Many blockchain companies are using a largely unregulated means of raising funds, commonly known as an initial coin offering (ICO). An ICO consists of the issuance of a newly generated cryptocurrency (generally referred to as a token) that runs on blockchain technology, in exchange for fiat currency (such as U.S. dollars) or other cryptocurrencies like bitcoin or ethereum. Broadly, tokens can either be classified as “utility tokens,” which provide users with access to the blockchain platform developed by the issuer or products or services provided by the issuer, or “security tokens,” which represent certain rights with respect to an entity, either as equity or debt. This GT Alert discusses the potential tax implications of the so-called utility tokens.
There is very little formal guidance on the U.S. tax consequences of issuing, acquiring, owning, using, and disposing of cryptocurrency. In 2014, the United States Internal Revenue Service (IRS) issued Notice 2014-21, in which it set forth its position on certain basic issues relating specifically to cryptocurrency. Other than such guidance, taxpayers have to apply general tax concepts developed in other areas.
Notice 2014-21 – In General
Pursuant to Notice 2014-21, all cryptocurrency is treated as property, not currency, for federal tax purposes. Thus, a transfer of a token will be considered a transfer of property, the tax consequences of which depend on several factors, including the fair market value, tax basis, and holding period of the tokens and the purpose (investment vs. trade or business) for which the tokens are held by the transferor (although for issuers the purpose would nearly always be trade or business).
Tax Implications of ICO for the Issuer
The issuance of utility tokens for cash, cryptocurrency, or other property generally will be treated as a sale of property in which the issuer has a zero basis (e.g., a sale of a self-created intangible asset). Accordingly, the issuer generally will recognize income upon the sale of the tokens. Newly issued tokens are generally not held by the issuer as a capital asset; thus, proceeds from the issuance of tokens generally will be treated as ordinary income. Because tokens will almost always be characterized as intangible property, it is important to determine whether income from the issuance will be characterized as sales income, royalty income, or services income, and also to determine its source (i.e., the jurisdiction in which it arises), since U.S. taxation generally is imposed only if an item of income is sourced to the United States.
In 1998, the IRS issued Treas. Reg. § 1.861-18 (also known as the Software Regulations), which provides a methodical framework to determine the character of income from the transfer of intangible property. Under the Software Regulations, such income is classified as income from: (1) the sale of copyright rights; (2) the license of copyright rights; (3) the sale of a copyrighted article; (4) the lease of a copyrighted article; (5) the provision of services related to a computer program; or (6) the provision know-how related to a computer program.
Although the Software Regulations were issued long before blockchain technology was even contemplated, they can be used as a starting point for determining both the character and source of income from a cryptocurrency transaction.
Generally, issuance of tokens should not result in the transfer of intangible property rights because token purchasers generally do not acquire an unfettered right with respect to the underlying blockchain technology (i.e., token holders do not have any specific public or derivative rights with respect to blockchain technology). Thus, issuance of tokens would more likely be characterized as a sale of the inventory produced by the issuer, and might be analogized to a sale of intangible property that has indicia of a copyrighted article. Accordingly, income from the sale of inventory would be ordinary income and, assuming the tokens would be considered to have been “produced” by the issuer, such income would be sourced based on the location of production of such inventory. However, based on the actual facts, the issuance of a token could also be treated as a license/lease or a service. If the issuance is treated as a license, the royalty received generally would be ordinary income and the source of the royalty would be determined based on the place where the IP is used. If the issuer of a token is treated as providing services, the income attributable to such services would be ordinary income and generally would be sourced to the location where the services are performed.
However, note that U.S. tax implications for non-U.S. issuers could vary significantly based on several factors, including where the tokens are considered to have been “produced,” whether the owners of the non-U.S. issuer are U.S. citizens or residents, whether any substantial trade or business is carried on in the U.S. by the issuer or a related party, the location of the management of the issuer, and any marketing activities in the United States.
Tax Implications for Token Purchasers in an ICO
The purchasers of tokens in an ICO generally do so either to obtain access to software on the blockchain platform or, alternatively, to hold as an investment asset, hoping the value of the tokens will increase based on the success of the project.
Generally, purchase of tokens using fiat currency should not be a taxable event. However, if tokens are purchased using another cryptocurrency (e.g., bitcoin or ethereum), a U.S. purchaser would be subject to U.S. federal income tax on the amount that is equal to the difference between the value of the tokens purchased and the tax basis in the cryptocurrency exchanged therefor. Beginning Jan. 1, 2018, the Tax Cuts and Jobs Act of 2017 limits the tax free like-kind exchange treatment of the Internal Revenue Code Section 1031 (Section 1031 Exchange) only to exchanges of like-kind real property. Thus, after Jan. 1, 2018, exchanges of one cryptocurrency for another are taxable. The status of pre-2018 exchanges is uncertain, and the IRS may take a position that exchanges of one cryptocurrency for another are not eligible for the Section 1031 Exchange treatment.
