Today in Tax: Digital Assets in M&As: Three Things Every Seller Should Know | Miller Nash LLP
Acquisitions in industries related to cryptocurrency and blockchain technology have exploded in 2021 compared to the previous two years. Early data suggests that 2022 will be another banner year for these acquisitions. This is not surprising as blockchain technology is suited for more business use cases. Also factor in price volatility driving a “crypto winter,” and it’s easy to see why 2022 could turn into a buyer’s market.
In previous articles, we’ve discussed three considerations for buyers (linked here), and in this article, we highlight three things every seller should consider when trying to sell digital technology.
Put your best foot forward
Even the most attractive digital product will only sell if priced correctly. It should come as no surprise, then, that companies that don’t clearly present the value proposition of their products have a hard time finding buyers willing to pay a fair price for the product. With this in mind, sellers should prepare for a sale by considering what may be attractive to a buyer or risk undervaluing their assets.
Buyers will have different expectations depending on the functionality of the assets and how they will fit into the buyer’s existing business, but all buyers will want to understand what they are buying and want to be sure that the assets purchased harbor no hidden surprises. Salespeople should be prepared with a clear explanation of the technology – how it works, how it differs from other products on the market, and how it makes life easier for users. This is often done by preparing a technical white paper explaining the strengths. Second, since regulation of digital assets is not uniform across jurisdictions or asset classes, sellers must be prepared to explain why the assets were not created or used. in a manner that could create a potential regulatory penalty or liability for the seller, buyer or users of the product.
This second point is a point of tension for many creators of digital assets. Often, digital assets are inspired by the desire to “cut out the middleman” or improve efficiency. The bureaucratic state does not sit well with this philosophy. But sellers must reconcile this dichotomy in an articulate way or face a lower purchase price from risk-averse buyers. This does not always mean that sellers must devote all their available resources to researching and complying with all regulations that may apply. This means that vendors must have a reasoned basis for their regulatory position and not overlook obvious compliance obligations.
One approach here is to perform an internal regulatory compliance audit before the point of sale to identify any material weaknesses or issues. This provides the opportunity to resolve an issue (or steer the narrative around the issue) before it is brought up by the buyer. Another, complementary approach is to document regulatory compliance activity on an ongoing basis and be prepared to support positions taken (particularly if the seller takes the position that a regulatory obligation does not apply), including including through research notes or legal opinions, as appropriate. . Using this approach, a risk-averse buyer can understand what the seller did and why, rather than worry about unexpected skeletons in the seller’s closet.
The tax consequences can be surprising
A traditional approach for sellers is to push for a company-level sale, rather than a sale of company assets. This is to ensure the treatment of capital gains on the sale proceeds. Often, however, buyers are wary of acquiring a company with its historical liabilities. Thus, the tax consequences of a sale are generally less straightforward than simply applying capital gains rates. Instead, sellers must consider the tax implications of selling each individual company asset, including company digital assets.
The federal tax treatment of these assets may vary – in some cases these assets may generate capital gains, but in others (particularly where the assets are “self-created” or are treated as inventory), the sale may generate ordinary income and be taxed. at higher rates.
Additionally, there may be state taxes applicable to the sale. Each state has its own set of tax laws and a sale may be subject to income tax, sales tax or other transfer duties. States generally do not impose sales tax on intangible assets, but there are exceptions. For example, Washington imposes a retail sales tax on the sale of certain digital assets, including certain types of blockchain-based assets.
Sellers should work closely with their tax advisors and negotiating team to model the tax effect of the transaction and avoid any surprises.
The sales structure must protect your interests
Finally, the structure of a sale can help put value in the seller’s pocket and protect them from unnecessary risk. Under ordinary circumstances, sales can often be structured to reduce or eliminate certain types of taxes. However, the menu of options for sellers of digital assets may narrow in some cases, especially if the buyer intends to fund part of the purchase price with cryptocurrency or other digital assets.
Corporate reorganizations provide an interesting example. Corporate mergers and other reorganizations can often be classified as tax-exempt if a significant percentage of the purchase price is comprised of securities issued by the purchaser. This can be a great approach for some parties, including some digital asset sellers, but it’s not a good option if the purchase price includes digital assets. Digital assets may disqualify the transaction because they do not necessarily qualify as “securities” for tax purposes (even though they look like securities under federal securities laws). In addition, their price volatility can also change the ratio of “securities” to non-securities in the purchase price, depending on when the value of the assets is measured, and cause a seemingly exempt reorganization tax is treated as taxable.
The structure of the transaction must also protect the seller from risk. As the recent “crypto winter” illustrates, the value of digital assets can change rapidly. If the market for the seller’s assets declines or evaporates, buyers may be inclined to abandon the trade. A better approach would be to include adjustments to the purchase price, or even termination fees, to prevent the deal from becoming economically unreasonable.
In short, structuring options should be carefully evaluated to ensure that the transaction structure actually delivers the expected benefits.