International tax structuring is a difficult and complex exercise for any industry. The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, made international tax structuring even more challenging. Delineating the international tax considerations for a blockchain enterprise, a new industry involving new technology with almost no regulatory guidance, can be difficult for any tax adviser. Putting aside the challenge of planning for an entirely new technology business, the international tax considerations for entities operating in the blockchain industry are not that different from any other industry. When U.S. shareholders are involved in a blockchain enterprise, structuring decisions are generally controlled by the regulatory landscape, the availability of licenses, U.S. international tax implications, and local jurisdiction tax implications.
Brief overview of blockchain
When many people hear the term "blockchain," they often think of bitcoin. That is understandable since bitcoin is the cryptocurrency that popularized blockchain technology. However, bitcoin is just one of many types of cryptocurrencies in the digital market, and cryptographically secured digital currencies are just one use of blockchain technology.
Blockchain technology allows for digital scarcity. That means a digital asset, or a representation of an asset, that cannot be easily replicated. Generally speaking, a blockchain is a distributed network of computers verifying transactions written to an append-only common ledger. Besides cryptocurrencies, another common use of blockchain technology involves smart contracts. The most prominent example is ethereum, a blockchain-based platform on which smart contracts can be developed and executed. Ethereum uses a cryptocurrency called ether as a form of payment to the operators of the platform in exchange for executing specific operations upon satisfaction of conditions contained in smart contracts.
Software and platform developers in the blockchain space have used blockchain platforms (usually ethereum) both as a means of launching their services and raising capital for their blockchain enterprises. Frequently, the blockchain enterprise is funded through an initial coin offering (ICO), which may occur before the software or platform is even developed. An ICO is similar to an initial public offering; however, no equity or ownership is issued to those contributing to the venture. In an ICO, developers create a smart contract that issues new "tokens" in exchange for the investors' contribution of ether, bitcoin, traditional currencies, or other cryptoassets.
The new token being developed is usually either a "utility token" or a "security token." Utility tokens in this context are generally limited in number and represent a right, similar to a license, to use the platform in the future. All future users of the platform are generally required to use the token. In these cases, an ICO is essentially a crowdfunded means of selling future services. Security tokens, in contrast, represent real-world assets, typically the expected profits of the blockchain-based business. Like traditional securities, security tokens, when offered to U.S. persons, likely fall under the oversight of the SEC.
Investors are drawn to tokens because of both their speculative nature and their high liquidity on cryptocurrency exchanges. For example, a recently founded cryptocurrency exchange held an ICO for its own token. After a year of operation, the exchange reported hundreds of millions of dollars in profit, while the value of the token increased by almost 25,000% at its peak from its beginning value of just a fraction of a dollar. Daily trading volume of the token is regularly a significant portion of its market capitalization. Given the startup nature of many blockchain enterprises, a token's market value fluctuates widely based on the performance of the development team, news events, and sometimes fraud or manipulation of the market. Many cryptocurrency exchanges are not yet subject to the strict regulations placed on global stock markets, although some are subject to regulation.
Entrepreneurs in industries with traditionally illiquid markets, such as real estate, have taken note of token liquidity. This has brought about the creation of security tokens (sometimes referred to as "asset-backed tokens"). With a security token, the token issued to investors is a digital representation of an asset (e.g., gold, real estate, art, partnership interests, etc.) held by a trust or other legal entity. Security tokens can be traded on the open market or offered to a limited market of prescreened accredited investors. In situations where accredited investors are required, many of the practices and procedures put in place are self-regulatory measures because, globally, many jurisdictions are significantly behind in developing their own regulatory frameworks.
Regulatory landscape and the availability of licenses
The United States currently suffers from a lack of formal regulatory guidance for the blockchain and cryptocurrency industry. While many blockchain pioneers are U.S. citizens, they often choose to locate their business operations in a foreign jurisdiction where the regulatory environment is more clear and favorable for blockchain and cryptocurrency operations. Initially, low- or no-tax jurisdictions with flexible tech-friendly environments were attractive for setting up blockchain entities. However, the increased risk of fraud due to the lack of regulation in the virtual assets markets has highlighted the need to establish operations in jurisdictions with comprehensive regulatory schemes. As a result, blockchain entrepreneurs are generally now interested in establishing blockchain entities in jurisdictions with blockchain or cryptocurrency legislation in force.
