banned Soliciting of anyone is allowed Testing for interest, soliciting OK Initial disclosures Non-accredited: Equivalents of what they get in registered offering, plus anything accredited investor can get For accredited, see 506(c) Optional; must be available to answer questions Financial statements for past two years disclosed, plus offering circular with audited financials 506(b), 506(c), and Reg. A Tier 2 (cont.)
  18. 18. Issue 506(b) 506(c) Tier 2 Ongoing disclosures Form Ds Form Ds Yes, if 300+ holders; annual, semiannual, and current events. But special exemption from Exchange Act registration until over $75M float. Share restriction Restricted for a year Restricted for a year Unrestricted; affiliates still have some limits Allowed securities? ABS not specifically banned ABS not specifically banned Asset backed-securities banned 506(b), 506(c), and Reg. A Tier 2 (cont.)
  19. 19. EXCHANGES Statement on Potentially Unlawful Online Platforms for Trading Digital Assets Divisions of Enforcement and Trading and Markets March 7, 2018 Online trading platforms have become a popular way investors can buy and sell digital assets, including coins and tokens offered and sold in so-called Initial Coin Offerings ("ICOs"). If a platform offers trading of digital assets that are securities and operates as an "exchange," as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration Exemptions from registration include Alternative Trading Systems
  20. 20. ALTERNATIVE TRADING SYSTEMS (“ATS”) A platform that trades securities and operates as an “exchange” must be registered as a national securities exchange or operate under an exemption from registration, such as the exemption provided for ATS. • An ATS must have rules designed to prevent fraudulent and manipulative acts and practices • Entity operating ATS must register as a broker-dealer and comply with additional requirements • Caution against using term “Exchange”
  21. 21. CFTC Commodities Futures Trading Commission The CFTC regulates transactions in commodities interests and aims to protect market users and their funds, and the public from fraud, manipulation, and abusive practice related to derivatives and other products that are subject to the CEA. 7 U.S.C. §1(a)(9) (2012). The CFTC’s jurisdiction flows from the definition of a “commodity” under §1(a) of the CEA. In September of 2015, the CFTC issued a determination that “Bitcoin and other virtual currencies are encompassed in the definition and property defined as commodities.” In re Coinflip Inc., CFTC No. 15-29 WL 5535736 (Sept. 17, 2015).
  22. 22. FINCEN Financial Crimes and Enforcement Network • The purpose of FinCEN is to “safeguard the financial system from illicit use and combat money laundering and promote national security through the collection, analysis, and dissemination of financial intelligence and strategic use of financial authorities” • In the event the above-detailed analysis leads a person to determine they are in fact a Money Services Business, MSBs are required to a) register with FinCEN, b) conduct a comprehensive assessment of its exposure to money laundering, c) implement an Anti-Money Laundering Program based on such risk assessment, and d) comply with the recordkeeping, reporting and transaction monitoring obligations set down in parts 1010 and 1022 of 31 CFR Chapter X
  23. 23. FINCEN FEB 13 LETTER Financial Crime Enforcement Network (FinCEN), Dep’t of Treasury letter to Senator Ron Wyden (D- Ore) 1) A developer that sells convertible virtual currency (i.e., bitcoin, ether, ripple, etc) including in the form of ICO coins or tokens, in exchange for another type of value that substitutes for currency is a money transmitter and must comply with AML/CFT requirements that apply to this type if MSB ( and register as a MSB with FInCen - a form filed annually and disclosure of some financial information). 2) An exchange that sells ICO coins or tokens, or exchanges them for other virtual currency, fiat, or other value that substitutes for currency, would typically also be a money transmitter. 3) FinCEN AML/CFT rules likely do not apply to ICO structures where (a) the tokens are offered as securities - SEC jurisdiction and their AML/KYC requirements or (b) future interests in commodities - CFTC jurisdiction and their AML/KYC requirements.
