Tax Implications of Returns to Investors from Security Tokens
Written by Alexis Nicolaou, Partner Distributed Ledger Technologies at Grant Thornton Blockchain Cyprus and a member of the FuturEstate Alliance
The emergence of security tokens has revolutionized the way investments are made and managed. These digital assets offer various returns to investors, in the form of either dividends, interest, or capital gains. It is crucial for investors to understand the tax implications associated with these returns. In this article, we will delve into the tax considerations and obligations that arise from investing in security tokens and receiving returns in the form of either dividends, interest, or making a capital gain.
In the absence of specific guidelines on Direct and Indirect tax implications of security tokens by most tax authorities, the views expressed are based on the basic and fundamental provisions of the Legislation that is currently in force in the article writer’s country, Cyprus.
It must be stressed that a careful consideration of the specific characteristics and facts of each case is necessary.
Classification of Security Tokens
Before examining the tax implications, it is essential to determine the classification of security tokens.
Even though currently no legislation exists for the digital tokens, it can be noted that they have similar characteristics to equity, bonds or derivatives. Similarly, they provide a return similar to dividends from shares or to interest payments like bonds or to payments related to the performance of a specific asset of the company like derivatives. A consistent reporting/classification of these digital assets in the company’s balance sheet (equity or liabilities) is a prerequisite.
The classification of security tokens impacts how they are treated for tax purposes.
Direct Tax considerations
Income such as interest or dividend received by their owner will be taxed accordingly following the general provisions of the tax legislation.
In case where the security token is sold by the holder, then the tax result arising from the transaction could be a gain/loss on the disposal. The taxability of the gain or allowance of the loss will depend on whether the said token is a capital or income asset for the holder and consequently whether the gain /loss is of a capital or income nature. The classification of the position is achieved following the “badges of trade” (i.e., profit seeking motive / the number of transactions / the nature of the asset / existence of similar trading transactions or interests / changes to the asset / the way the sale was carried out / the source of finance / interval of time between purchase and sale / method of acquisition).
- Dividends from Security Tokens: In the context of security tokens, dividends can be distributed in the form of other tokens or other assets including fiat money. When investors receive dividends, they may have tax obligations, such as:
- Taxable income: Dividends are generally considered taxable income and may be subject to special defence contribution tax rates. The tax treatment may depend on the investor’s jurisdiction and the specific circumstances of the investor.
- Withholding Taxes: Some jurisdictions impose withholding taxes on dividends paid to non-resident investors. These taxes are typically withheld at the source and can be subject to tax treaties between countries.
- Interest Income from Security Tokens: Investors in security tokens may also earn interest income, especially when investing in debt-based tokens.
Tax considerations relating to interest income include:
- Taxable Income: Interest income is typically considered taxable income and is either subject to ordinary income tax rates or special defence contribution rates. The tax treatment may depend on the investor’s jurisdiction and their tax residency status.
- Reporting Requirements: Investors receiving interest income from security tokens might be required to report it on their tax returns and provide relevant documentation for accurate reporting.
- Capital Gains from Security Tokens: Investors may realize capital gains when selling security tokens to third parties at a higher price than their initial investment. Key tax implications include:
- Capital Gains Tax: The tax rate can vary depending on the nature of the asset to which it is linked, the holding period and the investor’s jurisdiction. Short-term gains often taxed at higher rates than long term gains.
- Reporting and Documentation: Investors are required to accurately report their capital gains from security tokens and maintain appropriate documentation to support their calculations.
Indirect Tax Considerations
As mentioned above, security tokens are analogous to equities, debentures or derivatives. They are granting rights to dividends like equities / shares or to interest payments like bonds or to payments linked with the performance of a specific asset of the company like derivatives. Such tokens are designed as tradeable assets that are held for investment purposes and often classified as a security under applicable laws.
- Dividend income is treated as being outside the scope of VAT. Hence no VAT is charged on such income. The reason being that dividend income is not considered to constitute a consideration for a supply made for VAT purposes.
- Any interest income to be received by the owner of the security tokens or proceeds from the sale of security tokens will be exempt for VAT purposes.
Investing in security tokens across borders can give rise to additional tax issues. Investors should be aware of potential issues related to double taxation, foreign tax credits, and tax reporting requirements in both their home country and the jurisdiction where the security tokens are issued or traded.
As security tokens gain popularity in the investment landscape, understanding the tax implications of the returns they generate is crucial for investors. This article has provided an initial overview of the tax considerations surrounding dividends, interest income, and capital gains from security tokens. However, it is essential to consult with a tax professional or seek expert advice specific to your jurisdiction and individual circumstances to ensure compliance with applicable tax laws and regulations.
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