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Tax Tokens: A Potential Solution for DeFi

Tl;dr:  Decentralized Finance, or “DeFi,” offers an innovative way of conducting traditional finance peer to peer, without the need for intermediaries like banks or brokers. But these same features make it difficult to accurately tax DeFi transactions. While DeFi continues to attract interest from individuals and institutions around the world, the lack of government guidance on taxation has led to increasing uncertainty. This paper explores the issue of DeFi and tax and proposes the use of an optional “tax identity” attestation token linked to each transaction that can facilitate collection of a transaction tax.

By Coinbase Institute

August 22, 2023

ITL-7

I. Introduction 

DeFi encompasses a range of transformative technologies that aim to “democratize finance” 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. But unlike in TradFi, 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.

DeFi apps are typically governed and run by DAOs, a new type of organization that is user-owned and governed. Unlike traditional corporations or partnerships that delegate decision making to a board of directors or general partner, DAOs are governed collectively by their members. They are also autonomous because their protocols rely on smart contracts—software programs stored on a blockchain that execute automatically when certain conditions are met. DAOs and smart contracts are both transparent, publicly auditable, and not reliant on a single or central authority. 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 can connect their digital wallet to a DeFi app by providing only their public “key,” which is a cryptographic code that allows them to receive crypto. They 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.  

These special characteristics of DeFi, which make it so “transformative to the future of finance,” also make it difficult to shoehorn into traditional tax regimes. Tax laws were designed with traditional banking systems in mind, and rely to a great degree on intermediary reporting.  Nonetheless, taxes are a part of modern society, and the IRS has started to issue guidance and bring 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. 

This paper proposes a solution in the form of an “identity token” that would be linked to each DeFi transaction and contain necessary taxpayer information. The token could be transmitted to tax authorities accompanied by a small “transaction” tax that would effectively pre-pay the income tax due on each DeFi transaction.   

In addition to providing a solution for DeFi and tax, this proposal illustrates the value of crypto technology to transform large sections of the economy. Tokens 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

II. The U.S. Tax System Relies on Intermediary Reporting    

The U.S. Tax Code has historically relied on information reporting by intermediaries, such as employers and financial services entities, to enhance compliance. This is evident throughout the Code. For example, Section 6045 requires brokers to report customer information such as name, address, and total taxable gain or loss for the year. Section 6041 requires businesses to report certain information about payments to others, including salaries. And section 6050W requires payment settlement entities like eBay and Venmo to file an annual form on certain payments. These reports frequently involve filing one of the IRS “1099 Forms” that report information about income payments received by taxpayers throughout the year.   

Intermediaries are well placed to provide tax information because they know the type of payment being made, the amount of that payment, and the identity of the recipient. In fact, information reporting is one of the IRS’s strongest enforcement tools. But the fundamental IRS approach of relying on intermediary reporting presents serious challenges within a DeFi ecosystem. Although all DeFi transactions are transparent and visible on the blockchain, the pseudonymity of participants means that their identity is unknown. 

III. Tax and DeFi

The different characteristics of DeFi protocols can raise a variety of questions and potential tax consequences. For example, Compound is a protocol that facilitates crypto borrowing and lending. Borrowers pay fees via the protocol’s smart contracts, and parties are rewarded for their use of the protocol with COMP governance tokens. A user who lends crypto and ultimately receives more in return has received an “accession to wealth” that likely would be considered taxable income. But both the timing and nature of this gain is unclear—is it as the token exchange rate climbs, or only when tokens are exchanged, and should it be considered investment or ordinary income? And none of this income is reported by the protocol to the IRS. 

Uniswap is another popular protocol that operates as a fully decentralized exchange. It employs an automated protocol that incentivizes traders to become “liquidity providers,” which means they contribute crypto to a common pool that is used to support trades. Liquidity providers receive a token in exchange for their contribution, which they can later return for a portion of the protocol’s trading fees.  

Again, the tax implications of these transactions are unclear. U.S. resident liquidity providers may owe taxes based on their participation in the liquidity pool—it may be a taxable event to convert one’s crypto into a share of the pool. And they will be taxable on any earnings incurred when they exchange their share of the pool for the proportionate amount of crypto there. In short, users could incur taxes when adding and removing liquidity from the pool, and could owe separate taxes based on their overall crypto earnings. 

