How Security Tokens are Treated for Tax Purposes
One of the latest concepts in financial markets is to allow investors easy access to multiple asset classes by digitizing these financial securities. A great example of this idea is the merger of Entoro Capital with New Alchemy. The newly formed conglomerate gathers blockchain expertise from Alchemy with a broker-dealer platform at Entoro. The resultant entity allows trade of financial securities in the form of online tokens.
As new laws are being introduced by SEC to monitor and regulate the digital currency market, policymakers are putting a lot of emphasis on how they can generate taxable income from digital tokens. Financial securities like debts and common stocks if converted into virtual tokens can be treated as inventory for tax purposes. However, this is not easy for the regulators as well, since each digital token which is backed by a securitized asset needs an independent to determine its actual worth in the market. While the concept of taxable security tokens is relatively, it would not be long when lawmakers start tapping into corporate giants who wish to increase their share value through digital trade.
What is a securitized asset?
If an organization wants to raise funds for its operations through the general public, it can offer interested individuals’ certain number of shares in the corporation. These share certificates are generally termed as securitized assets. While this is a simple example of asset securitization, the process is not always that simple. Since illiquid assets usually back securities, it is essential for money makers to develop effective strategies, so that value for a security does not go down with a change in market trend.
Consider for instance the mortgage crisis of 2008. During that time, lenders were offering mortgage loans to many types of applications. This resulted in home loans being disbursed into the sub-prime market as well. Financial institutions bundled together their home loans into mortgage-backed security to protect their interests, which was offered to the general public. As sub-prime borrowers started to default, the MBS or Mortgage Backed Security started to lose its value and people started to sell it at a rapid pace. With the housing industry losing at both ends of the string, the result was a severe market crash of 2008.
How security tokens are taxed?
By treating security tokens as items that can generate profit for their owners, lawmakers can apply tax laws on them. Again, the concept of taxing security tokens is not that simple. There are two major steps involved in treating security tokens for tax purposes. An explanation of both these steps is given below:
Identifying the inventory behind the token
Like any other certificate that has value, financial securities do have a certain amount of value based on the ‘it’ or the material they are being backed by. Many decades ago, it was easy to categorize securities into either common or preferred stock or interest-bearing bonds. With time, financial securities have become much more sophisticated, and lawmakers require a lot of hard work to generate taxable income from them.
Adding another layer of the digital token to these securities raises the complexity level as well. To help you understand how each digital token’s worth is different from the other, consider a paper rim producer who charges $100 for a single bundle. To file income tax, all they need to do is calculate total revenue and apply a tax percentage to it. On the other hand, when shareholders are offered corporate stocks or treasury bonds, the income generated from each of these certificates cannot be determined until the ‘it’ or the entity that is backing that certificate is analyzed. Based on the taxable income of the organization, the tokens can be treated for tax purposes as well.
Types of securities that can be converted into digital tokens
Three forms of corporate assets that can be converted into digital tokens. These include
- Interest yielding debt or bonds
- Common Stocks
- Shared ownership contracts
Since taxable income depends on which category the underlying digital token falls in, the next step is to identify if security is debt, equity or shared ownership. SEC has general rules for categorizing if an underlying asset is a debt or equity, but due to the complex nature of financial markets today, it is not that easy to separate equity from debt. Here are some guidelines on how each of these instruments is different from each other:
– Debt is usually offered as a loan and creditors cannot claim anything else but their principal and accumulated interest. Equity holders, on the other hand, can have a say in company operations as they have a certain percentage of stake in the company. This allows them to receive dividends and voting rights as well.
– Cost of capital is not fixed in equity while for creditors, the cost of capital is usually fixed.
– When you have equity certificates of a corporation you are not liable to be paid dividends when the organization has incurred a loss. Creditors, on the other hand, get their loan amount paid whether a company generates profit or not. Besides that, creditors always have the preference over shareholders which it comes to repayment.
Additional aspects to consider while differentiating debt and equity
- What title was given when allocating rights to the certificate.
- Whether the maturity date of a financial instrument is fixed or not.
- What was the intent of parties involved when issuing the certificate?
- Is there any amount of adequate or thin capitalization?
What is shared ownership?
While digital tokens backed by debt and equity can be easily treated for tax purposes, regulators face a problem when two or more parties share the ownership of a particular asset. Consider an author who wrote a best-selling novel. Now, this author wants to give a publisher the rights to publish this book. Since the author did not share the ownership of the book, the policymakers can easily generate income tax from both parties. But what happens when the book writer wants to sell their copyright to a couple of other parties? Each party involved in this type of trade will have to bear the loss if readers do not like the book.
Tax law suggests that if parties join forces to carry out a trade and are willing to share the risks and rewards that come with it, then this is called tax partnership. Security tokens issued against tax partnerships are treated differently than simpler assets like debt and equity.
How do lawmakers deal with security tokens backed by shared ownership?
When the holder of an asset like a best-selling novel distributes its rights to multiple publishers, in this scenario, the profits may be distributed among indirect owners as well. Hence, security tokens assigned to these shared assets are collectively paid by all stakeholders.
Future of Security Tokens
For corporations and individuals to maximize the use of security tokens, engineers will have to strengthen the Blockchain infrastructure further. This will allow owners to easily trade these digital coins online and associate many different types of financial securities with these tokens.
Sources suggest that security tokens are still a nascent name in the financial markets. The transaction network of digital tokens will have to be strengthened before the majority of corporate investors start putting their money in this financial instrument. Besides that, people are still confused as to how Security Tokens will fair against utility tokens. Utility tokens were introduced so that potential investors could be attracted to newly introduced digital currencies. A significant benefit of utility token was and still is that they can generate value for investors if they gain popularity in the market.
Security tokens, on the other hand, are considered as a digital wrapping on traditional financial instruments. Hence, how an investor will be able to generate income from a security token on a digital exchange still need to be seen. Some researchers suggest that issuance of security tokens can be done in two phases. There could be a primary digital token which gives ownership of the underlying asset to investor and then there could be a secondary digital token which can easily be traded on digital currency exchange. This will not only help in strengthening the security token infrastructure but will also provide an incentive to potential investors for purchasing these tokens.
The key to generating a high level of taxable income through security tokens depends on how well SEC and other compliance bodies regulate them. If security tokens can be easily classified into their respective asset classes, lawmakers and tax officers can define effective strategies to treat them for tax purposes. Security token investors should also take advise from tax experts before investing in this asset class so that they know all the tax nuances associated with these tokens.