Crypto companies and exchanges are facing unprecedented pressure from financial regulators around the world, with many digital asset businesses starting to consider moving to friendlier locations. This article is part of a series discussing the key considerations of relocating, as well as comparing the appeal of a number of alternative locations. VIEW THE SERIES
Leaving the US is a complicated process and not for the faint of heart. Generally, there are two approaches. The first is to keep a US holding company with staff in the US, but set up one or more subsidiaries outside the US. The second is to leave the US completely, set up a non-US holding company with one or more subsidiaries outside the US and completely exit the US with no ongoing US operations. This article addresses the US issues raised by both options.
US tax obstacles
The single most significant impediment to leaving the US are the potentially adverse federal and state tax implications of doing so. First, established crypto companies will inevitably own assets that the IRS would classify as “intangibles”, such as computer software, algorithms, trademarks goodwill, customer lists, and the like. Transferring such intangibles to a foreign company can be accomplished as (i) a license in exchange for royalty payments, (ii) a sale for a fixed or variable amount, or (iii) as a capital contribution.
Under the first option, since the foreign subsidiaries will be wholly owned, any such transfer will have to be done on an arm’s length basis to comply with the requirements of Section 482. As a result, the transferring US company will have to pick-up taxable income in the case of a license or sale; many US crypto companies have net operating losses that could be used to reduce the taxable income, but the net amount will be subject to federal and possibly state income tax. This raises the question of where does the cash (the IRS still does not accept crypto as payment for taxes) to pay the taxes come from. A particular concern for many given the current crypto winter they are experiencing with significantly reduced crypto values.
Similarly, a contribution of the intangibles in exchange for stock or equity by the transferring US companies will result the transferring US company having to recognize taxable income under Section 367. Section 367 imputes a royalty from the transferee company back to the transferring US company, with the royalty being “commensurate with income”.
Another potential US tax issue arises where senior management remains based in the US. Foreign subsidiaries can in certain situations become subject to US corporate income tax on a portion of their income allocable to the US. If the foreign subsidiary has its own staff of front and back-office personnel, then the involvement of the US based senior management can be structured to avoid that problem. However, if many or all of the back-office functions remain in the US, then the IRS could seek to tax the foreign subsidiaries on the basis that the US staff constitute a dependent agent (where the foreign subsidiary is resident in a country with which the US has an income tax treaty) or is engaged in a US trade or business (in all other cases). The “US trade or business” test is easily satisfied and would apply to the foreign subsidiaries set up in a tax-haven country. Even if the IRS did not raise this issue, the US parent company would need to charge the foreign subsidiaries for the services performed for their benefit by the US parent company, again on an arm’s length basis under Section 482.
Another issue is how the foreign subsidiaries are financed? Loans from the US parent? Equity investment?
The second option is even more challenging. Typically, under the second option, the shareholders of the US company would exchange their shares in the US company for shares in a foreign holding company. Easy to accomplish under corporate law, but a challenge under tax law. Congress enacted “inversion” provisions under Section 7874 specifically to address such transactions. If the conversion of the US company constitutes an inversion, then the effect of Section 7984 is to classify that new foreign company as a US company for all tax purposes. This will result most likely in two levels of corporate tax – US corporate tax because the IRS will treat the foreign corporation as a US corporation and foreign tax (unless in a pure tax-haven) in the local jurisdiction. Because the foreign company is considered a “domestic” company by the foreign jurisdiction unlikely that that foreign jurisdiction will allow the foreign company to claim a foreign tax credit for the US corporate taxes. The situation gets to be even more complicated if that foreign jurisdiction imposes a dividend withholding tax. US shareholders would end up paying the foreign withholding tax as well as US income tax on the dividend, but because the foreign company is treated as a US company for all purposes, the US shareholders would not be able to claim a foreign tax credit for those foreign withholding taxes. The same issue would arise for the non-US shareholders – US dividend withholding tax at most likely a 30% rate as well as foreign income tax with no credit for the US withholding taxes. A really bad result for both the company and its shareholders.
US regulatory obstacles
The SEC sued the crypto exchange Bittrex for alleged violations of the US securities laws, even as it acknowledged that the exchange was not based in the US and had procedures and warnings in place to try and keep US based persons from holding and trading crypto assets on the exchange.
This gives rise to a concern that if a US exchange/token issuer sets up operations outside of the US but keeps it senior management team in place the SEC would continue to take the position that the US parent company is continuing to violate US securities law as unregulated securities exchanges or unregistered securities issuers. The CFTC may take a similar view. In the past, companies might have been able to meet with the SEC or the CFTC to discuss these problems and agree upon a solution; however, in light of recently events it is unclear whether such meetings remain an option.
The SEC also recently sued both Binance and Coinbase as part of their continued enforcement actions. The Coinbase lawsuit alleges that it is an unregistered securities exchanges and seeks to force it to stop operations. In the two lawsuits, the SEC continued to assert its position that most if not all tokens other than Bitcoin and ETH are securities under the Howey test and therefore constitute unregistered securities.
Another issue is whether crypto companies who remain headquartered in the US would be able to maintain bank accounts in the US, particularly if the banking regulators continue with “Operation Chokepoint 2.0”. Without a US based bank account, US headquartered crypto companies will find it difficult to make payroll, withhold taxes, pay rent etc.
