Treasury Issues Paper: what opportunities and risks do ICOs pose for Australia?

What opportunities and risks International Coin Offerings (ICOs) pose for Australia and whether our regulatory framework is well placed to manage those opportunities and risks is the subject of an Issues Paper released by Treasury in the most recent regulatory response to the growing digital environment and structural changes in financial services markets. Interested parties can make submissions by 28 February 2019.

Background

The Australian Government has identified innovations in financial technology (FinTech) as transformative for the Australian economy. ICOs have emerged as a niche form of fundraising for the FinTech community and are currently testing regulatory frameworks in Australia and around the world.

Treasury has released the Issues Paper to solicit views of interested parties on:

• the opportunities and risks posed by ICOs for Australia;
• whether our regulatory framework is well placed to allow those opportunities to be harnessed while appropriately managing the associated risks; and
• whether there are other actions that could be taken to best position Australia to capitalise on new opportunities.

Unlike many other regulatory responses to ICOs, the Treasury’s Issues Paper is refreshingly positive, recognising FinTech as ‘potentially transformative for the Australian economy’. While there are risks associated with ICOs, the Treasury acknowledges that jurisdictions around the world are competing to attract ICOs and to establish themselves as a hub for innovative technology companies. The Issues Paper is framed at establishing ‘whether our existing regulatory framework is well placed to allow those opportunities to be harnessed whilst appropriately managing the associated risks; and, whether there are other actions that could be taken to best position Australia to capitalise on new opportunities’. In a regulatory climate where consumer protection is top priority, especially in light of the recent Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, it is exciting to see a regulator willing to explore innovative fundraising models.

We summarise the key questions posed by the Issues Paper.

Definitions and token categories

ICOs typically involve the creation of a digital token by an issuer using distributed ledger technology (DLT). Digital tokens issued in an ICO generally have certain rights attached which grant to holders:

• the right to another digital currency (‘currency’ token);
• the right to a promised future cash flow linked to an underlying business or investment (‘equity’ or ‘investment’ token); or
• the right to access a product or service provided by the issuer usually at some future point in time (a ‘utility’ token).

With such varying and often constantly evolving features and rights, categorising ICOs and digital tokens has proven a difficult and imprecise task.

Key Treasury question

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

Drivers of the ICO market

ICOs have been perceived as an attractive alternative to more traditional methods of investing. It allows members of the public who are not sufficiently large-scale to be angel or venture capital investors to participate in start-ups by purchasing digital tokens at an earlier stage than they would be able to under more traditional investment structures.

Speculative investor behaviour has emerged as a key driver of the proliferation of digital tokens, although large losses and outright fraud have recently tempered some of this optimism.

Key Treasury questions

• 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?

Opportunities

ICOs may allow businesses to raise funds to be spent on early-stage platform and product development, enabling business to start up quickly and allow early mover advantages to rapidly evolving markets.

ICOs may allow individual investors to gain exposure to a start-up or small business in the early stages of growth, and/or provide access to a product or service that they value.

An ICO-friendly jurisdiction may attract ancillary services and in turn may generate positive flow-on effects for the wider economy.

Key Treasury questions

• How can ICOs contribute to innovation that is socially and economically valuable?
• What do ICOs offer and existing funding mechanisms do not?
• Are there other opportunities for consumer, industry or the economy that ICOs offer?
• How important are ICOs to Australia’s capability to being a global leader in FinTech?

Risks

A large number of ICOs have failed and many have turned out to be scams or have raised money illegally from public investors due to non-compliance with regulatory obligations.

In addition to the traditional financial risks of investing in early-stage start-ups, retail investors in ICOs may find that the rights attached to digital tokens do not accord with their expectations or do not exist. ‘White papers’ are the typical disclosure document, which are not regulated and often lack detail or consistent information. Misrepresentations made by token issuers may be of significant harm to consumers.

The rate at which ICOs are creating new digital tokens may also create difficulties for macroeconomic management.

Key Treasury question

• Are there other risks associated with ICOs that policymakers and regulators should be aware of?

Regulatory frameworks in Australia

The Australian Consumer Law currently regulates ICOs that are not deemed to be ‘financial products’. The ACCC has delegated powers to take action against misleading and deceptive conduct to ASIC. Consumer protection provisions apply to ICOs whether or not they are financial products.

Additional provisions apply to financial products and services as outlined in the Corporations Act. The Corporations Act can require those that deal in financial products to be licensed (subject to certain exemptions) and to comply with disclosure, registration and other obligations in relation to offering a financial product. The review notes that ASIC Information Sheet 225 on the regulatory treatment of ICOs will be further updated in Q1 2019.

New regulatory frameworks have been suggested, separate from current financial services law, to support the development of an ICO market in Australia. An example is the Corporations Amendment (Crowd-sourced Funding) Act 2017, which established a new legislative framework for fundraising via crowdsource platforms.

Key Treasury questions

• 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?

Tax treatment of ICOs

Current tax law contains tests to determine whether a particular interest is a debt interest or an equity interest (or neither) for tax purposes. These ‘debt and equity tests’ may impact the tax treatment of the proceeds of the ICO, including whether a return on an interest in an entity may be frankable and non-deductible to the issuer (like a dividend), or whether it may be deductible to the issuer and not frankable (like interest).

The GST treatment of sales and purchases of tokens as part of an ICO primarily depends on whether it meets the definition of a digital currency, a security or something else.

Key Treasury questions

• 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?

What should you be doing?

Responses to the Issue Paper are due by 28 February 2019. Through our involvement in various industry associations, we will be involved in making submissions to the Treasury.

Please don’t hesitate to contact us if you would like to discuss any of the broad questions raised by the Treasury or if you are considering making a submission.