Tokens as a potential solution for DeFi and tax

At Coinbase, we’re working hard to help update the financial system by building trusted products that expand the utility and adoption of crypto because we believe crypto and blockchain technology can increase economic freedom and opportunity around the world. Coinbase chose to become a public company in the US because we believe the US would best be served by embracing this fundamental innovation, but we’re also focused on international markets, many of which are moving forward with strategies to become “crypto hubs.” We would like to see the US take a similar approach, but a regulation-by-enforcement approach in the US is instead leading to a disappointing trend for crypto development in the US. One of the many innovations that holds enormous promise in the US but also raises questions of regulatory clarity is decentralized finance, or “DeFi.”  

DeFi encompasses a range of transformative technologies that make finance more open and accessible by enabling direct peer-to-peer transactions. It includes many of the same products and services as traditional finance, including lending and borrowing, exchanges, derivatives, and insurance. As explained below, however, the tax treatment of DeFi services, as with many types of digital asset transactions, is currently unclear. Just this month, the Senate Finance Committee sought input from experts and stakeholders on the taxation of digital assets, acknowledging that the current lack of clarity has made reporting difficult for taxpayers. 

Historically, tax laws have been designed with traditional banking systems in mind, and rely to a great degree on intermediary reporting. But in DeFi, there is no third party intermediary. Rather, DeFi leverages blockchain technology, decentralized autonomous organizations (DAOs), and smart contracts to enable trustless, peer-to-peer financial transactions over the internet. These special characteristics, which make the technology so transformative, also make it difficult to shoehorn into traditional tax regimes. 

For example, DeFi apps are typically governed and run by DAOs, an organization that is governed collectively by its members, and can function autonomously because their protocols rely on smart contracts — software programs stored on a blockchain that execute automatically when certain conditions are met. This arrangement facilitates a “trustless” system, which is seen as essential to the proper functioning of a decentralized, digitally native community. Transactions on DeFi protocols are also pseudonymous — transparent and public, but not linked to a user’s real-world identity. Users do not need to provide a name, address, or other identifying information, and will not receive an IRS form from the DeFi protocol, as taxpayers typically would for savings accounts.  

Nonetheless, taxes are a part of modern society, and the IRS has begun issuing guidance and bringing enforcement actions against taxpayers with unreported crypto income. The crypto ecosystem now has the opportunity to develop digitally native solutions that balance transparency and compliance with user privacy and decentralization.

A new primer by the Coinbase Institute proposes a solution in the form of a tax attestation token that could be issued by a trusted third party to the user’s digital wallet. The token would remain securely in the user’s wallet and stored “offchain,” protecting users’ sensitive personal information. A separate “onchain” tax attestation token could then facilitate income tax reporting by allowing the third party, such as an exchange, to associate the two tokens and submit the information to the appropriate tax agency on a user’s behalf. This would allow users to essentially prepay the tax due at the time of the transaction.

In addition to suggesting a potential solution for DeFi and tax, this proposal illustrates the value of crypto technology to transform large sections of the economy. Tokens in particular can increase efficiency in “creating, issuing, and managing assets” and making markets more secure and transparent. In the tax arena, top accounting firms have recognized that blockchain technology and smart contracts can streamline and automate indirect tax collection and be used to provide reimbursements and perform on-chain audits. Tokens can also enable more streamlined and efficient compliance monitoring, as discussed in the Coinbase Institute’s paper on crypto technology and illicit finance. 

Coinbase believes that crypto entities should continue to actively engage with governments and other standards-setting organizations globally to develop a fair and accurate tax regulatory framework for crypto, including the possible use of an optional tax attestation token. Such a token could provide greater compliance and transparency, and reassure market participants who want to engage in DeFi transactions but are hesitant to do so without knowing the identities of their counterparties. This new paradigm could be spearheaded by the U.S. government, the OECD, the European Commission, or another non-U.S. taxing authority (similar to the Common Reporting Standard, which was spearheaded by the OECD to facilitate the exchange of tax information among TradFi institutions). Specifically, Coinbase supports launching a standards-setting association to discuss issues, reach consensus, work with government, and involve and educate users.  

For more on the potential of crypto-native solutions for tax, explore the Coinbase Institute’s primer on Tax Tokens and DeFi. Coinbase is committed to building the most trusted products, services, and tools, and we look forward to further exploring this topic with policymakers.