Introduction: What is Tokenization?
Tokenization is the process of converting an asset into a token on the blockchain. It operates by dividing—or fractionalizing—the ownership of an asset (whether the asset is a piece of real estate or entire property, a building, artwork, and so on) into digital tokens. These tokens are then offered to investors in an Initial Coin Offering (ICO) or Security Token Offering (STO). Investors can purchase a token—or ownership share—in the digital asset. The funds are typically used to support regular business activities or expansion plans of the business. That said, the overall tokenization process is intricate and can involve many regulatory issues and reporting obligations. This article, drafted by the blockchain attorneys at Oberheiden, P.C., outlines how an attorney can help you with your tokenization project.
5 Reasons You May Need a Tokenization Lawyer
Tokenization projects involve multiple regulatory regimes such as the federal securities laws, money transmitting laws under the Bank Secret Act (“BSA”), and tax reporting issues, as some examples. We list and explain five reasons why individuals may need a lawyer for their tokenization project.
1. Tokenization projects—regardless of the asset to be tokenized—are a complicated and multi-step process that often demands the experience of a tokenization attorney.
A successful tokenization project involves multiple steps. At every step, you have to assess whether you have compliance obligations under federal law. For instance, at the outset, designing your token will directly impact whether you will have to register your token as a “security.” You will also need to design your token with your business’s particular goals in mind. This includes issue price, intended purpose, function, transferability, and so on. Other factors that directly impact the token and success of your business include marketing efforts, terms of issuance, target audience, and auditing. Additionally, if your business needs specialized contracts such as smart contracts, an attorney can draft legal services agreements. Therefore, an attorney is a critical component of your tokenization project.
2. Your tokenization project may implicate the SEC registration provisions and require that your tokens be registered or exempted.
Tokenized projects are often introduced to the public via STOs or security token offerings. Many of these security tokens in STOs satisfy the Securities and Exchange Commission (SEC) definition of “security.” The SEC and courts use a test called the Howey Test (from a Supreme Court opinion) to determine if a particular token needs to be registered as an “investment contract.” This Test has four elements: (1) investment of money; (2) in a common enterprise; (3) with the expectation of projects; and (4) derived solely from the efforts of others. All these four factors must be satisfied for the company to be under an obligation to register their tokens or proceed with an applicable exemption.
Tokens that do not satisfy this test are called “utility” tokens. Utility tokens do not need to be registered with the Commission because they are not securities—they are instead utility tokens that entail consumptive purposes for closed ecosystem projects. If the token does not involve a “security,” then the offering is simply called an ICO, or an initial coin offering.
3. A tokenization attorney can help you determine if you have any additional registration, reporting, and disclosure compliance obligations under federal law.
If your token is determined to be a “security,” your company must register them or follow an applicable exemption to registration. But that is certainly not the end of the story. Once you are dealing with “security,” there are various other obligations to be aware of. For instance, your business will have to follow the reporting and disclosure requirements of the Exchange Act of 1934. Also, if your business uses a special online platform to facilitate the trades of the token, the platform may have to register as an exchange. Further, if your business involves individuals who are giving out investment advice or helping facilitate the trades, they may need to register to do business as an investment adviser or broker-dealer.
Another important consideration involves those under the BSA. The BSA and FinCEN rules require certain businesses to register as money transmitters, have compliance programs with anti-money laundering (AML) components in place, and maintain strong KYC policies and procedures. Your attorney will help you assess these obligations.
4. Issuing new tokens as a part of your tokenization project may also create tax reporting implications.
As can be imagined, conducting an STO will impact your tax filing obligations. In 2014, the internal revenue service (IRS) released Notice 2014-21, which articulated the IRS´s position on basic concepts regarding cryptocurrencies, or “virtual currency.” For instance, it held that virtual currency transactions are to be treated as property for federal income tax purposes. Crypto transactions can lead to either ordinary or capital income. Income from your STO produces ordinary income, which is taxable at one´s ordinary tax rates.
There may also be a second tax event with STOs. The second tax event occurs when the individual decides to sell or otherwise dispose of their token from the STO. This is capital income and will be reported as either long- or short-term capital gain/loss depending on how long the tokens were held. Additionally, Section 162 of the IRC allows businesses to take a deduction for certain expenses that were incurred as a part of their business. An attorney experienced in crypto and tax issues should be retained for such services.
5. An attorney experienced in tokenization can help your project utilize and take advantage of the advantages offered through tokenization.
Tokenization is still a novel business opportunity. Not many individuals and businesses understand nor appreciate all the benefits that it can offer. Hiring an attorney experienced in tokenization can help you realize and take full advantage of such benefits. Examples of benefits offered by tokenization include the following: increased security: lower entry barriers; increased liquidity; faster transaction speed; more investment and diversification opportunities; automation; transparency; and decreased cyber-attacks. If your business is looking to undertake a tokenization project, make sure you first discuss your ideas and plans with an attorney to fully understand how your business can reap the most benefits.
“Whether your project will involve fractionalizing a piece of real estate, artwork, or digital equity shares, you will need the legal services of an attorney experienced in handling tokenization projects. An attorney can assess your project in detail and help you determine if you have any registration obligations under the federal securities laws for your token, the individuals who are working at your company, and the platform itself. Failure to do so could lead to substantial fines and penalties.” – Dr. Nick Oberheiden, Founding Attorney of Oberheiden P.C.
Conclusion
Tokenization is a unique and novel project plan that involves fractionalizing pieces of an asset, such as real estate assets, into smaller pieces called tokens, which is one of the most common blockchain-based digital assets, that are sold to investors. These transactions are transferred and stored on the blockchain. The tokens generally represent an ownership share in the asset. If you are considering a tokenization project, consider the five points in this article. A tokenization attorney can assess your registration obligations, evaluate the benefits of a tokenization project, determine if you have tax reporting requirements, and evaluate your compliance obligations under the BSA and FinCEN rules. If a tokenization project is in your company´s future, get in touch with an experienced blockchain attorney today.
