Taxation of ICOs

As an innovative way to raise capital in the blockchain space, ICOs offer numerous opportunities but also raise tax and regulatory issues. This post gives you an overview of the tax aspects of ICOs from a private and business perspective and shows how to avoid tax pitfalls.

What is an ICO and how does it work?

An ICO is a method of raising capital that is frequently used in the area of cryptocurrencies and blockchain technology. An ICO is comparable to an initial public offering (IPO), but for digital assets such as cryptocurrencies or tokens.

The tokens issued as part of an ICO can be linked to different ‘values’, e.g. voting rights, access to a platform or a share in the company’s success.

This is how an ICO works:

  • Project presentation: A company or project presents its idea, often through a so-called white paper. This paper explains details about the planned technology, use cases, team and financing.
  • Token creation: The company creates digital tokens based on a blockchain. These tokens often represent a specific utility or a share in the project.
  • Token sale: Investors can purchase these tokens during the ICO, usually in exchange for established cryptocurrencies such as Bitcoin (BTC) or Ethereum (ETH). The price per token is set in advance.
  • Use of funds: The funds raised are used for project development, marketing and other operational activities.

Advantages and risks of an ICO

ICOs enable the collection of funds without the use of traditional financing methods such as bank loans or venture capital investments. Anyone with a cryptocurrency wallet can participate, making ICOs globally accessible. Furthermore, early investments in successful projects can generate enormous profits.

Some of the most successful ICOs include:

  • Ethereum (ETH): One of the most well-known ICOs, raising around $15.5 million in 2014. It sold 50 million tokens at $0.311 each.
  • Filecoin: Filecoin is a crypto coin for sharing and file hosting. This ICO raised over $250 million in 2017 and was one of the largest in blockchain history.

However, the risks should also be kept in mind:

  • Lack of regulation: In many countries, ICOs are not regulated or are only lightly regulated, which opens the floodgates to fraud and abuse.
  • Speculation: Many investors are speculating on price gains alone, without any interest in the technology.
  • High losses: If the project fails, the tokens can lose

Taxation of ICOs for private individuals

Anyone who buys tokens as a private individual in the course of an ICO must take this into account in their tax return, similar to crypto trades. The regulations on private sales transactions apply, for which the tax liability is determined by comparing the value at the time of purchase and sale.

The one-year speculation period must be observed: if the purchased tokens are held for more than a year, the profit is tax-free. However, the one-year period for an ICO begins at the time of payment.

For more information on the tax treatment of crypto, NFTs and other digital assets for private investors, please visit: Blockchain Tax Advisory

Regulatory issues surrounding an ICO

Before we address the taxation of ICOs from a corporate perspective, we would like to briefly touch on the regulatory aspects. Anyone initiating an ICO must familiarise themselves with the regulatory requirements. It is necessary to clarify the extent to which the token issued in the ICO is subject to the regulatory requirements of the German Federal Financial Supervisory Authority (BaFin) and which prospectus requirements must be observed. According to the current state of opinion, this in turn depends on the type of token:

  • Currency tokens or payment tokens: These act exclusively as a means of payment. At present, it can be assumed that trading, brokering and advising on the investment will require the permission of BaFin.
  • Security tokens: The buyer receives membership rights or contractual claims to assets. As a result, it can currently be assumed that these tokens are subject to the same regulation as comparable traditional financial instruments, e.g. if the token is classified as a security (in which case a securities prospectus and/or a securities information sheet is required) or as a participation right (in which case an investment prospectus and/or an investment information sheet is required).
  • Utility tokens: These tokens can only be used in the issuer’s network to purchase goods or services. Whether or not they are subject to regulation often depends on the utility token in question. One factor that plays a role here, for example, is the issuer’s expected return on the tokens.

Taxation of ICOs for companies

From a corporate perspective, the tax treatment of ICOs is usually much more complicated than for private individuals. The primary aim of the revenue generated by an ICO is, of course, to benefit the project or company development, rather than going largely to the tax office. This is also possible in principle, but requires well-thought-out planning of the ICO. The following aspects, for example, are relevant here:

  • Choice of law of the issuer
  • Design of the token to be issued with the ICO
  • Tax and regulatory requirements must be given equal consideration (in some cases, these must be weighed against each other to find the financially better solution)

Tax traps when issuing tokens to founders and employees

The free or discounted allocation of tokens to employees or founders can be considered a non-cash benefit and thus subject to payroll tax/possibly also a hidden profit distribution. The timing of the accrual of this benefit is crucial:

  • Time of receipt: According to a letter from the Federal Ministry of Finance (BMF) dated 10 May 2022, the non-cash benefit is regularly received when the tokens are booked into the recipient’s wallet, but at the latest as soon as the tokens are tradable.
  • Valuation of the non-cash benefit: The non-cash benefit is determined based on the final price at the point of issue, reduced by the usual discounts, at the time the claim is granted. A monthly non-cash benefit allowance of €50 (until 31 December 2021: €44) can be taken into account here.

In addition, issuers must take into account the dry income problem: this is where a tax liability arises without the recipient having liquid funds available to pay these taxes. This can particularly be the case if the allocated tokens cannot be sold immediately or if the market value of the tokens fluctuates significantly.

In order to minimise tax disadvantages, companies can, for example, consider vesting models. In this case, vesting plans are developed in which the tokens are transferred over a certain period of time, thus spreading the tax burden over time and alleviating the dry-income problem.

It is advisable to carefully examine the specific tax implications of the token offering and, if necessary, to seek professional advice in order to avoid unexpected tax liabilities.

ICO and sales tax

According to the currently prevailing opinion, sales of cryptocurrencies are only exempt from VAT if they can be used exclusively as a means of payment. However, in the case of an ICO, the tokens issued often have a connection to the respective business model. It is therefore always necessary to check carefully whether and to what extent a VAT exemption applies.

Furthermore, the following points must be taken into account from a VAT perspective in the case of an ICO:

Type of token issued: The VAT treatment depends largely on the type of token:

  • Utility tokens: These tokens grant the holder access to certain services or products of the issuer. The issue of such tokens can be considered as an advance payment for future services and thus subject to VAT.
  • Security tokens: Tokens that have the character of equity or debt capital may be considered securities. Their issue could be exempt from VAT if they fall under the corresponding exemption clauses.

Time of tax accrual: For utility tokens, VAT liability generally arises at the time of issuance of the token, since this constitutes a service provided in return for payment. The subsequent redemption of the token by the investor then successively leads to the reversal of the liability and to revenue recognition.

Determining the place of performance: Determining the place of performance is crucial for the question of which country is liable for the sales tax. For electronically provided services to end users within the EU, the place of performance is the domicile of the recipient of the service. This can lead to the issuer having to register for sales tax in various countries.

Trade tax for ICO

Companies that carry out an ICO may have to pay corporation tax (for limited companies) and trade tax on the capital raised. The legal form of the company and the type of token are decisive factors here.

Taxation of ICOs: assessment and advice on the best possible tax structure

Due to the complexity and potential tax and regulatory risks involved in conducting an ICO, it is advisable to seek tax and legal advice at an early stage. Careful planning and documentation are crucial to avoid tax pitfalls and to properly fulfil tax obligations.

Our tax advisors and lawyers will be happy to assist you with an initial assessment of your planned ICO and the related tax issues.