Today in Tax: Digital Assets in M&As: Three Things Every Buyer Should Know | Miller Nash LLP

Cryptocurrencies, digital assets, and blockchain-based technologies seem to be popping up everywhere. As the market for these products matures, new markets emerge. Competitors, new entrants and investors acquire the technologies and platforms themselves, or the companies that developed them. The opportunity to acquire a new product or technology is exciting, but before signing the dotted line, buyers should consider the following three ways digital assets influence a potential acquisition.

Due diligence

All types of digital assets present complex practical and legal issues. In practice, integrating the targeted technology or product into the buyer’s business structure is critical to the long-term success of the acquisition. With digital assets, this is easier said than done.

Commentators generally refer to the blockchain as if it were a standardized system. Yet, there is no universal technical standard applicable to digital assets. Each blockchain has its own standards and procedures, which means that products and services based on different blockchain technologies cannot communicate with each other. Buyers should carefully consider how the acquired technology will fit into their existing technology stack.

As with many new technologies, blockchain and related innovations do not fit neatly into the legal and regulatory structures designed to solve the problems of the physical economy. Regulatory regimes are lagging behind advances in technology. In some cases, this means uncertainty or unexpected compliance requirements. Buyers should carefully assess a target company’s past actions to identify areas of particular risk for regulatory non-compliance.

The main areas to consider are:

  • Federal and state securities regulation;
  • commodity regulation;
  • Banking and financial regulation, including money transmission and anti-money laundering laws;
  • Intellectual property;
  • Data protection and digital security;
  • Privacy; and
  • Tax.

An in-depth discussion of these areas is beyond the scope of this article: follow us for future articles. [David Brandon; Bryce Parkllan]

Each acquisition transaction is unique. Buyers should consult an attorney to determine the extent of due diligence appropriate to the particular circumstances of the transaction. A well-written letter of intent will help identify and provide access to the right information, and a well-written purchase agreement can protect the buyer from past indiscretions by the target.

Asset Valuation

Volatility is a feature of many cryptocurrencies. It is common for prices to fluctuate by 15% or more in terms of hours. A sudden drop in value can undermine the expected value of a target company. Acquiring a business with cryptocurrency assets is not for the faint-hearted. But, there are ways to protect the value of a proposed investment. For example, strong provisions allowing for price adjustments can ensure that the buyer does not pay too much. Alternatively, a purchase agreement may allow the acquisition to be terminated if the price falls below a specified level.

Another problem arises with hard-to-value digital assets. Non-fungible tokens (NFTs) are unique assets and are not always traded on an open market. Similarly, unproven or new technologies are notoriously difficult to evaluate. Buyers may need to increase their due diligence efforts to understand the value and commercial viability of these types of assets.

Structure of transactions

There is no one-size-fits-all approach to buying or selling a business. But, there are some universal structuring choices. For example, should the transaction be structured as taxable or non-taxable? Like a stock sale or an asset sale? The answers to these questions dictate the federal income tax results for the buyer and seller.

Duty-free transactions are typically used when sellers do not collect, but intend to continue to play a role with the buyer. This is usually accomplished by issuing stock in the buying company to the sellers. Federal tax rules limit the amount of non-capital compensation sellers can receive in a tax-free transaction before it becomes taxable. It can be difficult to meet these requirements if sellers expect to receive payment in the form of digital assets or equity whose value is derived from the ownership of digital assets. The volatility in the value of digital assets makes it difficult, but not impossible, to determine whether the transaction will qualify for tax-free treatment.

In taxable transactions, conventional wisdom tends to bias sellers toward equity sales and buyers toward asset sales. This convention is likely true in most cases involving the acquisition of businesses holding digital assets, but the incentive for buyers may not be as strong in situations where the acquired assets are not depreciable or depreciable (eg. example, cryptocurrency or NFT).

Traditional tax considerations are further skewed when parties want to pay the purchase price using digital assets. Since cryptocurrencies are treated as goods, a purchase made using a cryptocurrency is treated as a sale of that currency. Thus, a taxable sale could result in a taxable gain or loss for the buyer, not just the seller.

Of course, non-tax considerations are also at play here. Poor corporate hygiene or regulatory non-compliance can cause a buyer to demand the sale of an asset, rather than inheriting the skeletons in the target company’s closet.

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