SECURITY TOKEN OFFERINGS: EQUITY OR DEBT?
HOW FINANCIAL STATEMENTS ARE AFFECTED
Security Token Offerings (STO) is the new method of fundraising. STO follow a similar structure to ICO. They involve the sale of crypto tokens which are built on a blockchain and are backed by something of value (i.e. shares, dividends, bonds, other assets or profits from the company), which can be traded, sold, or held by the investors.
Security tokens are digital assets and they are considered to be the securities of the future, providing an attractive alternative to companies seeking fundraising.
This publication aims not only to give suggestions regarding the possible accounting treatment of STO, but also to determine the Tax and VAT treatment of STO from the issuer company’s perspective, using supportive illustrations.
This exercise will be performed from the perspective of a Cyprus tax resident private company limited by shares (LTD), being the STO issuing company, and we will address how the STO is classified and recorded in the accounting records of the issuing company, and how the issuing company will be potentially taxed in terms of both direct taxation (Corporate Tax) and indirect taxation (VAT).
The tax treatment of the investors or token users would largely depend on the tax laws in their country of residence, and it is outside the scope of this publication.
Finally, in the absence of specific guidelines by the Cyprus Tax Authorities on both TAX and VAT implications and of a specific accounting standard on STO, we will express our views based on the basic and fundamental provisions of the Cyprus Tax and VAT Legislations that are currently in force, while having in mind the general provisions of the relevant International Financial Reporting Standards (IFRS), mainly of IAS 32 (Financial Instruments: Presentation) and IFRS9 (Financial Instruments: Recognition and Measurement).
B. CLASSIFICATION OF SECURITY TOKENS (STO) AS FINANCIAL INSTRUMENTS
Up to current date, the International Accounting Standards Board (IASB) has not set any specific accounting standard which focus on the accounting treatment of crypto-assets in general. However, the principles outlined by established accounting standards can be further exploited as a main guidance for the accounting treatment of security tokens. The classification of the tokens will further determine the accounting treatment of the tokens in the accounting records of the issuing company.
The two principal accounting standards that will be further analysed are the IAS 32 (Financial Instruments: Presentation), which outlines the accounting requirements for the presentation of financial instruments, particularly as to the classification of such instruments into financial assets, financial liabilities and equity instruments, and the IFRS 9 (Financial Instruments), which includes requirements for recognition and measurement, impairment and de-recognition of financial instruments.
In order to be able to determine whether security tokens can be classified as financial instruments, we need to examine whether the definition of financial and equity instrument under the IAS 32, applies for a security token.
As per IAS 32, a financial instrument is a contract that gives rise to a financial asset of one entity (holder), and a financial liability or equity instrument of another entity (issuer). Also, according to the standard, an equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.
Security tokens issued during an STO, could be considered as assets that promise rights of ownership, payment of dividends or entitlement to share of future profits. As such, security tokens will create a contractual obligation for the issuing company to deliver cash back to the token holders (investors). Therefore, it can be strongly argued that security tokens can be classified as financial instruments.
C. CLASSIFICATION OF SECURITY TOKENS - DEBT OR EQUITY INSTRUMENTS?
The fundamental principle of IAS 32, is that a financial instrument should be classified either as debt or equity instrument according to the substance of the contract, not its legal form and the definitions of financial liability and equity instrument.
Consequently, each security token’s characteristics have to be carefully and individually examined, in order to be in a position to correctly classify a token.
a. Characteristics of Equity Instruments
As per IAS 32, the issuer of a financial instrument, classifies it as an equity instrument if there is no obligation to deliver cash or another asset to another entity.
However, there is a “fixed for fixed” requirement for the issuer to receive or deliver a fixed number of its own equity instruments in exchange for a fixed amount of cash (or other financial assets).
As mentioned above, an equity instrument is a contract that evidences a residual interest in assets of an entity after deducting all of its liabilities.
Other characteristics/factors that are indicators of an equity instrument are the following:
• The financial instrument is non-redeemable
• There is no expiry date
• Dividends (returns) are discretionary, not mandatory
b. Characteristics of Debt Instruments
As per IAS 32, a financial liability is any liability that is a contractual obligation to deliver cash or another financial asset to another entity; or to exchange financial instruments with another entity under conditions that are potentially unfavourable to the entity; or a contract that will or may be settled in the entity’s own equity instruments and is:
• A non-derivative for which the entity is or may be obliged to deliver a variable number of the entity’s own equity instruments; or
• A derivative that will or may be settled other than by exchange of a fixed amount of cash or another financial asset of a fixed number of the entity’s own equity.
It is important to note that the prominent feature of debt instruments is that the issuer does not have the unconditional right to avoid delivering cash or another financial asset to settle a contractual obligation.
Other factors that may indicate the existence of a debt instrument are the following:
• Any variability in either the number of own equity shares delivered or in the amount of cash/financial assets received
• Limited life to the instrument
• Redemption is at the option of the instrument holder
• Redemption is triggered by a future uncertain event which is beyond the control of both the holder and issuer of the instrument
• Dividends (returns) are non-discretionary but mandatory
Having considered the above principles, it is vital that the characteristics of each STO to be individually assessed (on a case by case basis), in order to properly classify and record the security tokens in the accounting records of the issuer. The classification will essentially depend on the promises made by the issuer to the investors.