  24. 24. STATE REGULATIONS State registration requirements • Each State has their individual Broker-Dealer requirements and Blue Sky Laws worth investigation for anyone engaged in Token Sales. States are beginning to take their own approaches to regulating businesses acting within Virtual Currencies. New York implemented a “BitLicense” • June 2015 New York Department of Financial Services enacted the BitLicense which requires those engaging in “Virtual Currency Business Activity” be licensed. • Licensing requires application and payment of fees and must maintain capital sufficient to ensure the financial integrity of the Licensee and its ongoing operations. • Alabama, Connecticut, New Hampshire, North Carolina, and Washington are some of other states to have adopted legislature on regulating Virtual Currency Activity. • California has tried to implement the Virtual Currency Act (A.B. 1123)
  25. 25. Tax Considerations • Equity? • Debt? • Capital asset? • Barter exchange? • Prepaid goods or services? • Subpart F Issues: CFC/PFIC? • Deferral? • Open - transaction? • Forward contract ? • Executory Agreement to Sell? • Information Reporting • FATCA • FBAR • Compensation
  26. 26. • Section 965: Transition Tax • Section 245A: Participation Exemption • Section 951A: Global intangible low-taxed income (“GILTI”) • Section 250: Foreign-derived intangible income (“FDII”) • Subpart F • Passive Foreign Investment Companies (PFIC) • Transfer Pricing Rules • Tax exempt organizations vs associations • Compensatory Issue International Tax Rules
  27. 27. • One time inclusion of E+P of certain foreign corporations • Effective tax rates of • 15.5% to extent of cash • 8% non cash assets Section 965 – Transition Tax
  28. 28. • Deduction for certain foreign source dividends from 10% owned foreign corporation paid to domestic corporation • Modified territoriality Section 245A – “Participation Exemption”
  29. 29. • Foreign minimum tax on GILTI of 10.5% until 2025 • Based on net income less deemed return on tangible assets • Individual taxed at 37% Global Intangible Low-taxed Income (“GILTI”)
  30. 30. • C corporations • Foreign net income in excess of deemed return on tangible assets • 37.5% deduction • Effective tax rate of 13.125% (until 2025) Foreign-derived Intangible Income (“FDII”)
  31. 31. • Certain types of mobile income (SPF income) of controlled foreign corporations (more than 50% owned by US shareholders) taxable as deemed dividends to US shareholders (10% owners) Subpart F
  32. 32. • U.S. persons owning shares of a passive foreign investment company (PFIC) have either (i) current taxation on the income of the PFIC (under a QEF election) or (ii) a deemed tax and interest regime. PFIC
  33. 33. • Code Sec 482 requires transactions between related parties to be at arm’s length Transfer Pricing
  34. 34. • Charitable • Civic Leagues • Clubs • Business Leagues • Etc. • Not organized for profit • No private investment • Prohibited transaction: loss of status • Disregarded as agent or nominee Tax Exempts: 501(c)
  35. 35. US Platform Cayman Swiss Foundation $ or crypto tokens ICO Structure Tax Vulnerabilities utility $ 1) Treatment of Swiss Co as agent 2) Subpart F income/ PFIC 3) Transfer price 4) GILTI tax 5) Compensation
  36. 36. • Consumer Protections • Breach of contract, false advertising, fraudulent or negligent inducement • Industry Specific Regulations • Global Regulatory Regimes • FTC Other Interested Agencies
  37. 37. ROYSE LAW FIRM, PC Contact Us PALO ALTO 1717 Embarcadero Road Palo Alto, CA 94303 LOS ANGELES 11150 Santa Monica Blvd. Suite 1200 Los Angeles, CA 90025 SAN FRANCISCO 135 Main Street 12th Floor San Francisco, CA 94105 Palo Alto Office: 650-813-9700 CONTACT US m @RoyseLaw MENLO PARK 149 Commonwealth Drive, Suite 1001 Menlo Park, CA 94025 SANTA MONICA 520 Broadway Suite 200 Santa Monica, CA 90401 SAN FRANCISCO 135 Main Street 12th Floor San Francisco, CA 94105 Menlo Park Office: 650-813-9700 CONTACT US @RoyseLaw ORANGE COUNTY 135 S. State College Blvd Suite 200 Brea, CA 92821