Jurisdictions with any significant blockchain regulation typically require detailed applications, background checks, and licenses. This can be expensive and time-consuming, but when a licensed blockchain company operates within a defined regulatory framework, the risk of fraud shrinks dramatically. Licensing generally provides other benefits, too. For example, business service providers, such as banks, accountants, and auditors, are generally more willing to provide their vital services to a regulated blockchain enterprise. Operating in a regulated jurisdiction is also helpful in attracting investors, as well as meeting both U.S. and non-U.S. anti-money laundering (AML) and know-your-customer requirements along with other similar rules.
Certain non-U.S. jurisdictions, such as Malta, have become crypto-friendly by passing cryptocurrency and blockchain legislation and by making licenses available (Gibraltar, the Bahamas, Switzerland, and Luxembourg have taken similar measures). The Cayman Islands is one of the few jurisdictions that has remained crypto-friendly despite a lack of crypto-specific legislation. The Cayman Islands instead has put in place general legal and regulatory structures that offer securities and AML protections but that are designed to facilitate growth and enterprise. Additionally, the Cayman Islands provides an attractive tax environment, as there is no corporate income tax, capital gains tax, or withholding tax on dividends, interest, and royalties.
Tax and structuring considerations
In addition to the nontax regulatory landscape, U.S. international tax implications must also be considered when U.S. shareholders will have a direct or indirect ownership interest, or when there are other U.S. entities in the structure. Accordingly, when forming a blockchain enterprise or expanding the international footprint, planning opportunities are available to mitigate U.S. tax and to achieve an attractive global effective tax rate. The first consideration is whether to establish a corporate structure or a flowthrough structure for U.S. federal income tax purposes.
Using a corporation may present U.S. tax advantages: A corporate structure may be beneficial for certain U.S. taxpayers that are considering the formation of a blockchain enterprise outside of the United States. For example, U.S. C corporations may benefit from the new 21% U.S. corporate income tax rate established by the TCJA. Under the TCJA, U.S. C corporations forming a foreign corporation may also benefit from certain deductions (i.e., the global intangible low-taxed income (GILTI) deduction) from income that are available only to U.S. C corporations.
At the same time, however, the TCJA repealed section 958(b)(4), which previously prevented the creation of additional controlled foreign corporations (CFCs) through "downward attribution" from non-U.S. persons to U.S. persons. Therefore, when a non-U.S. person sets up a blockchain enterprise in a foreign jurisdiction, if there are U.S. persons elsewhere in the structure, care must be taken to avoid creating unintended CFCs. An unintended CFC could create a reporting obligation or tax liability for the U.S. persons in the structure. Where a foreign corporation is likely to become a CFC in the structure, interposing a U.S. C corporation above the foreign corporation could mitigate the adverse consequences of CFC status. Assuming the foreign corporation is an eligible entity, its shareholders could make a check-the-box election to treat it as disregarded for U.S. federal income tax purposes and thereby avoid the CFC rules altogether.
A U.S. C corporation that forms a foreign corporate blockchain enterprise may benefit from the 50% GILTI deduction. Congress enacted section 951A as part of the TCJA to largely end deferral for U.S. shareholders on the net earnings of a CFC (including active income) that exceed what is considered to be a routine return of 10% of the CFC's basis in its tangible assets. The GILTI rules apply to all U.S. persons, whether individuals, corporations, partnerships, or trusts, that hold a direct or indirect interest in a CFC. However, under section 250, eligible U.S. C corporation shareholders are allowed a 50% deduction on the GILTI generated in a CFC. Those U.S. corporations can also potentially claim a foreign tax credit for a portion of the foreign taxes the CFC paid on their pro rata share of the CFC's GILTI. At the 21% U.S. corporate income tax rate, the 50% GILTI deduction results in an effective tax rate of 10.5% on GILTI, not taking into account the application of available foreign tax credits. A U.S. C corporation shareholder in a blockchain enterprise that is a corporation and established in a zero-tax-rate jurisdiction should expect a residual U.S. tax of 10.5%. However, if the foreign jurisdiction has a tax rate in excess of 13.125%, there would likely be no residual U.S. tax after the GILTI deduction and foreign tax credits.
