Crypto Equity Crowdfunding : magic Internet equity, app-coins, or both?

The last week of October saw the crypto-currency community seized by the dread of government crackdown as rumours spread that the US Securities and Exchange Commission (“SEC”) had turned their attention to the crypto 2.0 world. The panic was, unsurprisingly, premature. The purported SEC letters received by various crypto-currency and crypto-equity businesses merely sought further information about the business operations, fundraising activities and finances of the recipient companies. It was alleged but not confirmed and in fact later denied, that certain bitcoin based companies have been targeted by the SEC for the offering of unregistered securities. This surely won’t be the last time crypto 2.0, digital assets, and securities law appear together on the news-cycle. Questions related to new types of digital finance and securities law will surely only grow with the success and expansion of second generation services which have origins in digital currency, such as Bitcoin.

Though difficult to qualify, “crypto 2.0” generally means second generation cryptography based services that build software layers on top of existing financial systems including bitcoin and traditional fiat currency. Crypto 2.0 services include the creation of and trade in complex financial products that enable a range of different types of investment. Some crypto 2.0 services, such as Ripple, offer real time asset exchanges. Others, such as Mastercoin, allow users to trade just about anything of value online peer to peer. Another crypto 2.0 player generating a lot of buzz is Bitshares X, a distributed database and ledger that also provides for the trading of different digital math-based assets.

Most of these new financial services are built on top of ‘DAC’s. DAC stands for distributed (or decentralized) autonomous corporation. A very simplified definition of a DAC is that it is a protocol, software and network that can perform any number of functions, depending on how it is programmed. Activity on a DAC can be directed in a number of ways. For example, BitShares X is a family of distributed autonomous corporations. It describes its DAC as “as an exchange where currencies, commodities, and stock derivatives can be traded with most of the features used by professional traders including shorts and options. The bank takes a cut on every transaction and pays these transaction fees to the delegates and then shareholders…”. Shareholders are holders of BitSharesX, a digital coin or asset that can also be traded and whose value is related to the success of the BitSharesX exchange. All the transactions that go through BitSharesX charge a fee. This fee is paid to the “delegates” who support the network and verify transactions. They maintain servers, process transactions, and take a charge via the network fees. Other fees may be distributed back to holders of BitSharesX. Some compare it to owning shares in a stock exchange company, such as the Nasdaq. One key difference, however, is that Nasdaq is a legal entity, a corporation with a governance structure. BitSharesX has its own ‘governance structure’, but these “corporate by-laws” exist as a software protocol. Shares in BitSharesX are not shares in a legal entity incorporated under a statute. While these assets may not be stock in a corporation, they may, according to their characteristics, be considered an investment contract. This means that BitSharesX units may be considered securities.

Activity on a DAC can be directed in a number of ways. One such was is through the appcoins issued by the DAC. Appcoins are the tokens that users need to interact with the DAC. These tokens trade on exchanges such as BitShares, a crypto asset exchange affiliated with but distinct from BitSharesX. Other types of assets that trade on BitShares are BitUSD, BitEUR, and BitCAD – all crypto assets whose unit value is meant to track the US dollar, the Euro, and the Canadian dollar. These are stand alone assets and not based on DACs.

Applications of second-generation cryptography services that are getting the most traction are those used for financing and for asset trading. Seedcoin, for example, invests in bitcoin related start-ups through a bitcoin denominated fund. People purchase equity in ventures by sending bitcoin and can view un-registered prospectuses online. There is also Cryptostocks, a crowdfunding platform that allows users to invest in a wide range of products. Swarm is another decentralized crowdfunding start-up.

The first legal question that comes to mind is whether crypto crowdfunding involves the selling of equity, and would thus qualify as equity crowdfunding. While crowdfunding online has become a popular way to raise money for individual projects, securities regulators have not yet allowed companies to raise money by selling equity using the crowdfunding model. This is changing, slowly. Many provincial regulators, such as Saskatchewan, have put out calls for public commentary on proposed rules that would allow for equity to be sold through crowdfunding, provided certain conditions are met. One of the major questions flowing from crypto equity crowdfunding projects and DAC related fundraisers that raise money (or Bitcoin) by selling other appcoins is whether this constitutes selling equity. Alternatively, one can also speculate that these activities resemble more closely the type of crowdfunding used today on kick-starter – whereby people send money to pre-purchase a product. In this case, the product is an appcoin or token that that allows the purchaser to interact with a software program and trade for other appcoins. Some cases are clearer than others as to whether the type of asset being bought represents equity in a venture and would thus be subject the securities laws. In such a case these crypto-equities may be able to operate through crowdfunding exemptions that will eventually be implemented.

