Initial offerings of virtual currencies are proliferating, and they present a host of domestic and international tax issues.
The core principles of U.S. taxation of cryptocurrencies were spelled out in IRS Notice 2014-21, which established that cryptocurrency is treated as property and not as currency, domestic or foreign. Consequently, if a business issues tokens, whatever it receives in return generally will be taxable to the issuer unless the transaction is not taxable under another operative tax provision. In some situations, though, the income from the offering could be deferred. Similarly, trading tokens also will generate gain or loss. In short, the notice only defines a cryptocurrency for U.S. tax purposes – as property and not currency. It does not provide operative tax treatment.
It is common to use a foreign-based cloud company to raise capital through initial coin offerings (ICOs) because of the virtual nature of the technology employed, but this assumes that the substance and ownership of intellectual property (IP) meets existing transfer pricing rules without disrupting the company’s overall global business strategy.
Outlined below are some of the key U.S. tax considerations in connection with a foreign-based ICO.
- Tax reform. H.R. 1, commonly known as the Tax Cuts and Jobs Act (TCJA), brings a lower U.S. corporate rate of 21 percent, which might make U.S. holding companies quite attractive in many situations. However, the ability to defer both federal and state tax with a foreign structure still provides many planning opportunities, but it requires careful navigation as tax reform evolves and many questions continue to be answered.
- Technology transfer. If the new company will employ substantial proprietary IP, including technology related to the cryptocurrency itself, transferring that technology to a foreign affiliate could create significant tax consequences for the U.S. transferor.
- Foreign company U.S. source income. If the foreign affiliate operates in the U.S. (if, say, some or all of the actual business activities and IP development occur in the U.S.), then the foreign affiliate will be subject to U.S. federal and state taxation. To be respected as a foreign taxpayer and to avoid being taxed in the U.S., a foreign affiliate needs to have substance in the foreign jurisdiction and very limited activity in the U.S. At a minimum, a foreign affiliate’s contracts and agreements must be conducted and executed outside of the U.S. to avoid creating a taxable presence in the U.S.
- Transfer pricing. If the ICO requires substantial U.S. activities or services of U.S. officers and directors, there almost certainly will be a need to form a separate U.S. company to perform any domestic activities that are required in order to avoid taxable presence. The U.S. company engaging in these activities must be remunerated at arm’s-length prices under appropriately executed agreements between the domestic company and the foreign company.
- Potential for deemed dividend. The U.S. maintains a set of complex anti-abuse rules commonly known as Subpart F. Subpart F applies only to a controlled foreign corporation (CFC), which is a foreign corporation more than 50 percent owned by five or fewer 10 percent U.S. shareholders. Under the Subpart F rules, income realized from certain activity or from the sale of products both sourced and sold for use or consumption outside the foreign company’s host country may be treated as a dividend taxed to any U.S. shareholder at ordinary rates. The ICO and activity of the foreign affiliate must be arranged in a way that does not trigger Subpart F income. Furthermore, the TCJA has initiated several new anti-abuse provisions on foreign-based income that CFCs must navigate as well.
- Foreign jurisdictions. Careful review of the foreign jurisdiction’s local law is needed to ensure both the tax and regulatory environment are consistent with expectations.
The preceding tax considerations are not an exhaustive list of the issues. As always, the only clear imperative when dealing with tax issues related to international structuring is to proceed with experienced tax advisers.