ICOs: Why Regulators Worry About and Investors Can’t Get Enough

Table of Links

Abstract and 1. Introduction

1. Bitcoin and the Blockchain

   2.1 The Origins

   2.2 Bitcoin in a nutshell

   2.3 Basic Concepts

2. Crypto Exchanges

3. Source of Value of crypto assets and Bootstrapping

4. Initial Coin Offerings

5. Airdrops

6. Ethereum

   7.1 Proof-of-Stake based consensus in Ethereum

   7.2 Smart Contracts

   7.3 Tokens

   7.4 Non-Fungible Tokens

7. Decentralized Finance and 8.1 MakerDAO

   8.2 Uniswap

   8.3 Taxable events in DeFi ecosystem

   8.4 Maximal Extractable Value (MEV) on Ethereum

8. Decentralized Autonomous Organizations - DAOs

   9.1 Legal Entity Status of DAOs

   9.2 Taxation issues of DAOs

9. International Cooperation and Exchange of Information

   10.1 FATF Standards on VAs and VASPs

   10.2 Crypto-Asset Reporting Framework

   10.3 Need for Global Public Digital Infrastructure

   10.4 The Challenge of Anonymity Enhancing Crypto Assets

10. Conclusion and References

5. Initial Coin Offerings

Many blockchain developers undertake projects to launch their own blockchain or another token on top of an existing blockchain like Ethereum. This is somewhat like a start-up launching its product. For this purpose, developers need funds for development as well as a user base for the token or blockchain who participate in the network and contribute in terms of nodes, value in tokens and transactions over the blockchain. Thus, many developers come out with initial coin offering and sell/promise to sell the new tokens/crypto assets to investors at a price, just like in the IPO of a company, to raise capital for the project. To enable investors/buyers to understand the proposed token/blockchain the developers usually come out with a whitepaper which contains:

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• The long terms goals of the developers for the token/blockchain

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• The detailed architecture and code of the token/blockchain

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• Plan for marketing and advertisement

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• The USP of the token/blockchain

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• Details like developer fee, the initial distribution of assets and rights and permissions on the blockchain/token for user and developers

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• Details of reward and incentive mechanism in mining and transactions, if any

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This makes the participants and investors stakeholders in the success of the project and spreads the risk involved in launching a new token/blockchain. However, ICOs are not regulated in many jurisdictions or their regulation is not clear. This results in investors not having rights and safeguards similar to the equity markets. As many crypto assets are very similar to securities in nature there is a possibility of intervention of securities regulators which aim at enforcing investor protection measures imilar to securities markets. There are numerous examples of various successful ICOs. Ethereum was funded through an ICO in 2014 where buyers exchanged Bitcoin for Ether. In the Ethereum ICO some amount was set aside for the developers and the Ethereum Foundation. Nowadays Ethereum through its smart contract execution enables the creation of new tokens and platforms which are interoperable on the Ethereum Blockchain.

\ ICOs are important taxable events as the fair market value of new crypto assets at the time of their acquisition would be the basis for calculating the capital gains on the ‘disposal’ of such assets in lieu of fiat currency or another crypto asset (subject to domestic tax laws). Also, as most crypto assets are highly centralized in the initial phases and its only after the crypto asset gains some traction that their control is transferred to a completely decentralized organization, such crypto assets may be classified as securities and subject to taxes due on securities and regulations of the securities regulator.

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6. Airdrops

Another method used by developers of new tokens or blockchains is to give out crypto tokens for free to incentivise its usage and enhance market presence and exposure. These free tokens are known as airdrops. They are also a kind of reward for the early adopters of the new crypto asset. For example, Uniswap, a decentralized exchange gave 400 Uniswap token to all the Ethereum accounts that had interacted with its smart contract prior to September 1, 2020. This was aimed at rewarding users for using the Uniswap exchange and make them stakeholders in the success of Uniswap.

\ To receive airdrops users are required to perform actions like using the platform or service, signing up for newsletters and mailing lists, hold tokens for a specified period, contribute to the development of the project etc. Non-Fungible Tokens or NFTs can also be airdropped for using an NFT platform or buying/selling NFTs.

\ Airdrops are also important taxable events and in most jurisdictions an income tax is chargeable upon the receipt of an airdrop. The receipt of an airdrop is not taxed but is considered acquisition of a crypto asset with zero basis in some jurisdictions. Also, the subsequent sale, swap, spend or gift transactions are also subject to capital gains. In some jurisdictions, depending upon the domestic tax laws and guidance, gifts might not be taxed.

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:::info Author:

(1) Arindam Misra.

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:::info This paper is available on arxiv under CC BY 4.0 DEED license.

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