Without doubt the crypto-equity sector of the growing financial tech (fintech) industry will draw the scrutiny of securities regulators who are mandated to protect the investing public. At face value, many of the crypto 2.0 businesses appear to be involved in soliciting investments from the general public. Less certain though, is how securities law will apply to these novel virtual assets whose underlying characteristics are varied and difficult to define. Even more confusing is the fact that virtual assets are referred to by those using them with the same vocabulary as financial products traditionally treated as securities and governed by the relevant legislation. This, despite that fact that it is far from certain which types of digital assets would qualify as such. If there’s anything is be sure about it’s that this rapidly innovating technology isn’t slowing down anytime soon.

At last – some clarity from the CRA on Bitcoin mining

If you are mining bitcoins or alt-coins or have been considering getting involved with mining, it is important to be aware of the tax implications. The Canada Revenue Agency (“CRA”) has let it be known in a technical interpretation that mined digital currency, unsurprisingly, is not immune from tax treatment.

For tax purposes, a key consideration to be made is whether your mining consists of a personal or a business activity. If the activity is considered a business activity the mined bitcoins may be considered inventory or capital property and taxed accordingly. If it is a business activity then expenses and certain losses associated with the mining operation can also be deducted. We know from previous CRA bulletins, that payments received in respect of, or in connection with, a business carried on by the taxpayer, must be included in the taxpayer’s income from that business. Bitcoins rewarded to miners for supporting the network and verifying transactions, where the mining activities are considered business activity, must be calculated as income.

Whether your mining operation is a business or personal activity is determined on a case-by-case basis. However, there are some key elements that can facilitate making the distinction. A personal activity is endeavored to provide a personal benefit rather than a financial one; it is primarily undertaken for pleasure, entertainment, or enjoyment rather than for profit, business, or commercial reasons. Drawing on the Supreme Court’s decision Stewart v. Canada, the CRA explains that “In order for an activity to be classified as commercial in nature, the taxpayer must have the subjective intention to profit and there must be evidence of businesslike behavior which supports that intention”. Even a personal hobby can be considered a business activity if it is pursued in a sufficiently commercial and businesslike way – and consequently would be considered income under the Income Tax Act. For example, you may be a bitcoin enthusiast and for fun in your spare time, decide take a bunch of old computers you have lying around and set them up to start mining bitcoins or dogecoins. Is this a personal or business activity?
The determination of whether an activity is undertaken for profit is based on facts and determined case-by-case. In light of this understanding, it is very possible that your mining operation is a business activity and you just don’t know it.

For some, mining is merely a hobby activity and for others it represents a major commercial undertaking in which significant sums have been invested with the expectation of very high returns. Not all mining activity will be subject to this test –large-scale mining operations that involve multiple stakeholders and external financing are clearly business activities. Only where there is a personal and hobby element involved might bitcoins or altcoins generated through mining activity not be considered business income. An activity that has been financed externally is an indication that an activity is being operated in a business like manner (Stewart v. Canada par. 59). A reasonable expectation of profit is another one of several factors taken into account in making the determination. Other factors that may be considered include, without limitation, the taxpayer’s training, the taxpayer’s intended course of action, and the capability of the venture to show a profit.

If the activity is a business activity then the bitcoins may be evaluated as inventory. It will be necessary to determine the value of the taxpayer’s inventory for the purposes of computing a taxpayer’s income from business. There are specific rules pertaining the valuation of inventory. Different methods exist for valuing inventory and which one is used can be relevant.

The CRA also indirectly references the consequences of loss of bitcoins from theft when they are acquired in the context of business activities. A loss of trading assets, such as inventory, which would include mined bitcoins, or cash, through theft, defalcation or embezzlement is normally deductible in computing income from a business if such losses are an inherent risk of carrying on the business and the loss is reasonably incidental to the normal income-earning activities of the business (see IT-185R). One wonder’s whether mined bitcoins that were lost in connection to Mt. Gox would be considered “reasonably incidental” to the activities of the business.

Exchanges operating entirely in digital currency fall within reach of the taxation rules – says the CRA. The purchasing of one digital asset with another, through an exchange would be treated as a barter transaction and the value of the goods must be brought into the taxpayer’s income if they are business related. The value received from such an exchange might also result in a capital gain.

While this post aims to provide some clarity with respect to your tax obligations the greatest comfort can come from your bitcoin legal expert. Note that the technical interpretation provides general comments and is intended only to assist in making determination. For greater clarity –consult your bitcoin legal professional. Note that the technical interpretation does not confirm the income tax treatment of a particular situation, it is aimed to assist taxpayers engaging in activities related to the creation of, or trading of, digital currency.