For businesses that have decided that they want to take the strategic decision to enter the digital age and conduct an initial coin offering (ICO), the next two questions are inevitable: one, from what jurisdiction should that business choose to launch and conduct its ICO and two, what suitable structure should be put in place for that business in that jurisdiction?
In answer to the first question, we released an article in September 2017 which examined the legal regime of the Cayman Islands against the backdrop of initial coin offerings (ICOs) and which outlined some of the advantages of conducting an ICO through an entity formed in the Cayman Islands. As the pre-eminent tax neutral jurisdiction for investment funds with a securities law regime that is generally more permissive than other jurisdictions, the Cayman Islands has indeed become a popular choice for many businesses conducting ICOs. However, the second question has perhaps been the more difficult to answer. This article considers structuring an ICO in the Cayman Islands for non-asset backed token ICOs.
No One Size Fits All
Before any step is taken on the road toward an ICO, it is critical that comprehensive legal and tax advice is obtained for each business before any token is sold or any entity formed. When considering what type of entity should be formed and where it will fit in a business' corporate structure, the first call should be to onshore tax advisors and the second call should be to onshore and offshore lawyers. As ICOs are still novel transactions both in the Cayman Islands and abroad, analysis of the applicable legal, regulatory and tax treatment of such transactions and the structures that conduct them continues to evolve. Therefore, this article should not be treated as advice and merely sets out an analysis of structuring issues in the Cayman Islands.
Platform or Protocol
We are seeing a trend in ICO projects falling into two camps. The first is the launch of new decentralised blockchain protocols which either sell "native" digital assets built into the blockchain (similar to bitcoin) or tokens generated on a third party blockchain (such as Ethereum) which are then exchanged in future for the native asset (a Blockchain Project). As these businesses are often looking to launch a decentralised product that will ultimately be governed by a community, such businesses often wish to incorporate a vehicle that represents this ownerless product. Cue the Cayman Islands foundation company: a supremely flexible vehicle that operates on a basis akin to an incorporated trust structure. Conceptually these vehicles are suited for the benefit of the community as they can be shaped to be stand-alone, ownerless entities restricted in making dividends or distributions. Proceeds raised by the ICO are paid to service providers which are tasked and incentivised to fulfil the objectives of the foundation company. Whilst some Blockchain Projects have opted to use the ever-popular exempted company of the Cayman Islands for their ICO (as outlined below), we are of the view that, subject to appropriate tax advice, consideration of the Cayman Islands foundation company is a must for all Blockchain Projects. For further information on foundation companies, please see our article of March 2018.
The second project is the development of tokens generated on a third party blockchain which are then used for utility purposes on a platform (a Platform Project). As these Platform Projects are usually looking to launch technology with a traditional ownership structure, many find that the exempted company of the Cayman Islands suits their needs well. Incorporated with a familiar constitution governed by a memorandum and articles of association, with directors, officers and shareholders and an ability to pay dividends, many businesses choose this tax neutral vehicle to be the Token Generator, being the entity that generates and sells the tokens. For further information on exempted companies, please see our article of November 2016.
One or Two or More?
The central entity for the purposes of an ICO is the Token Generator. Many businesses are often tempted to use the Token Generator as a multi-purpose vehicle either as holder of the project's intellectual property (IP) or as developer of the protocol or platform. Although this is entirely permissible, businesses must be alive to the fact that the Token Generator is usually operating a crowd funding-like business in an ever-evolving regulatory landscape. Therefore, we suggest that future possible liabilities be ring fenced by having the Token Generator kept separate from the developer of the protocol or platform (the Developer). This is one of the many reasons that the most "common" structure for an ICO now involves at least two entities: the Token Generator and the Developer.
As the Developer is often separate to the Token Generator, the question then arises as to where to situate the Developer. Following appropriate tax advice, we have often seen the Developer remain onshore for many projects. However, many choose to incorporate the Developer in the Cayman Islands, both inside and outside the Special Economic Zone (SEZ). The SEZ is a government-designated zone that is designed to attract certain types of business to relocate to the tax neutral Cayman Islands. Crucially for blockchain-based projects, the SEZ targets software development businesses thereby making a full-scale relocation attractive. Whilst there are many legal and regulatory considerations for incorporating an entity within the SEZ, the choice to move the Developer to the SEZ appears to be primarily tax and lifestyle driven. It is perhaps this reason that many businesses chose to form their Developer initially as a Cayman Islands exempt company as there is always the option of converting such entities into Special Economic Zone Companies in future following appropriate advice and consideration.
Whilst many projects are launched with both a Token Generator and Developer, others also choose to incorporate separate IP holding companies or separate software operators in addition to the above. This choice is often driven by the preferences of each business, its risk appetite and its tax considerations.
Parent or Partner?
As per above, more and more ICO structures now involve one or more vehicles based either onshore or offshore. We are seeing a wide approach as to how the Token Generator and the Developer relate to each other following formation. Often the Developer is the parent of the Token Generator which, upon completion of the ICO, distributes up the funds to enable the Developer to develop the platform or protocol. Rarely do we see the inverse of this structure with the Token Generator as parent as this would possibly subject the entire structure to the potential liabilities discussed above. We also see the Token Generator and the Developer structured as affiliates or as completely separate from each other, particularly where the Token Generator is an ownerless foundation company. Where the entities are affiliates or are separate, thought should be given as to how the Token Generator, Developer and any other entity relate to each other. Failure to correctly document these relationships could lead to unintended consequences. For example, where the Token Generator transfers the ICO funds to a separate Developer, thought should be given as to what consideration is being given by the Developer for such funds. We have seen structures where the Token Generator holds the IP but then licenses the IP to the Developer, transfers the ICO funds to it under a service agreement and effectively employs the Developer to develop the platform or protocol. We have also seen service agreements whereby the Developer holds the IP but employs the Token Generator as a fundraiser. In all scenarios, the creation of a nexus between the parties is critical in order to clarify the obligations of each entity, the ownership of property and the separation of liability. As always, tailored legal and tax advice is essential for any business before any decision is made on structuring intercompany relationships.
Businesses contemplating an ICO will be comforted to know that this is becoming a trodden path in the Cayman Islands and certain trends and patterns are beginning to emerge on how to structure such a venture. Notwithstanding these developments, each business is encouraged to obtain appropriate tax and legal advice right at the start of their project and must be alive to the issues highlighted above. Ogier is at hand to assist any business contemplating an ICO from the Cayman Islands.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.