What is an Initial Coin Offering?
An ICO (Initial Coin Offering) is an offer to invest in units of a new cryptocurrency or crypto-token in exchange for established cryptocurrencies such as Bitcoin or Ethereum. ICOs have become an increasingly popular method of fundraising for start-ups and companies seeking to fund innovative projects based on blockchain technology.
When a start-up wishes to raise funds through an ICO, it typically prepares a plan setting out the project’s goals and requirements, how much it intends to raise, how many tokens the founders will retain, which currencies are accepted, and how long the campaign will run. Much like an Initial Public Offering (IPO), where investors buy shares in exchange for money, ICO investors buy distributed crypto-tokens in exchange for established virtual currencies or fiat money. If the funds raised fall short of the minimum threshold, the ICO is deemed to have failed and the money is returned to investors.
In short, the issuer company transfers tokens to potential investors in exchange for established cryptocurrencies which, once the threshold is reached, are used to finance the operations for which the ICO was set up.
Tokens
Tokens are, in essence, digital contracts granting rights to the investor. To create a token, the company first writes the basic rules — the amount and value of the tokens and any special conditions. Once created, the platform acts as executor for all future transactions, ensuring the conditions are met. Interested parties may then buy tokens, subject to availability, in exchange for another cryptocurrency or fiat currency. Several types of token exist — including credit tokens, asset tokens, payment tokens and hybrid combinations — but the two most common are:
- Utility tokens: these grant access to the services provided by the project. Investors purchase them for future use on the platform. They confer no ownership or equity in the company or project
- Equity (or stock) tokens: these represent assets such as participation in the company’s earnings or an entitlement to dividends and interest, analogous to shares in a company. Holding equity tokens may even confer voting rights, much like common stock
The Legality of ICOs
No specific legislation yet regulates the framework for ICOs, but this does not mean the market is unregulated. Existing securities and financial market legislation, together with published circulars on the risks involved, may apply. For example, EU legislation provides that an offer of securities with total consideration below EUR 5,000,000 over a twelve-month period carries no obligation to publish a prospectus or seek CySEC permission. ICOs involving security tokens may fall within the scope of this regime.
In Cyprus, the regulator, CySEC, follows the guidelines of the European Securities and Markets Authority (ESMA) and issues public circulars on dealings in virtual currencies. While there is no specific regulatory framework, there is no express prohibition either.
Setting up a Legal Structure in Cyprus
A company must be incorporated in Cyprus to undertake the issue of the tokens. It is advisable to establish the company in a trustworthy and solid jurisdiction such as Cyprus, so as to reflect the competence and seriousness of the ICO and the underlying project. It is common practice to establish a second company to act as an escrow, for transparency purposes, which accepts the funds and releases them once certain conditions are met.
Alternative Investment Fund Structure
According to ESMA, an ICO may qualify as an Alternative Investment Fund with a Limited Number of Investors (AIFLNP) to the extent it is used to raise capital from a number of investors in accordance with its investment policy. CySEC may accept the set-up of an ICO through a Cyprus Alternative Investment Fund, provided the AIFMD rules are followed.
Taxation
As an EU member with a favourable tax system, an extensive double tax treaty network, a well-organised and regulated regime, low set-up costs, a strong financial services infrastructure and well-educated professionals, Cyprus can offer real comfort to prospective investors launching an ICO. There is no specific legislation on the taxation of cryptocurrencies, so the general taxation rules apply, depending on the type of token issued.
For utility tokens, corporate tax of 15% applies and the tokens may fall within the scope of VAT (19%), as they can be defined as a pre-payment for the right to use the company’s goods or services. During the ICO stage, however, utility tokens may not be recognised as an exchange for goods or services where the service is not yet provided; the related revenue can be deferred until the company’s performance obligation is met and the service is actually rendered. Any profits are then taxed at the corporate level at 15%.
For security (equity) tokens, the tokens are considered capital in the company and are not taxed, nor do they fall within the scope of VAT — since, by definition, they have the same effect as shares in a traditional company limited by shares. As shares, interests in companies, debentures and other securities qualify as exempt transactions under the EU VAT Directive, equity tokens should be treated in the same way.
In addition, Cyprus offers a highly attractive Intellectual Property (IP) Box regime, under which the effective corporate tax rate of 15% may be reduced to as low as 3%, provided certain conditions are met.
How ASC Can Help
ASC advises on every stage of an ICO — token classification, company and escrow structuring, Alternative Investment Fund set-up, regulatory compliance with CySEC and ESMA guidance, and tax planning including the IP Box. Legal compliance must be sought before and throughout the launch; contact us to structure a robust and successful offering.