The character of the gain or loss will depend on the purpose for which the exchanged cryptocurrency was held by the purchaser. If cryptocurrency was held as a capital asset (i.e., similar to stocks, bonds, and other property held for investment), then the gain or loss should be capital gain or loss, and would be short-term or long-term gain or loss (which are taxed at different rates) depending on whether it has been held for more than one year. If the exchanged cryptocurrency was not held as a capital asset, the taxpayer will realize ordinary gain or loss on the sale or exchange. Generally, most purchasers would fall within the first category and the gain or loss should be treated as capital gain. A purchaser’s basis in the tokens will be equal to the purchase price of the tokens (translated into U.S. dollars at the time of purchase if purchased using another cryptocurrency).
Tax Implications of the Use of Tokens
Pursuant to the Notice, a taxpayer will have gain or loss upon an exchange of tokens for other property or services. Such services would include the use of utility tokens on blockchain platforms. Thus, if a token is being paid as a fee for the right to use a blockchain platform or is being used as “currency” in exchange for services or other property on or through a blockchain platform, such an exchange of tokens would be a taxable event for U.S. federal income tax purposes. For example, if a purchaser purchases a token for $1 with an intent to use that token as a membership or access fee on the issuer’s platform after it is developed and, in fact, uses the token after nine months when the token is trading at $5, the purchaser would have $4 of short-term capital gain without receiving any cash from the transaction to pay the tax. Similarly, if the token is trading at less than $1 at the time of its use, the taxpayer may be able to claim short-term capital loss.
Notice 2014-21 provides that a taxpayer who receives virtual currency (i.e., tokens) as payment for goods or services must include the fair market value of the tokens in gross income, measured in U.S. dollars as of the date the virtual currency was received. Thus, in the above example, if the issuer provides a service that can be accessed only by using the tokens that it had previously issued, the issuer would have to pick up income equal to the fair market value of the tokens at the time of the use. As a result, if the tokens were issued for $1 each and at the time of its use the value goes up to $5, the issuer would be required to include $6 in its gross income (i.e., $1 at the time of the issuance and $5 at the time of the use), and any business expenses could be claimed as a deduction against such income. The issuer’s tax basis in the tokens received in exchange for the services would be equal to the fair market value of the tokens at the time of their receipt, i.e., $5 in the above example. If the issuer reissues the tokens that it received, the tax implications on issuance, as discussed above, would apply and the gain or loss would be calculated based on the new tax basis.
In addition to the federal income tax consequences on the use of tokens, state and local tax consequences such as sales and use tax may also arise. Thus, if a utility token is used to obtain a taxable service (for example, Software as a Service, which is taxable in many states), most states would treat the use of the token to receive the taxable service as a taxable event subject to sales or use tax as they would tax a barter transaction. This is similar to a gift card. When a gift card is purchased, there is no sales or use tax, but when it is redeemed for a taxable product, sales tax is charged. Likewise, when a token is purchased, it is possible no sales or use tax would be due, depending on the state or locality. On the other hand, when it is redeemed for a taxable service, sales tax would be triggered, based on the fair market value of the taxable service.
Each transaction that involves the transfer of tokens would likely be a taxable transaction. As per the recent IRS bulletin (IR 2018-71), the IRS made it clear that taxpayers could be subject to criminal prosecution for failing to properly report the income tax consequences of cryptocurrency transactions. Any such failure could result in a fine of up to $250,000 and a prison term of up to five years. In 2016, the IRS issued a very broad John Doe summons on Coinbase, demanding information on each one of its accounts, which was ruled in favor of the IRS by a federal judge. The IRS will likely subpoena other cryptocurrency exchanges that a taxpayer uses to obtain information on the trades. Thus, careful planning is essential to determine the tax implications to the particular taxpayer undertaking such a transaction.
1These are also sometimes referred to as a first token sale (FTS) or a token generating event (TGE).
2 In general, tokens issued in most ICOs should be distinguished from other intrinsic cryptocurrencies that are generally used as a medium of exchange (e.g., bitcoin, litecoin, etc.) or give access to a platform on which other blockchain projects are built (e.g., Ether, Ubiq, Eos, etc.). Some cryptocurrencies, such as Ether, could be treated as hybrid tokens that can be used as a medium of exchange for ICOs of other cryptocurrencies, but also allows smart contracts for other blockchain projects to be built on its platform.
3 Notice 2014-21, 2014-16 IRB 938, 03/25/2014, IRC Sec(s). 1001
4 Notice 2014-21, 2014-16 IRB 938, Q&A-7.
5 These regulations are limited to transactions involving “computer programs,” which is defined as a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. . . a computer program includes any media, user manuals, documentation, data base, or similar item… that is identical to the operation of the computer program.” Treas. Reg. 1.861-18(a)(3).
6 Treas. Reg. § 1.861-18(c).
7 If a token issued in an ICO is treated as pure equity (e.g., if purchasers have voting or profit sharing rights), the issuer may argue for no tax on the issuance. Certain factors listed in Notice 94-47 must be considered to determine whether an interest in a company could be treated as equity.
8 IRC § 863(b).
9 IRC § 861(a)(4).
10 IRC § 861(a)(3).