How are Security Tokens Taxed?

by Ryan Reneau

This is the first of a series summarizing the relevant issues and analysis that a security token issuer should navigate with their advisors. We start the series by answering the most basic question: when an investor receives a token, what did she receive?

New Alchemy and Entoro Capital (Entoro) are strategic partners offering an integrated solution for blockchain securities. Entoro’s technology-enabled investment bank and broker-dealer combined with New Alchemy’s blockchain technology and advisory expertise offers a one-stop solution for issuing tokens in a regulated securities environment. The partnership leverages the capabilities of both Entoro and New Alchemy, to provide a unique, integrated offering to Issuers with Security Token Offerings (STOs).

Securitizing assets through issuance of digital tokens raises numerous tax issues. The Internal Revenue Service issued guidance in 2014 stating digital tokens are property for purposes of US federal income tax. As a result, some issuers have reported the issuance of utility tokens as the sale of inventory.

Unlike the “initial coin offerings” launching utility tokens that receive substantially the same treatment from coin to coin, each digital token representing a securitized asset will be unique and require an independent analysis.

Each Token is Unique

Despite being property, the issuance of security tokens may not be characterized as the sale of inventory. The tax treatment of a transaction should follow the economic substance. A digital security token representing a securitized asset is not the “it” sold in an issuance. The “it” is the bundle of economic rights tied to the digital token.

By simple analogy, a retailer selling reams of paper reports the sale of inventory. In contrast, the issuer of stock delivers to a shareholder a piece of paper, a stock certificate, evidencing ownership of a share of stock. The exchange of the stock certificate for cash is not the sale of inventory despite the physical transfer of a sheet of paper. It is a contribution to the corporation’s capital.

Accordingly, the first step in analyzing the tax consequences of securitizing an asset is answering the question what is the “it” being transferred via the digital token.

Three Categories

The next step is determining what tax characterization should be accorded to the set of rights the token represents. Broadly, bundles of economic rights are divided into three categories for US federal income tax purposes: debt, equity, and shared asset ownership. There is no bright line between these categories.

The courts have identified factors that help differentiate between them, but the case law always operates by looking backward. Deciding whether a financial instrument should have been characterized as debt or equity was easier in 1940 when the prevailing instruments were common stock, preferred stock, bonds, and term loans. The financial markets have increased in complexity since then, with security tokens being the latest evolution, but tax law continues to use the same categories.

Debt versus Equity

When determining whether a security token is debt or equity, the following factors are relevant:

the title given to the set of rights;
the presence or absence of a fixed maturity date;
the source of principal payments;
the source of interest payments;
the right to enforce payment of principal and interest;
participation in management;
the status of the contribution relative to regular corporate creditors;
the intent of the parties;
“thin” or adequate capitalization;
common identity of creditors and stockholders (i.e., do the stockholders also own all the debt proportionally);
ability of the company to obtain loans from outside lending institutions;
the extent to which the advance was used to acquire capital assets; and
the failure of the debtor to repay on the due date or seek a postponement.

Note: these factors change slightly between U.S. federal circuits, so it is important to determine which jurisdictions’ factors apply.

Shared Ownership

The shared ownership economy that has emerged does not fit neatly within the debt-equity construct. Tax law deals with this by creating tax partnerships even when state law partnerships do not exist. The definition of a partnership is broad. If parties join to carry on a trade or business and share in the economic risks and rewards, then a tax partnership exists.

A tax partnership merges the “aggregate theory” and “entity theory.” (For some purposes, a partner is treated as owning a portion of each asset within the partnership, and, for other purposes, the partners are treated as owning an interest in an entity). This grants an issuer flexibility to design nuanced relationships with investors on one hand; on the other, it greatly increases the complexity and compliance burden.

This rule is not without its exceptions. For example, it’s not unusual for oil and gas operators to share ownership of the underlying minerals with royalty owners and non-operating working interest partners. The owners of the various interests in this circumstance may be allowed to elect out of partnership status under a special exception in the tax code even thought their economic outcomes are closely tied together.

There has been little to no discussion whether the ownership of identical portions of intangible assets creates a partnership. Certainly, a book publisher and an author would not be considered to have joined together. The relationship has been defined as a license paying a royalty to the author who owns the copyright.

A complication arises when the author sells her copyright. What if she sells it to two individuals who purchase thirty-seven percent (37%) and sixty-three percent (63%) several years apart? They would likely not be partners. What if she sells the entire interest to one hundred individuals and each purchaser takes an identical one-hundredth of the copyright? This situation is much more grey. What if she sells the rights to a book she has not written yet to one hundred investors in identical portions? This begins to look like a partnership where one hundred individuals join together to fund the next hit novel.

Securitized Assets

A special purpose corporate vehicle can be used to avoid the partnership issue when securitizing an asset. In short, the asset is sold or contributed to a corporation, sometimes in a low-tax foreign jurisdiction, and then investors purchase equity in the corporation. This is a common structure for “asset backed securities,” which are financial instruments collateralized by a pool of similar or homogenous assets.

Returning to the copyright example, if the author contributed the copyright to a corporation, then sold one hundred shares of stock to investors, there would be no doubt as to the characterization of the investors’ economic rights. They would be equity. An economic outcome similar to directly owning a portion of the copyright is achieved without the looming partnership issue. In the next few weeks, within the series, we will discuss the certainty that comes at the potential cost of another layer of tax. There is no free lunch.

Conclusion

Securitizing assets through digital tokens is no more or less complex from a tax law standpoint than using traditional means. The key to eliminating the mystery and uncertainty for a security token offering is defining what economic rights the token holders receive and identifying the legal instruments creating those rights. Once in the hands of competent tax advisors, they should be able to walk an issuer through the nuances of their unique facts.

Disclaimer: This article is meant for general education purposes only. Please consult your tax advisor on your specific facts and circumstances.

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