01 February 2019

Australian government consults on ICOs

As international digital asset developments gain pace, the Australian Department of the Treasury has released an exploratory consultation paper on initial coin offerings (ICOs), with responses to consultation due 28 February 2019.

The consultation paper poses a wide range of questions for response, including:

  • What is the clearest way to define ICOs and different categories of token?
  • What will be the key drivers of the ICO market going forward?
  • What are the opportunities and risks posed by ICOs?
  • What changes, if any, are needed to Australia’s current regulatory and tax treatment of ICOs?

In this alert, we summarise the questions asked in the consultation paper.

How should we define ICOs and categorise tokens?

The consultation paper asks:

  • “What is the clearest way to define ICOs and different categories of tokens?”

Drawing a distinction between ICOs and crowdfunding, the consultation paper acknowledges there is no ‘widely-adopted definition’ of ICO and provides the following definition:

“[I]t typically involves the creation of digital tokens by an issuer using distributed ledger technology (DLT). The tokens are acquired by investors and potential consumers through online auction or subscription, typically in exchange for a cryptocurrency such as Bitcoin or for official fiat currency such as United States dollars”.

The consultation paper also draws a distinction between the following types of tokens:

  • ‘currency’ tokens, also known as ‘stablecoins’, linked to another digital currency
  • ‘equity’, ‘asset’ or ‘investment’ tokens, linked to promised future cashflow linked to an underlying business or investment
  • ‘utility’ or ‘access’ tokens, granting a right to access a future product or service
  • financial products, often referred to more generally as ‘security’ tokens
  • tokens to which no rights attach such as ‘community’ or ‘donation’ tokens

What will drive the market going forward?

The consultation paper asks:

  • “What is the effect and importance of secondary trading in the ICO market?”
  • “What will be the key drivers of the ICO market going forward?”

The consultation paper draws particular attention to these four potential drivers, which have been observed as driving the market to date:

  • developments in distributed ledger technology
  • digital token creators developing ICOs as a new funding model
  • investor ‘exuberance and speculation’ resulting from the opportunity to invest in start-ups which may be in an earlier stage than other investments available to the investor
  • growth of digital token exchanges and wallet providers bringing liquidity and other opportunities

What are the opportunities and risks posed by ICOs?

The consultation paper asks:

  • “How can ICOs contribute to innovation that is socially and economically valuable?”
  • “What do ICOs offer that existing funding mechanisms do not?”
  • “Are there other opportunities for consumers, industry or the economy that ICOs offer?”
  •  “How important are ICOs to Australia’s capability to being a global leader in FinTech?”
  • “Are there other risks associated with ICOs that policymakers and regulators should be aware of?”

The consultation paper draws out some key potential benefits of ICOs for business, consumers and the broader Australian economy, including:

Industry

Consumers and investors

Broader Australian economy

  • A potentially faster and cheaper fundraising model, especially for early-stage start-ups, which allows the issuer to retain full ownership and control
  • The potential to issue to a large number of small investors, both as a source of new funding (especially for early-stage start-ups, without the need to relocate overseas) and a potential source of building a stronger and broader customer base by relying on network effects

  • The potential to simplify cross-border transactions through tokenisation

  • The potential to gain exposure to early-stage start-ups or to access a certain product or service, in a similar way to loyalty programs but with the potential for liquidity in the tokens they purchase
  • The potential for investors to benefit from an increase in a token’s value over time or from diversification of their portfolio
  • The potential to reduce counterparty risk technologically, including through smart contracts
  • The potential to drive economic growth through innovative technology
  • The potential to attract new funding for start-ups or generate greater efficiencies in capital allocation across the financial system.
  • The potential for positive flow-on effects by attracting ancillary services to the economy, including cryptographic token exchanges, wallet providers and professional services 




 

The consultation paper draw outs some key potential risks posed by ICOs, including:

Industry

Consumers and Investors

Broader Australian economy

  • The risk of scams, non-compliance with regulatory requirements or a failure of the project or business which has been funded