IV. Government Enforcement and Regulation 

A. Government Enforcement Actions   

Federal and state governments have begun seeking out and taking enforcement actions against users who fail to report crypto income, whether earned through DeFi or centralized exchanges. For example, the IRS has issued summonses against various crypto dealers and exchanges to obtain customer information. The agency also sent out over 10,000 “educational letters” to crypto holders in 2019 after determining they had “potentially failed to report income and pay the resulting tax from virtual currency transactions.” The IRS confirmed that it obtained the names of crypto holders through various compliance efforts.

State authorities have also threatened enforcement. In March 2022, New York Attorney General Letitia James warned that the consequences of failing to properly report crypto income “are potentially far-reaching and severe,” and could “carry significant civil or criminal penalties” or even lead to prosecution.  

B. Current and Proposed Regulation 

The IRS has issued limited guidance on crypto and tax. Its first guidance, in 2014, indicated that virtual currency should be treated as property, not currency, much like stocks. This means that holders are taxed on the sale price of crypto minus its “basis,” or the cost of acquiring it. The IRS has also issued narrow guidance on specific issues such as the tax implications of air drops, receipts of Bitcoin cash, and exchanging certain types of crypto for  another. The agency also updates its frequently asked questions on virtual currency transactions. In sum, this guidance is welcome, but very limited. 

Institutions around the world have also taken tentative steps to clarify the taxation of crypto. In October 2022, the Organisation for Economic Cooperation and Development published a Crypto-Asset Reporting Framework (CARF), which standardizes the reporting of tax information on crypto transactions, with a goal to automatically exchange such information. CARF covers the scope of crypto-assets subject to reporting, what entities and individuals must collect and report data, which transactions are subject to reporting and information reporting, and due diligence procedures to identify users and determine the relevant tax jurisdictions for exchange and reporting purposes. CARF’s definition of crypto assets targets those that can be transferred or held in a decentralized manner, which includes stablecoins, crypto derivatives, and certain non-fungible tokens (NFTs).

In December 2022, the European Union Commission proposed legislative text to amend the Directive on Administrative Cooperation eight version, or “DAC8,” to help prevent tax fraud, evasion, and avoidance by requiring all crypto-asset service providers to report all transactions of clients residing in the EU. The rules will also set common minimal penalties for serious non-compliance. In addition, the Commission recommended extending financial institutions’ reporting obligations to include digital currencies and e-money.  

C. Proposal  

The optional use of an attestation token that would allow DeFi users to provide tax identity transparency, if they choose to do so, would solve many of these issues. The tax attestation token itself would be issued by a trusted third party to the user’s digital wallet. This process has the potential to allow for better verification, accuracy and data privacy than traditional paper versions of tax identifying forms (such as IRS Form W9 or Forms W8), which can be confusing to complete, unavailable electronically or misinterpreted through human error.

The tax attestation token would remain securely in the user’s wallet and stored “offchain,” meaning that any sensitive personal information would not be publicly available on the blockchain. A separate, “onchain” tax attestation token could then be created and linked to each DeFi transaction. Users could choose to easily facilitate income tax reporting by allowing the trusted third party to associate the onchain and offchain tokens and submit necessary information to the appropriate tax agency on their behalf. This process could both preserve user privacy and facilitate the collection of DeFi taxes by essentially allowing users to prepay the tax due at the time of the transaction.

Countries would not need to require the use of such a tax token, but could amend their tax laws to impose a combination of incentives, disincentives, or penalties. For example, to encourage tax compliance, countries could offer their residents a lower overall tax obligation for DeFi transactions that are properly reported and verified. Or if residents do not use the attestation token and fail to report income from transactions, they could be subjected to increased penalties for non-compliance.  

V.  Next Steps 

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 identity attestation token. At the same time, governments should encourage and facilitate innovation of this rapidly evolving technology. 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) in order to launch a standards-setting association to discuss issues, reach consensus, work with government, and educate users.  

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