Initial coin offerings (ICOs) of virtual currencies are becoming more common in today’s business environment. These offerings present a variety of international and domestic tax issues, including when ICOs involving U.S. real estate investments intersect with the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA).
The only formal IRS guidance on cryptocurrency to date is Notice 2014-21, which limits its application to convertible virtual currency (CVC). The notice describes CVC as virtual currency “that has an equivalent value in real currency, or that acts as a substitute for real currency.” Under Notice 2014-21, CVC is treated as property and not as currency for U.S. tax purposes. The notice provides some guidance for ICOs that issue CVC as tokens, which are digital representations of value issued in connection with an ICO. However, the notice does not provide guidance on non-CVC tokens issued in an ICO, as often is the case when the tokens represent access to future services, software, and personal or real property.
Because of the absence of integrated regulatory guidance in the U.S., including the tax treatment of anything other than CVC, ICO issuers frequently use a foreign-based cloud company to do an ICO in a jurisdiction that has a more developed regulatory framework.
Real Property Investments
The virtual nature of the technology employed allows foreign-based ICOs to be completed in an efficient manner even when the underlying value is in the U.S. Foreign investors increasingly are exploring opportunities to invest in U.S. real estate through ICOs, but the lack of U.S. tax guidance creates uncertainty and potential issues for foreign ICO investors in connection with FIRPTA.
When the tokens represent an interest in U.S. real property, foreign investors and foreign issuers need to be wary of the likely FIRPTA consequences in addition to any local tax or regulatory issues related to a foreign ICO. FIRPTA requires that a foreign investor be taxed on the gain from disposition of any U.S. real property interest (USRPI) as would any U.S. taxpayer, unlike gains from the sale of other types of property, which generally are exempt from U.S. tax in the hands of a foreign seller. A USRPI is an interest, other than as a creditor, in real property located in the United States or the U.S. Virgin Islands, as well as certain personal property that is associated with the use of real property. IRC Section 1445 requires the buyer or closing agent to withhold 15 percent of the fair market value on a disposition of a USRPI by a foreign person to assist in the collection of any income tax due under FIRPTA. A U.S. corporation for which the fair market value of real property constitutes more than half the value of all operating assets (known as a U.S. real property holding company, or USRPHC) also is a USRPI.
Because FIRPTA requires income tax on a disposition of a USRPI by a foreign person, any disposition where the token qualifies as a USRPI will be subject to withholding under Section 1445. However, the indeterminate nature of tokens might present an opportunity to alleviate tax under FIRPTA. If the tokens represent a USRPI, any gain realized upon a disposition would be subject to FIRPTA. But if the tokens represent a security in a foreign corporation, the ICO might fall outside the purview of FIRPTA.
The classification of the investment vehicle itself will be critical to the treatment of the ICO security under U.S. tax law. If the tokens represent an investment in a U.S. corporation, the investment likely would qualify as a USRPHC and a foreign investor would be subject to FIRPTA. On the other hand, if the tokens represent an investment in a foreign corporation (such as the issuer of the tokens), dispositions, sales, and exchanges of the tokens should not be subject to FIRPTA.
The U.S. tax implications of an ICO based on U.S. real property are somewhat ambiguous due to the lack of framework and guidance on cryptocurrency. Foreign investors should exercise caution when investing or participating in an ICO whose funds ultimately will be used to invest in U.S. real property. Investors should work with U.S. tax advisers that have expertise in both cryptocurrency matters and FIRPTA when evaluating ICOs as an avenue for investment in U.S. real estate.