In addition, it is worth mentioning that a security token may have both the characteristics of debt and equity instrument, consequently, the classification may prove to be a challenging process. In such case, in our opinion, the characteristics of the tokens should be weighed against that of debt and equity instruments, and the classification should be made accordingly.
Illustration 1 - Asset backed security token offering
X Ltd is an investment property company which receives rental income from a building that hires out. The directors of X Ltd have decided to tokenise the building through the use of the Blockchain Technology, and offer it to the public at a value established from an external valuator.
In the published White Paper, X Ltd states the potential future rental income and the capital appreciation prospect of the building, promising that the investors will receive proportionally to their tokens held, the net rental income at the end of each calendar year, along with any potential profit on disposal of the building, upon occurrence.
Also, upon disposal of the building, the tokens must be redeemed back to X Ltd (since X Ltd will no longer control the property), and X Ltd will use the disposal proceeds to settle the contractual liability created on the issuing of the tokens, and the proportion of any profits.
Having in mind the characteristics described above, X Ltd does not have the unconditional right to avoid delivering cash to settle its contractual obligation. Also, the tokens have a limited life (since the tokens will be discarded on the disposal of the building) and the redemption is at the option of the token holder.
In addition, there is a variability in the amount of cash received by the token holders (as net rental income may differ from time to time).
Taking into consideration the above, one can strongly argue that the characteristics of debt instrument overweight the characteristics of equity instrument, therefore the tokens issued from X Ltd can be classified and treated as debt instruments.
Illustration 2 - Equity security token offering
The directors of Y Ltd have a strong background of real estate and they decided to raise funds through an STO. The funds to be raised will be used for investment property projects.
In their White Paper, Y Ltd states that the security tokens will give ownership rights to the token holders in Y Ltd, rights for taking decisions for the investment property strategy, the utilisation of the STO funds and the reinvestment strategy of the income arising for the investment properties (from rentals and profit from disposals). Also, any dividend distribution to be made to the token holders will be at the discretion of Y Ltd’s directors.
Finally, no option exists for the investors to redeem the STO back to Y Ltd on demand.
Having in mind the characteristics described above, the tokens issued are non-redeemable, they do not have an expiry date, and the dividends are discretionary.
Therefore, one can strongly argue that the characteristics of equity instrument overweight the characteristics of debt instrument, and as such the tokens issued from Y Ltd can be classified and treated as equity instruments in the accounting records of Y Ltd.
The above illustrations highlight the fact that the characteristics of the security tokens have to be carefully examined, in order to properly classify the tokens as debt or equity instruments. Such classification will subsequently determine the accounting treatment of the tokens in the accounting records of the issuing company.
D. ACCOUNTING TREATMENT OF SECURITY TOKENS
Having considered that as per the guidance of IAS 32 securities can be classified as Financial Instruments, IFRS 9 (Financial Instruments: Recognition and Measurement) will be further examined in order to determine the accounting treatment of security tokens in the accounting records of the issuing company.
The accounting treatment can be separated in 3 distinct phases:
• The issuance of the Security Tokens
• The return of profits to the Investors
• The final redemption of the Security Tokens
a. Issuance of Security Tokens
Security Tokens classified as Equity Instruments
According to the guidance given by IFRS 9, on the initial recognition of financial instruments, the instruments are measured at fair value. The fair value at initial recognition is normally the transaction price. Therefore, the amount of funds raised from the investors during the STO represents the initial fair value.
Since the tokens are classified as equity instruments, the issuing company needs to recognize the tokens in the equity and reserves of the issuing company.
As far as the subsequent measurement is concerned, the tokens will not be revalued at each year end, being classified as equity instrument.
Security Tokens classified as Debt Instruments
According to the guidance given by IFRS 9, on the initial recognition of financial instruments, an entity recognises a financial liability in its statement of financial position, when a contractual obligation arises. The initial recognition will be at fair value, which represent the funds raised from the investors.
Regarding the subsequent measurement, according to the standard, financial liabilities can be measured at either:
• Amortised cost using the effective interest method or
• Fair Value through profit or loss
It is worth noting that the choice of the appropriate measurement method will depend on the specific characteristics and promises stated during the issue of the tokens and the published white paper.
In the case that the token will be redeemed back at its original value, and the tokens will generate a fixed return to the investors, then the Amortised Cost method would be the most appropriate method.
In the absence of the above characteristics, the Fair Value method (i.e. the expecting value of the obligation to be settled) may be the most appropriate method for subsequent measurement. Any unrealised increase/decrease of the fair value of the liability, will be recorded under other comprehensive income of the issuing company.
b. Return of profits to the Investors
Security Tokens classified as Equity Instruments
As mentioned above, the directors of the issuing company discretionally may proceed with distribution of earnings to the security token holders. Such distributions are recognised directly in equity in the form of dividends.
