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SECURITY TOKEN OFFERINGS: EQUITY OR DEBT? HOW FINANCIAL STATEMENTS ARE AFFECTED
Security Token Offerings (STO’s) are the new method of fundraising. STO’s follows a similar structure to ICO’s. 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 STOs, but also to determine the Tax and VAT treatment of STOs 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 STOs, 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’s), 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.
- 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.
- 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
- The issuance of the Security Tokens
- The return of profits to the Investors
- The final redemption of the Security Tokens