Tax and Regulatory Dilemmas: A Guide for Crypto Companies Eyeing Relocation
Relocating a cryptocurrency or digital asset company from the United States is a complex endeavor that demands a comprehensive assessment of numerous factors, spanning tax implications, regulatory constraints, and operational challenges.
My friend Charles Kolstad wrote the definitive piece on this. In recent times, these considerations have gained increasing prominence as crypto businesses face heightened scrutiny and regulation worldwide, prompting some to explore more favorable jurisdictions for their operations. This article delves into the pivotal considerations for crypto firms contemplating an exodus from the United States, outlining the challenges and alternatives available.
One of the fundamental issues that crypto companies must grapple with when contemplating a departure from the US is how to structure their international presence. Typically, there are two primary approaches: retaining a US holding company while establishing one or more subsidiaries outside the US, or a complete exit strategy where the company sets up a non-US holding company and terminates all US operations. Each approach has its unique set of challenges and tax implications that require careful evaluation.
For crypto companies choosing the first option, where a US holding company coexists with foreign subsidiaries, the transfer of valuable intangible assets to these subsidiaries can trigger significant federal and state tax implications. These intangibles often include computer software, algorithms, trademarks, goodwill, customer lists, and similar assets. The Internal Revenue Service (IRS) classifies these assets as "intangibles," and their transfer necessitates careful consideration.
The transfer of intangible assets to foreign subsidiaries typically occurs through three methods: a license in exchange for royalty payments, a sale for a fixed or variable amount, or as a capital contribution. However, the process is not straightforward. According to Section 482 of the Internal Revenue Code, such transfers must be executed on an arm's length basis. This means that the US company must undertake these transfers as if they were unrelated parties, adhering to market rates and fair value assessments. As a result, the transferring US company may need to recognize taxable income, especially in the case of licenses or sales. To mitigate this tax burden, some US crypto companies may leverage their net operating losses to offset taxable income, but this still leaves the challenge of sourcing the cash to cover the tax liability. This is particularly concerning in times of market downturns, such as the crypto winter, when the value of crypto assets may be significantly reduced.
Another tax concern in this scenario is related to the contribution of intangibles in exchange for stock or equity in foreign subsidiaries. This transaction triggers taxable income recognition under Section 367, as it imputes a royalty from the transferee company back to the transferring US company, with the royalty being "commensurate with income." This poses additional tax complexities and considerations.
Furthermore, the location of senior management plays a crucial role in determining the tax implications of foreign subsidiaries. If senior management remains in the US and maintains involvement in the operations of these subsidiaries, there is a risk that foreign subsidiaries could become subject to US corporate income tax on a portion of their income attributable to the US. However, structuring foreign subsidiaries with their own front and back-office personnel, thereby reducing reliance on US-based management, can help mitigate this concern. Yet, if a substantial portion of back-office functions remains in the US, the IRS could argue that the foreign subsidiaries have a "US trade or business," which could trigger taxation.
In situations where foreign subsidiaries are needed to be financed, a significant choice arises: loans from the US parent company or equity investments. Each option has its tax and financial implications that need careful consideration. It is vital to weigh the benefits and drawbacks of each financing method in the context of the company's specific financial situation and long-term objectives.
The second option, which involves a complete exit from the US and the establishment of a non-US holding company, presents even more intricate tax challenges. Under this approach, shareholders of the US company would exchange their shares for shares in a foreign holding company. While this may seem straightforward from a corporate law perspective, it encounters substantial tax hurdles. Notably, the US Congress enacted anti-inversion provisions under Section 7874 to address transactions of this nature.
The crux of the issue lies in determining whether the conversion of the US company qualifies as an inversion. If it does, Section 7874 deems the new foreign company as a US company for all tax purposes, introducing the likelihood of double taxation – both US corporate tax and foreign tax (unless the subsidiary is located in a pure tax haven). This dual taxation scenario is further complicated if the foreign jurisdiction imposes a dividend withholding tax. US shareholders may find themselves subject to foreign withholding taxes and US income taxes on the dividend, with no avenue to claim a foreign tax credit for the withholding taxes. The same predicament applies to non-US shareholders, as they may also face US dividend withholding taxes and foreign income taxes, with no recourse to offset the US withholding taxes.
These complex tax considerations necessitate meticulous planning and a clear understanding of the tax implications of each option. Engaging tax experts and legal counsel with expertise in international tax law is imperative for crypto companies looking to navigate these challenges effectively.
In addition to tax considerations, regulatory hurdles pose substantial challenges for crypto companies contemplating an exit from the US. The US Securities and Exchange Commission (SEC) has been increasingly active in regulating the cryptocurrency space, taking legal action against both US-based and foreign-based exchanges and token issuers. These actions have raised concerns among crypto companies about the potential extraterritorial reach of US securities laws.
For instance, the SEC's lawsuit against Bittrex, a crypto exchange not based in the US, highlighted the agency's willingness to pursue enforcement actions even against entities operating primarily outside US jurisdiction but with US customer involvement. The SEC alleged violations of US securities laws, asserting that Bittrex allowed US-based individuals to trade crypto assets on its platform. This case underscores the risk that, even if a crypto company sets up operations outside the US, the SEC may assert that the US parent company continues to violate US securities laws by operating unregulated securities exchanges or issuing unregistered securities.
The Commodity Futures Trading Commission (CFTC) may adopt a similar stance regarding its regulatory jurisdiction over crypto derivatives and other financial products. This evolving regulatory landscape raises uncertainty about the feasibility of discussions and negotiations with regulatory bodies to reach mutually agreeable solutions, as might have been the case in the past.
Notably, the SEC has also pursued legal action against two of the most prominent cryptocurrency exchanges, Binance and Coinbase. The lawsuit against Coinbase alleges that it operates as an unregistered securities exchange and seeks to halt its operations. In both lawsuits, the SEC reiterated its position that most tokens, excluding Bitcoin and Ethereum, should be classified as securities under the Howey test, making them subject to registration requirements. These actions signal the SEC's unwavering commitment to regulating the crypto industry more rigorously.
Another pressing concern for crypto companies planning to maintain their US headquarters is the accessibility of US-based bank accounts. Initiatives like "Operation Chokepoint 2.0," which aims to crack down on high-risk industries and businesses, may jeopardize the ability of crypto companies to maintain essential banking services in the US. Without access to US-based bank accounts, companies may encounter difficulties in conducting routine financial operations, including making payroll, withholding taxes, and paying rent. This could significantly disrupt business operations and create additional challenges for those wishing to remain headquartered in the US.
The decision for crypto and digital assets companies to leave the US is a multifaceted one that requires meticulous consideration of tax implications, regulatory constraints, and operational challenges. The choice between maintaining a US holding company with foreign subsidiaries or executing a complete exit strategy demands careful evaluation and a world-class lawyer, like Charles!