Across various blockchain conferences I have recently attended, 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: the Securities and Exchange Commission (SEC) considers all ICOs to be securities and with a utility token, this is the death of investment.
Certainly you could establish a company abroad. In reality, however, it’s not that simple. For starters, even companies formed to have an international domicile face the risk of SEC securities sanctions. 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. There still can be legitimate reasons to form abroad when the business model has other markets as primary sources of income, or for beneficial ICO legislation. Many of the choices I see businesses making in this area are misguided, however, and more based on trends than on legitimate business decisions.
When it comes to favorable jurisdictions in which to set up shop, there seems to 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 that jurisdiction, establishing a business there is for naught. If the bulk of work is done in the U.S., the main market is the U.S., if one of the heads of the company lives in the U.S., or if investment is sought in the U.S., then the U.S. securities laws still apply. To get around these regulations, some companies have chosen the route of putting language on their websites that they do not allow U.S. investments. This still does not solve the problem at hand, though — and when I’m meeting with them at a crypto conference in the U.S., seems downright silly. Why are you present in the U.S. if none of your business strategy is here other than to raise investment? This makes zero sense to me. I’m certain the SEC and Department of Justice (DOJ) would take the same position.
Foreign-based firms, especially those formed in tax havens such as the Cayman Islands, are asking for trouble if running a token sale. For one thing, it can make a company seem a bit shady from the outset. Moreover, as certain domiciles have been singled out as havens for abusive tax structures — especially in the post-Panama Papers world — ownership of entities in these jurisdictions can lead to more intense governmental scrutiny. Many European countries have blacklisted known tax havens and apply a harsh tax regime to income from these locales.
Malta may be the best of these choices, 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 become approved involves legitimate hurdles to pass that prove a company and project is based on solid footing. These investor protections are welcome to the industry, although they may also sideline some smaller projects that cannot meet these standards.
My friend Alex who runs an investment pool in Germany pointed out to me that for investors it is important to have recourse. And for companies based in many of these island paradises, there is no recourse if the founders of the company decide to buy a super yacht with the ICO funds instead of developing the underlying business.
With these considerations in mind, Alex prefers to invest in companies formed in Switzerland or the U.S. In these countries, 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 in which it is very challenging to get the message out investors without paying for marketing methods that invalidate a token offering’s utility status. Even with an STO, certain 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 sometime image of being 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 be able to purchase a token than a share because the token is more liquid, and thus can be exchanged for fungible currency.
Utility token offerings need to be immensely cautious, though — especially considering the global nature of the cryptocurrency world. 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.”
The case thus can be made that it makes sense to do an STO in the US, as this structure harmonizes neatly with the SEC’s Regulation D offering and Regulation Crowdfunding 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 formed as U.S.-based companies, these structures are a good fit for U.S. investors though may be suboptimal for foreign investors who stand to face a 30% withholding from any distributions. If formed outside of the U.S., under U.S. tax law this is a passive foreign investment company, meaning U.S.-based investors may get hit with a tax rate of as much as 80% on income. 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 be 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.