Depending on the structure of the enterprise and payment flows, a U.S. C corporation forming a foreign corporate blockchain enterprise may also benefit from the 37.5% foreign-derived intangible income (FDII) deduction currently available under section 250. FDII is generally the portion of a U.S. corporation's net income (other than GILTI and certain other income) that exceeds a deemed rate of return of the U.S. C corporation's tangible depreciable business assets and that is attributable to certain sales of property to foreign persons or to the provision of certain services to any person or with respect to any property located outside of the United States. At the 21% U.S. corporate income tax rate, the 37.5% FDII deduction results in an effective tax rate of 13.125% on FDII. To take advantage of the potential benefit from the FDII deduction, the U.S. C corporation would develop and license intellectual property (IP) (such as cryptocurrency trading algorithms, exchange platforms, and formulas) to the foreign blockchain enterprise. From a regulatory perspective, this arrangement is generally acceptable because the U.S. C corporation is merely licensing technology from the United States, not operating a blockchain enterprise.
Additionally, under section 245, U.S. C corporations may deduct from their income dividends received from 10%-or-more-owned foreign corporations, subject to certain limitations. However, a shareholder that claims such a deduction may not claim a credit for foreign taxes associated with the dividend. Therefore, it is important to consider whether a treaty will reduce any potential foreign withholding tax.
U.S. international tax considerations for flowthrough structures: Depending on the foreign jurisdiction, U.S. taxpayers may find that it is more beneficial to structure foreign operations in such a way that the income will flow through to ultimate investors for U.S. federal income tax purposes. Relevant factors that may lead to this conclusion include: (1) where most of the income is from IP developed and held outside of the United States, resulting in the U.S. shareholders' not benefiting from an increased FDII deduction; (2) where there are U.S. shareholders in the structure that are not C corporations; or (3) where a non-U.S. jurisdiction is chosen for the blockchain enterprise but there is no beneficial withholding tax rate on dividends, interest, or royalties. In the above circumstances, U.S. shareholders would likely prefer the income from the newly formed foreign entity to flow through to their own tax return. To obtain this treatment, the foreign entity must be an eligible entity and the initial classification election for the entity must be made within 75 days of its formation. Once the election is made, all income and, importantly, all losses will be recognized in the United States immediately. Further, the U.S. taxpayer may be able to claim a foreign tax credit for any foreign taxes paid locally within the foreign entity's jurisdiction.
Effectively connected income (ECI): If a foreign corporate blockchain enterprise is found to have a U.S. trade or business, it will be subject to U.S. income tax on the income that is effectively connected to that U.S. trade or business. For example, consider whether an ICO of a Cayman Islands blockchain enterprise, and the profits generated therefrom, could result in ECI. If the ICO funds were used to develop IP in the United States, or key employees or directors were present in the United States for significant periods of time, the IRS could argue that the Cayman Islands entity is conducting its business in the United States, and as a result, has income effectively connected to a U.S. trade or business. When setting up a foreign blockchain enterprise, business executives must consider carefully whether related activities undertaken in the United States create a taxable presence in the United States both for federal and state income tax purposes.
Factor to guide a choice of entity
Given the evolving nature of the blockchain and cryptocurrency industry, U.S. taxpayers setting up a blockchain enterprise generally strive to set up their structures as quickly as possible. Noncorporate U.S. taxpayers may consider using a U.S. single-member limited liability company to hold their foreign blockchain enterprise. This structure enables a rapid setup, while providing the U.S. taxpayer flexibility and additional time to decide between a corporate versus a flowthrough structure. Where U.S. shareholders invest in the foreign enterprise, it can be beneficial to first narrow down the possible jurisdictions based on the regulatory landscape and the availability of licenses. Then, U.S. and global effective tax rates may be modeled to compare a corporate and flowthrough structure. Ultimately, the best structure will depend upon a number of factors, including foreign taxes, the choice of entity, and the tax attributes and tax residence of the investors.
Excerpted from the April 2019 issue of The Tax Adviser. Copyright © 2019 by the American Institute of Certified Public Accountants, Inc.