DeFi Taxation Requires an Urgent Need for Regulatory Clarity

The collapse of FTX, driven by fraudulent individuals rather than by inherent flaws in digital assets, brought negative attention to the digital asset industry. This has given way to a lot of scrutiny by the US Securities and Exchange Commission, with Coinbase receiving a Wells Notice, Kraken receiving a $30 million fine and being forced to shut down its staking service, and Bittrex leaving the US.

The combination of potential “rug-pull” risks from centralized exchanges and regulatory scrutiny is driving crypto users back to decentralized finance and decentralized exchanges, resulting in an increase in assets locked across DeFi protocols from $38 billion at the start of the year to more than $47 billion currently. These platforms offer peer-to-peer trading with users retaining control of their assets, effectively negating the counterparty risk associated with an exchange’s potential failure.

Money laundering is a significant risk. When swapping on a DEX, users can’t ensure they’re not inadvertently receiving, for instance, tokens that were previously stolen or originated from sanctioned individuals and countries. Financial institutions lack the technologies and procedures for conducting thorough anti-money laundering due diligence.

A recent report from the Department of the Treasury shows risk awareness of illicit finance. But many taxpayers still are actively swapping, providing liquidity, and using apps. And when it comes time to report taxes, there’s been little guidance on the tax implications of many DeFi activities.

Taxation Complexities

DeFi introduces a layer of complexity to the already challenging landscape of cryptocurrency taxation. While the IRS has issued guidance, it hasn’t addressed many issues on DeFi, leaving taxpayers in a gray area.

In the existing guidance, cryptocurrencies are treated as property, which means that any interaction with DeFi protocols could result in capital gains and income tax liability. However, DeFi transactions aren’t as straightforward as traditional asset transactions, making it difficult to apply existing tax laws.

Two common DeFi activities, liquidity pooling and staking, illustrate the tax complexity introduced by these protocols. Liquidity pooling involves users depositing pairs of assets into a pool, which then serves as the infrastructure for a DEX. In return, they receive liquidity tokens.

It’s unclear whether this deposit should be considered a taxable disposal, leading to confusion and inconsistent practices even among professionals. Adding another layer of complexity, Uniswap V3, unlike V2, mints non-fungible tokens instead of liquidity tokens. Because users don’t return these NFTs when they remove liquidity, it raises further questions about tax treatment.

As the volume of transactions on Uniswap V3 grows, so does the uncertainty of its tax treatment. Similarly, earning staking rewards can be seen as earning interest income, but the fluctuating value of the tokens and lack of immediate liquidity add another layer of complexity to the tax considerations that the government hasn’t wanted to tackle.

Infrastructure Shortcomings

Centralized exchanges, which function similarly to traditional banks, are no strangers to tax reporting. The infrastructure bill imposes an obligation on these platforms to report digital asset transactions via 1099-DA forms, akin to the 1099-B forms for securities. However, DeFi’s nuances create considerable obstacles in the path toward accurate reporting.

A significant challenge in DeFi tax reporting is establishing the correct tax basis, whether due to data challenges or lack of tax guidance. In crypto, where assets often move in high volume between DeFi and centralized exchanges, it can become a labyrinthine task. One of the likely solutions around this may be gross proceeds reporting. However, the fundamental principle of taxation is that it’s calculated on gains, not on the absolute transaction value.

The infrastructure bill’s requirements presume a level of information control and transparency that DeFi platforms, by their very nature, don’t have. The decentralized essence means there’s no central authority to track the basis of each token as it moves within the ecosystem.

In light of this, the question arises: How can taxpayers, and even the IRS, have reliable reporting when the very foundations of establishing a tax basis are elusive at best? As it stands, the current reporting infrastructure and forthcoming 1099-DA regulations may not be equipped to deal with the realities of DeFi, leaving a considerable gap in accurate tax reporting.

Clear Tax Guidance in DeFi

Real people are making real gains in the world of DeFi, and they’re suffering real losses, all of which have tangible tax implications. This places an urgent need for clear, reliable tax guidance.

Current ambiguity leaves taxpayers, many of whom may not have access to professional help, to guess the best treatment or rely on third-party guidance that lacks authoritative weight. However, the challenge goes beyond just providing clear guidance. The DeFi space is known for its share of bad actors.

So how do you tax a system in which malfeasance is a known issue? How do you regulate such an environment? The situation is akin to attempting to ratify a constitution while a nation is embroiled in war. It’s a complex, messy endeavor, but it doesn’t diminish the issue’s urgency.

Conclusion

The complexity of DeFi taxation underlines the need for a robust, responsive regulatory structure. While DeFi holds enormous potential for financial inclusion, innovation, and enhanced market efficiency, it’s crucial to confront and manage the inherent risks involved.

Despite the shared characteristics with other cryptocurrencies in terms of taxation, DeFi stands out because of the absence of explicit IRS guidelines and its intrinsically decentralized nature. As DeFi continues to evolve, it’s imperative for stakeholders to innovate, collaborate, and navigate the taxation and anti-money laundering challenges in a way that bolsters the sustainable growth of this sector.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

David Canedo, CPA, specializes in taxation of digital assets. He is the head of tax and compliance strategy at Accointing by Glassnode, a subsidiary of Glassnode that provides tracking, consolidation, tax, and compliance solutions for crypto investors.