The United States Internal Revenue Service and Treasury Department have published minimal guidance on the tax treatment of virtual currency and no guidance on Simple Agreement for Future Tokens or secondary forward contracts on SAFTs. Accordingly, it is difficult to determine the appropriate U.S. federal income tax treatment of a secondary forward contract on a SAFT.
In 2014, the IRS issued Notice 2014-21 and updated it with FAQs that provided that convertible virtual currency is treated as “property and general tax principles applicable to property transactions apply to transactions using virtual currency.” Thus, a corporation’s issuance of such virtual currency tokens is taxable for U.S. federal income tax purposes.
Although there is no definitive guidance, it is likely that digital tokens underlying SAFTs would be considered property for U.S. federal income tax purposes. In light of limited guidance classifying tokens as property, some practitioners have attempted to embed terms and rights into the token instrument, causing such a token to be classified as equity, or less frequently, debt under fundamental tax principles. A corporation that issues equity or debt is not taxable on the issuance of either.
If a virtual currency token is classified as property for U.S. federal income tax purposes, a SAFT, which entitles the holder to receive a certain number of tokens upon issuance, might be characterized as an executory contract, or a forward contract, to buy the virtual currency token. A “traditional forward contract” has been defined as an executory contract pursuant that the buyer agrees to purchase from the seller a fixed quantity of property at a fixed price, with payment and delivery to occur on a fixed future date. Section 1259(d)(1) of the Internal Revenue Code of 1986 provides this for purposes of section 1259, “forward contract means a contract to deliver a substantially fixed amount of property (including cash) for a substantially fixed price.”
Several federal tax cases and published rulings provide that forward contracts to acquire property are open transactions for federal income tax purposes and no taxable event should occur until the seller delivers legal title and possession of the property to the buyer. However, almost all of these authorities address circumstances, in which a buyer, upon entering into the contract, either does not make an upfront payment, pays a refundable deposit to the seller or pays a non-refundable amount that represents a relatively low percentage of the ultimate purchase price.
In contrast, many SAFTs require upfront payments, which constitute a significant portion of the ultimate purchase price of a fixed number of tokens that are subject to the SAFT. This factor weighs against open transaction treatment for a SAFT because a significant non-refundable prepayment suggests that a taxable sale has occurred and authority is distinguishable.
In Revenue Ruling 2003-7, the IRS held that a seller of stock that is the subject of a variable prepaid forward contract escapes constructive sale treatment both under common law principles and because section 1259 of the Internal Revenue Code of 1986 is inapplicable due to the variable amount of stock that is required to be delivered to the buyer pursuant to the contract.
If the token does not yet exist because it is under construction, it is possible that even with the substantial upfront payment, the SAFT might still be considered to be a forward contract subject to open transaction treatment for federal income tax purposes. Thus, the corporate issuer might be able to defer income until the date of the issuance of the token to the SAFT holder in satisfaction of the SAFT. And a different conclusion might be reached if the issuance of tokens is imminent.
Secondary forward contract on a SAFT
What happens when the holder of a SAFT enters into a forward contract and accepts payment for the future delivery of a fixed number of the tokens underlying the SAFT? The issue is whether the SAFT holder is treated as constructively selling the SAFT upon entering into the prepaid forward contract in exchange for a significant cash payment approximately equal to the purported fair market value of the SAFT.
The taxation of the secondary forward contract seller may differ from the taxation of the corporate seller/issuer of the SAFT, who cannot provide the token because it does not exist yet. The SAFT itself may be an appreciated financial position because later-issued SAFTs with respect to the same to-be-issued token cost more — i.e., are issued at a smaller discount to the face value of the token — or because the fair market value of the SAFT on the secondary market has appreciated.
A secondary forward contract with respect to a SAFT seems to be much closer to the constructive sale fact pattern outlined by section 1259 of the Internal Revenue Code of 1986 and is distinguishable from common law and IRS authorities, which permit open transaction treatment either due to small upfront payments or due to the terms of a limited class of variable prepaid forward contracts.
Currently, section 1259 of the Internal Revenue Code of 1986 applies to an appreciated position (including a forward contract) in stock, a debt instrument or a partnership interest “if there would be gain were such position sold, assigned, or otherwise terminated at its fair market value.”
Section 1259 does not currently appear to apply to an interest in virtual currency tokens. However, there is a significant risk that a prepaid secondary forward contract on a SAFT could be a constructive sale. If Congress extended section 1259 to apply to virtual currency tokens or the IRS determined that based on the certain compelling facts, the common law constructive sale rules apply to cause a secondary forward contract on a SAFT to trigger a constructive sale of such SAFT.
The lack of guidance on tokens, SAFTs and secondary forward contracts on SAFTs means that it is virtually impossible to determine the U.S. federal income tax treatment of the various instruments with certainty and whether or not a constructive sale occurs upon entering into one or more of these agreements. Therefore, SAFT holders who enter into a secondary forward contract on the SAFT should consult their tax advisors to determine whether (based on the specific facts of the transaction) entering into the secondary forward contract likely results in a constructive sale of the SAFT for tax purposes and the applicable tax reporting requirements.
Since their inception, the issuance of SAFTs has presented difficult and controversial legal issues under the securities, commodities and tax laws in the U.S. In the meantime, secondary transfers of interests in existing SAFTs similarly present a set of difficult issues and risks that should be carefully considered by both prospective sellers and buyers in consultation with their legal advisers.
This is part two of a two-part series on the Simple Agreement for Future Token — read part one here.
The views, thoughts and opinions expressed here are the authors alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
This article was co-authored by Daniel Budofsky, Laura Watts, Riaz A. Karamali, Cassie Lentchner, James Chudy and Ryan Brewer.
Daniel Budofsky is a partner at Pillsbury Winthrop Shaw Pittman, based in New York City. He advises financial institutions, corporations, investment funds and asset managers on financial products and regulation in domestic and international transactions.
Laura Watts is senior counsel at Pillsbury Winthrop Shaw Pittman, based in San Francisco. She advises public and private companies on federal income tax issues arising in corporate transactions.
Riaz Karamali is a partner at Pillsbury Winthrop Shaw Pittman, based in San Francisco. He assists clients with negotiating and closing domestic and international venture finance, private equity, mergers and acquisitions, and technology transactions.
Cassie Lentchner is senior counsel at Pillsbury Winthrop Shaw Pittman, based in New York City. She utilizes her background in financial services regulations and regulatory relationships to strategically analyze and balance risk with business advancement and development.
James Chudy is a partner at Pillsbury Winthrop Shaw Pittman, based in New York City. He leads Pillsbury’s tax practice and advises clients on federal income tax aspects of mergers and acquisitions, bankruptcy reorganizations and business restructurings, corporate finance, private equity investments and digital currencies.
Ryan Brewer is an associate at Pillsbury Winthrop Shaw Pittman, based in New York City. He focuses on general corporate and securities law matters, including mergers and acquisitions, public and private offerings, corporate governance, and venture capital transactions.