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A Shift in the rhetoric
While attending events where Initial Coin Offerings (ICOs) or Token Generating Events are discussed, I noticed a change in the message. The presentations used to focus on how to craft your token so it would be as little like a security as possible to avoid regulation. Now the message is focused on building your token as a security, but crafting the sale of it in a way that it fits under the existing exemptions provided in security law. There are a few things driving this shift in the message, but I believe that tax implications are a big one. As the corporate year-end looms for all these ICO-driven corporations, the treatment of token sales by tax authorities is the next regulatory grey zone to navigate. This article discusses the Canadian tax law implications on the sale of utility tokens.
Tax departments and securities regulators care about different things
In Canada and the US, securities regulators and tax departments are independent. The declaration by a securities commission that a particular token is a security does not limit the tax department in any way when they determine how it should be taxed. When analysing investment offerings securities commissions apply the Howey or Pacific Coin tests, which focus on an investment of money, a common enterprise, the expectation of profit, and where the effort to create those profits comes from. The tax department, on the other hand, is looking at whether equity or debt was sold, when the revenue was generated. This sets up the possibility of a worst-case scenario for an ICO where your token is regulated like a security, while the revenue generated from the sale is taxed like corporate business income.
revenue generated from an ico is likely taxable as corporate income
The initial position of the Canadian Revenue Service (CRA) on cryptocurrencies is that either the rules for barter transactions should be applied or if they are bought and sold like a commodity then the securities transaction rules should be applied.
The Canadian Revenue Service (CRA) has not addressed the taxation of money raised by an ICO directly, but they have made clear how revenue generated from crowdfunding campaigns should be handled. Crowdfunding campaigns are analogous to ICOs in a number of ways, and the response from the CRA outlines the principles they considered when looking at these funding mechanisms.
The CRA’s crowdfunding statement says: “where funds are received by a taxpayer as a result of a crowdfunding arrangement for the development of a new product and that taxpayer carries on a business or profession, the CRA generally considers such funds to be taxable income (i.e. income from a source) unless it can be shown that the crowdfunding arrangement otherwise clearly represents a loan, capital contribution or other form of equity.”
If you apply the above statement to an ICO, it means that if the purchasers of utility tokens in an ICO sale do not receive equity in the company conducting the sale, or if the token sale does not clearly represent a loan agreement between the company and the purchaser, then the revenue generated will be taxable. Most token sales are designed not to transfer equity or issue debt to purchasers. This is what makes them so attractive to new businesses. This also makes the funds generated by them likely to attract corporate tax.
Despite this, token sales still represent a liability. The company issuing them has a performance obligation to the purchasers to build the platform that the tokens are to be used on. It follows that these corporations need the ability to deduct the future expenses they incur when building this platform from the revenue they generated when issuing the ICO. The Canadian Tax rules do allow them to do this to a certain degree. Corporations are allowed to carry back corporate losses and receive a tax refund for up to three years, they are also allowed to carry forward losses for up to 20 years to be offset against future taxable income generated by the corporation. Here is a link to the request for corporation loss carry-back form which is used for this purpose.
So, if you generate a large amount of income with an ICO in a single year, you will have to pay tax on all the revenue you received minus whatever expenses you had in that year. If you are developing your platform over the next two or three years and your company posts losses in those years, then you can carry those business losses back and receive a refund for the taxes paid.
If your company is incorporated offshore you may still have to pay Canadian Tax
The CRA, similar to securities regulators, uses the mind and management test when determining if a foreign corporation is actually a Canadian resident. The test, established in 1906 in the U.K by the DeBeers case and affirmed by the Canadian Supreme Court in King v BC Electric, looks at where the real business of the company is carried on and where the central control and management actually abide. The location where meetings take place, where documents are signed and where executives actually operate are important factors when determining corporate residency. If the CRA is satisfied that these things are happening in Canada they have the power to deem the corporation a resident and tax it as such.
Does GST/HST need to be charged on token sales
This one is tricky. There has been no official statement from the CRA on this. If the CRA is going to treat cryptocurrency transactions like barter transactions, then GST/HST would apply. There is a GST/HST exemption for financial services but since ICO’s are not sales of debt or equity and unless the token being sold was considered a currency by the CRA, it would be hard to see an ICO sale qualifying as a financial service.
It is possible to look at how the CRA handles GST/HST in similar situations as a guide, but they are far from definitive. Companies like Netflix are currently not required to charge sales tax on their services, but that may soon change. When a company sells gift cards, they do not have to charge sales tax on the sale of the card, but they do charge sales tax on the transaction when the card is redeemed. Certain types of crowdfunding campaigns are likely to be required to charge GST/HST but there has been no direction from the CRA on this. A typical sale of a utility token may have similarities to each of the examples above. However, it also has radical differences. In addition, there are practical barriers to administering a location-based tax on a blockchain service. I have not yet been able to find a good answer to the sales tax question.
to wrap up
Most token sales will likely be hit with corporate taxes on their revenue, but they should be able to recoup some or potentially all of the taxes paid over the next three years if their company posts losses. Foreign incorporation will likely not help a company avoid this tax if their central operations are in Canada. The sales tax question remains unanswered, but until the CRA makes clear their position a discussion of the particularities of your company’s situation with a qualified professional and a wait and see approach are perhaps the best options.
Stephen Pederson is a student legal researcher at Parr Business Law and president of the UBC Smart Contractors.