Crypto asset taxation – keeping up with the trends
Joshua I Stevens
Sullivan & Cromwell, London
Lisa Zarlenga Steptoe & Johnson, Washington, DC
Stefan Richter YPOG, Germany
Pepijn Pinkse Loyens & Loeff, Netherlands
Bruno Sousa Hasdex, Brazil
Nils Harbeke Pestalozzi Law, Zurich
Antti Lehtimaja Krogerus, Finland
Report on a conference session at the 11th annual IBA Finance and Capital Markets Tax Virtual Conference
Lisa Zarlenga introduced the panel and the session’s topic. She explained that the session would not go into detail on the technicalities of blockchain, but rather focus on recent developments and emerging tax issues in this area. Specifically, the panellists would address:
- classification of crypto assets for tax purposes;
- the intersection between traditional and blockchain capital markets; and
- tax compliance and enforcement.
As a warm-up to the discussion, an online poll was taken of the attendees’ familiarity with crypto assets, which showed that the vast majority had some or significant familiarity.
Classification of crypto assets
Stefan Richter led the discussion on the classification of crypto assets. He began his remarks with a warning that he could only provide a snapshot as the landscape is evolving rapidly.
Richter highlighted the various types of tokens currently on the market:
- currency or payment tokens, which are used as a means of payment but do not qualify as legal tender (except Bitcoin in El Salvador);
- stablecoins, which are a version of payment tokens that are generally backed by a reserve with assets;
- utility tokens, which provide the holder with consumption or access rights to a service or application;
- security tokens, which are similar to traditional financial instruments in that they give a share in cash flows, earnings, asset proceeds and so on;
- governance tokens, which give holders a say in an ecosystem through automated voting procedures;
- hybrid tokens, which have characteristics of one or more of the previously mentioned tokens; and
- non-fungible tokens, which are unique, irreplaceable proofs of ownership, for example of virtual art or collectibles.
Richter next addressed how crypto assets are classified for regulatory, accounting and tax purposes. There is a wide variation across jurisdictions: different tokens might be viewed (without limitation) as intellectual property, commodities, debt or equity for different purposes. There is no clear guidance for tax; it is necessary to consider the specific characteristics of each asset case by case.
Richter highlighted some of the tax issues that can then arise. For holders of crypto assets, tax issues arise:
- when they acquire the asset;
- during the lifetime of their holding; and
- when they exit.
At the point of acquisition, significant issues include how the relevant asset should be valued and the correct VAT treatment. As for ongoing tax issues, there are questions over both depreciation and the tax treatment of income. When crypto assets are sold, the difficulty of the tax analysis can be compounded where the disposal takes place in a barter transaction (for example, for a different crypto asset). Finally, various international tax angles arise – for instance, the characterisation of crypto asset income for treaty purposes.
Richter noted that there is a distinct set of tax problems for the issuer in an initial coin offering (ICO). First and foremost is the question of whether the receipts of the offering will be treated as ‘day one’ profit. If they are, that raises a further question of how future losses incurred developing the project can be offset. Another major issue is whether selling tokens is subject to VAT. There are a host of other issues, including whether withholding tax should apply to payments and whether income should be caught by controlled foreign corporation (CFC) charges.
Zarlenga gave the current US position as an example of the uncertainty concerning how crypto assets are to be taxed: IRS 2014 guidance states that convertible virtual currency is property for tax purposes, but it does not specify what kind of property. Additionally, it is unclear whether crypto assets can benefit from certain safe harbour provisions for securities and commodities.
The main takeaway for practitioners is that they will need to engage with crypto assets on a case-by-case basis.
The intersection of traditional and blockchain capital markets
Pepijn Pinkse began with a summary of the history of blockchain capital market offerings, beginning with the first initial coin offering (ICO) in 2012. Pinkse explained how accountability problems with the first generation of ICOs led to a high number of failures and scams. As a result, ICOs have dwindled from around 1,500 in January 2019 to only a few dozen a month at the moment. That said, today’s ICOs tend to be of higher quality.
Next came security token offerings (STOs). STOs are backed by assets (such as shares in a company) and provide much greater security for investors, but at the cost of falling under the purview of securities regulation – with the attendant compliance burden and regulatory oversight for the issuer. By contrast, the currently popular initial exchange offerings (IEOs) avoid the traditional centralised structures of capital markets by using a centralised exchange instead. IEOs replicate some of benefits and requirements of traditional capital markets (know your customer and anti-money laundering checks, and high liquidity) but not others (no protection against market manipulation). The fees also tend to be high.