  • The risk of uncertainty of the application of a regulatory regime

  • The risk of business and market uncertainty, including risks estimating costs and funds, challenges in valuing the business being funded and volatility of token prices
  • The risk that consumers will not be able to conduct technological or other due diligence or sufficiently understand the risks involved, including where disclosure is inadequate
  • The risks of fraud, the failure of a project or ICO to benefit the consumer, or the failure of consumer protection laws to protect consumers either legally or in practice due to the cross-border or technological nature of an ICO
  • The risk posed by extreme volatility of new tokens and the potential for market manipulation or other sale practices which may harm consumers
  • Security risks in connection with wallets and exchanges
  • The risk that speculation, fraud or capital misallocation could lead to lower overall economic growth or, by association, may affect investment in other technological innovations such as distributed ledger technology more broadly
  • The risk that a large-scale failure may undermine consumer trust and confidence in Australia’s regulatory system, or impact fundraising models such as crowdfunding, by association
  • If tokens became very widely adopted in mainstream society, the risk that their volatility could impact macroeconomic  management and stability

What changes, if any, should be made to the regulatory framework?

The consultation paper asks:

  • “Is there ICO activity that may be outside the current regulatory framework for financial products and services that should be brought inside?”
  • “Do current regulatory frameworks enable ICOs and the creation of a legitimate ICO market? If not, why and how could the regulatory framework be changed to support the ICO market?”
  • “What, if any, adjustments to the existing regulatory frameworks would better address the risks posed by ICOs?”
  • “What role could a code of conduct play in building confidence in the ICO industry? Should any such code of conduct be subject to regulator approval?”
  • “Are there other measures that could be taken to promote a well-functioning ICO market in Australia?”

This section of the consultation paper compares and contrasts different regulatory approaches which have been taken globally and highlights the key challenges for participants and regulators, especially challenges in applying current financial services regulation, anti-money laundering laws and securities laws to ICOs.  The consultation paper also broadly outlines the current application of Australian consumer law and financial services regulation to ICOs and cryptographic tokens and describes certain industry-led initiatives such as the SAFT framework.

In particular, the consultation paper contrasts regulatory approaches which specifically target ICOs or cryptographic tokens, such as those which provide formal determinations on the classification of tokens into sub-categories or which exempt certain tokens from the application of financial services regulation, against broader principles-based regulatory approaches. 

The consultation paper notes that aspects of these different approaches may trade off different risks and benefits including regulatory certainty, regulatory burden and consumer protection, and that the time and costs involved in introducing a new regime must be balanced against the potential benefits.

Importantly, the consultation paper notes that, similar to Australia’s recent crowdfunding reforms, “some industry participants have suggested that a new regulatory framework, separate from current financial services law, would best support the development of an ICO market in Australia”.

What changes, if any, should be made to tax treatment?

The consultation paper asks:

  • “Does the current tax treatment pose any impediments for issuers in undertaking capital raising activities through ICOs? If so, how?”
  • “Is the tax treatment of tokens appropriate for token holders?”
  • “Is there a need for changes to be made to the current tax treatment? If yes, what is the justification for these changes?”

The consultation paper summarises the government’s view of the current income and capital gains tax treatment of ICOs and cryptocurrencies for issuers, purchasers and holders, as well as the GST treatment of cryptocurrencies.  It recognises the variety of tokens which have already been issued, as well as the complexity of the relevant tax treatment and the difficulties for issuers and investors in determining how to account for cryptocurrencies.

This consultation paper follows on from revised guidance from the ATO last year and the ATO’s consultation on practical issues in the taxation of cryptocurrencies, and the earlier digital currency reforms to the GST framework in 2017.

Treasury has sought broad input on the tax issues in this space.  To date the tax considerations for token issuers have attracted less discussion and formal guidance than considerations for token holders, and this consultation is an ideal opportunity to consider the most appropriate tax treatment of these activities.

We’re here to help

As the questions raised for consultation are broad, with potentially far-reaching implications, we expect digital asset businesses, professionals and enthusiasts in Australia and elsewhere will be keen to provide input to help shape any future regulation.

Responses to the consultation are due 28 February 2019.  We will be working with our clients and relevant associations on this important topic.  If you are considering a submission and would like to discuss this with us, please don’t hesitate to contact us.

We also regularly publish on this rapidly developing area — see our previous alert on Australian regulation, case law and tax developments here, the latest regulatory developments in Hong Kong here and our alerts on global fintech developments here.




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