Security Tokens classified as Debt Instruments
Generally, security tokens that are classified as debt instruments, become repayable upon the redemption of the tokens back to the issuer. Therefore, any returns made to security tokens holders, which are not considered as repayment of liability and arise from the redemption of the security tokens, are to be considered as finance cost for the issuing company.
c. Final redemption of Security Tokens
Security Tokens classified as Equity Instruments
One of the main characteristics of equity instruments, is that such instruments are non-redeemable and have no expiry date. However, redemption of equity instruments may exist upon the issuing company’s discretion, especially if the issuing company cease its operations or terminates the project.
In such cases, limited liability companies usually undergo liquidation, where all assets are liquidated, and the creditors are settled. If any surplus of proceeds remains, the shareholders of the company will receive the residual return.
Security Tokens classified as Debt Instruments
A financial liability is derecognised when it is extinguished, meaning when the obligations specified in the contract is either discharged, cancelled or expired.
One of the main characteristics of a debt instrument is that it has a limited life which is predetermined upon the issuance of the debt instrument.
Therefore, upon the redemption of the security tokens, the issuing company will have the obligation to settle liability generated on the issuance of the tokens and depending on the White Paper’s promises, the final redemption may be in either a fixed or a variable price (for example the market value of the Token). The token holders will have a priority on the redemption.
E. TAX AND VAT IMPLICATIONS ON THE INITIAL ISSUANCE OF SECURITY TOKENS IN CYPRUS
a. Corporation Tax implications
As analysed above, on the initial issuance of the security tokens, there will be no accounting effect in the income statement of the company, in the form of revenue, but the equity or liabilities of the company, depending on the classification of the tokens, will be affected. As such, the issuance of the tokens itself might not trigger any taxable event for corporation tax purposes.
Equity tokens are considered to have the same characteristics as the share capital of a company, something that seems not to be applicable in tokens having similar characteristics with debentures (i.e. debt tokens).
One could also claim that in case the issued Equity Security tokens have similar characteristics with the share capital of a company, once regulated, they might also be eligible for Notional Interest Deduction (NID) on the new capital introduced into the company.
For more details as to Notional Interest Deduction (NID) applicability please refer to our relevant brochure issued by our Tax department which can be downloaded here.
Debt Security tokens
If the issuance refers to debt security tokens, equivalent of loans that carry an interest rate on the principal amount loaned to the company, such issuance would normally be reflected in the liabilities of the issuing company, generating no taxable income for the company.
If the proceeds generated from a debt security token are used in the production of taxable income for the issuing company perspective, then any interest element associated with this taxable income should be considered as an allowable expense for tax purposes reducing thus the taxable base of the company.
b. VAT implications
The VAT treatment of security tokens on the initial issuance, will depend on the return that such tokens promise.
If the tokens give rise to dividends (if classified as equity instruments), or interest payments (if classified as debt instruments), what is needed to be examined is whether such payments fall within the scope of the exemption under Articles 135(1)(b) and (f) of the EU VAT Directive 2006/112/EC.
The above articles specifically exempt:
• the granting and the negotiation of credit and the management of credit by the person granting it, and
• transactions (including negotiation but not management or safekeeping) in
ii. interests in companies,
iii. debentures and other securities,
Based on the above, one could argue that security tokens will most probably qualify as an exempt transaction for VAT purposes on the initial issuance, and would therefore not create any VAT liability for the issuing company.
Up to current date, there is no a formally accepted framework regarding the classification, accounting treatment and disclosures of transactions involved during an STO.
However, with reference to the currently established accounting standards, the token characteristics can be used to classify tokens (as equity or debt instruments) and according to their classification, tokens can be accounted for under the guidance given by the standards.
In the absence of established accounting standards, the accounting treatment of tokens can be proved significantly judgemental. Therefore, the in-depth understanding of the characteristics of each STO on a case by case basis, is crucial in order to determine the most appropriate accounting treatment, which should be tailored for each individual case.
In addition, entities should make sure that adequate disclosures are included in their financial statements, clarifying and supporting the basis on which the STO related transactions were accounted for.
In conclusion, the evolving nature of the crypto tokens along with the lack of guidance, can make the presentation of the financial information challenging. The outstanding benefits however, that STO can offer in contrast to the traditional financial instruments, and the immense evolution of BLOCKCHAIN technology in general, will most definitely put, if not already, at the top of the agenda of the IASB (International Accounting Standard Board) standard-setting activities and hence adding clarity as to the proper accounting treatment, presentation and disclosures.
Once the above guidance will be established, inevitably investors will further count on STO as being the next generation financial instrument and an attractive investment addition to their portfolio.
Authors – Contact Persons
CHRISTOS P. KINANIS
Lawyer – Managing Partner
Partner – Accounting & VAT Department
Senior Associate – Accounting & VAT Department
Associate – Accounting & VAT Department
This publication has been prepared as a general guide and for information purposes only. It is not a substitution for professional advice. One must not rely on it without receiving independent advice based on the particular facts of his/her own case. No responsibility can be accepted by the authors or the publishers for any loss occasioned by acting or refraining from acting on the basis of this publication.
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