No Match Found
The exponential growth of decentralized finance (DeFi) has brought access to, and interest in, these platforms to a wider range of users — from individuals to institutional investors and multinational organizations. The technology makes sophisticated finance transactions available to all kinds of users in a variety of locations.
Although other jurisdictions (e.g., United Kingdom) have started issuing tax guidance in this area, to date taxation of DeFi transactions has not been specifically addressed in published guidance by US tax regulators. As individuals and entities navigate this uncertainty, it is notable that all the characteristics that make DeFi transformative to the future of finance also are features that make it challenging to address from a US tax standpoint.
We outline below the fundamental features of a DeFi ecosystem, and highlight how they can affect the US taxation of the transactions entered into through the ecosystem.
The key takeaways are:
Action item: Investors and traders should start now to gather relevant information to make these determinations with the goal of having sufficient time to identify US tax consequences. This is particularly important where such information is not stored in a centralized account or reporting technology, or where such reporting technology does not capture all relevant data to facilitate required US tax reporting.
DeFi is a term used to describe a blockchain ecosystem in which participants can interact (via smart contracts) to engage in transactions typically engaged in today via traditional finance channels.
DeFi as a concept generally reflects five core tenets:
These five core features allow users to lend and borrow in cryptocurrency, create smart contracts or arrangements that derive their value indirectly from one or more cryptocurrencies, and/or earn periodic income (or yield) from participating in one or more of these transactions. The platforms themselves may fulfill a number of roles traditionally satisfied by financial intermediaries, such as exchanges, market makers, dealers, and banks. Purchasers of the tokens (which are used to support and pay transactional gas fees on these networks) benefit when more users use the platform (through either periodic income and/or appreciation in the tokens). Further, holders of the tokens may make them available (via staking) to help support validation of transactions on the network, earning additional returns or yield.
US income taxation generally is transactional — i.e., imposed at the time of receipt or sale of a token, with exceptions. In general, value fluctuations are not taxed between purchase/acquisition and sale (or disposition) of the token. Taxable events occur when a person does something with that token.
Timing of recognition of gain on transfers/exchanges: Although these platforms may use the terms “loan,” “lending,” and “yield,” the current US tax rules do not protect all loans of property from the recognition of gain.
Observation: Under current tax law, these transactions are not covered by the rules that protect loans of securities from the recognition of gain or loss. There are legislative proposals to broaden such protection to cryptocurrency loans, but even if such a proposal were enacted, it might not cover most DeFi platforms as currently structured.
Timing of recognition of periodic income: Participating in certain DeFi protocols entitles the holder to receive, or have set aside/credited to their account, additional tokens (representing “yield” or a portion of the fees earned on the platform).
The timing of income from these arrangements when paid in cryptocurrency is the subject of ongoing debate:
Observation: This question is further complicated in the DeFi context because DeFi protocols differ as to when the tokens are received, may be claimed, or are restricted from receipt by the token holder. The more meaningful restrictions on the receipt of the tokens, the less likely the tokens may be viewed as taxable until such restrictions lapse.
Amount of gain or income: The amount of taxable income or loss realized upon exchanging cryptocurrency for the DeFi token (and return receipt of cryptocurrency when exiting the DeFi protocol) is measured based on the fair market value of the cryptocurrency and token received or disposed of at the time of the exchange.
Observation: In many DeFi protocols, this information is not readily available and needs to be tracked separately by the taxpayer.
Character of income: The character of the income, deduction, gain or loss (which affects the tax rate applied and the items against which gains and losses can be netted) depends on the kind of income:
Observation: Such treatment could result in a potentially unfavorable whipsaw if yield (paid in tokens) is included as ordinary income when the trading price is high and then the token is sold when the price has dropped, resulting in taxable ordinary income at a higher rate and an inability to offset that amount with the loss on the sale of the token (because capital losses generally cannot be used to offset ordinary income).
Impact for non-US persons: Certain kinds of “periodic” income, if US source, may be subject to information reporting and withholding at source (at a rate up to 30%) if paid to a non-US person. Further, certain kinds of activities are taxable currently in the United States on a net basis if treated as “effectively connected” to a “US trade or business” (and in such cases may give rise to a requirement to file US tax returns).
Observation: Given the uncertainty in this area, prudent taxpayers will want to assess the risk specific to an investment with a qualified tax advisor.
Tax information reporting for US persons: Information reporting and backup withholding are required for certain types of payments (interest, dividends, other income, fees, etc.) and certain transactions (brokered dispositions, etc.). These payments and transactions give rise to information reporting that may have to be sent to both the IRS and the taxpayer.
Observation: The scope of these information reporting rules is not yet clear. The Treasury Department and the IRS are working on published guidance to clarify the application of these rules (with an expected effective date of January 1, 2023).
Global tax information reporting under the Common Reporting Standard (CRS) and the Crypto Asset Reporting Framework (CARF):