An evolution of IEOs are initial decentralised exchange (DEX) offerings (IDOs), which use a DEX that is operated not by an organisation but by a smart contract. Issuers are subject to community vetting rather than vetting by a central authority. There is no middleman and no fees. The downside is that the interface is hard to engage with for many people, but it is becoming more standardised and user-friendly.
Finally, there are decentralised autonomous IPOs also based on smart contracts. The key innovation here is that investors contribute a pool of capital and get to vote on the allocation of funds to offerings.
Pinkse echoed Richter’s warning that the tax analysis is highly uncertain. There is very little guidance and a host of major potential problems.
Bruno Sousa then gave an industry view of the blockchain capital markets landscape. Working for an asset management company that specialises in crypto means he has witnessed the struggles of regulators firsthand.
Sousa explained the concept of ‘Web 3’, which is the new layer of the internet being built using crypto. It has a host of applications (and, despite common supposition, little criminal activity). Its essence is disintermediation. Many Fintech companies simply become a new middleman, but decentralised finance (DeFi) is an innovation that changes this because the intermediation is performed by a smart contract. It is truly decentralised.
Sousa elaborated on the opportunities this creates for financial services. For example, a DEX matches buyers and sellers, providing liquidity like a traditional exchange but without the middleman. DeFi can also be used for lending transactions, using crypto as collateral with interest rates that change over time to reflect supply and demand. Insurance is another application, with the collective risk of a given policy shared by peers in the pool.
Sousa emphasised how different DeFi is from traditional models and the challenge this presents for tax in trying to apply old rules to new facts. He argued that new rules are needed, but that it will be a struggle for all participants while this is a work in progress.
Sousa also noted a number of operations that DeFi can perform which are entirely novel, such as yield farming and liquidity mining. He also spoke of the emergence of ‘staking’ as an alternative to mining as a way to validate blockchain transactions. Similarly, there continues to be evolution in the stablecoin space, with various types emerging:
- fiat-backed stablecoins;
- crypto-backed stablecoins; and
- algorithmic stablecoins.
The tax consequences of all of these innovations still need to be worked out.
Zarlenga agreed that few jurisdictions have answers for the tax questions posed by DeFi. Practitioners must give advice based upon first principles. She noted that the transfer of crypto assets as part of a loan, yield farming or liquidity mining may be considered a taxable event, as well as any income earned on DeFi activities. She also noted that the imposition of tax on DeFi activities could have a big impact on the development of those activities.
Tax compliance and enforcement
Nils Harbeke’s central message was that the challenges for tax compliance and enforcement in respect of DeFi are considerable.
Harbeke highlighted the information problem posed by DeFi for tax authorities, such as enforcing withholding tax obligations. In traditional finance, the middleman can provide the information needed by tax authorities. Centralised crypto exchanges can play a similar role. With decentralised structures, however, there is no middleman to turn to for the information. As a result, it is necessary to combine information from lots of sources, including individuals.
Harbeke considered what possible solutions there might be. He drew an analogy with corporate entities. Corporate entities are legal fictions for which named natural persons are required by law to take responsibility. Similarly, one solution for tax authorities in relation to DeFi might be to require decentralised networks to register as if they were an entity and nominate responsible persons. There are limits to that solution where the participants in the network are anonymous. This in turn raises the question of whether there needs to be disclosure of beneficial owners involved in DeFi transactions. Another alternative would be for governments to integrate themselves into the network using distributed ledger technology.
On this, Zarlenga noted that the US is imposing an obligation on third-party brokers to report on digital assets from 2023, and that there is uncertainty over whether the breadth of the definition could catch validators and hardware and software developers.
To conclude the session, Antti Lehtimaja spoke on decentralised autonomous organisations (DAOs), which are communities that operate under agreed rules governed by a smart contract. DAOs can fulfil multiple functions, from lending exchanges to charities. The fact that the governance protocol is programmed into a smart contract means that payments and rules are executed automatically without the need for interpretation. This does mean, however, that unforeseen situations that have not been taken into account in the programming create ambiguity. In those situations, the DAO community is able to vote in order to choose a resolution.
Lehtimaja noted some of the significant features of DAOs. These include the fact that most DAOs engage service providers for specific tasks, rather than having employees, and the fact that they often just hold a crypto wallet rather than a bank account. This means that whenever they wish to purchase something in the ‘real world’ they may need to incorporate a ‘BidCo’ for that purpose.
Lehtimaja then explained that the architecture and features of DAOs make them problematic for tax. They lack a physical presence, so it is unclear where they are resident and how they should be taxed. They sit outside the contemporary intellectual framework for tax (including Pillar 1). The concept of virtual permanent establishments may help, but not many countries have adopted this concept to date.
Building on Harbeke’s remarks, Lehtimaja also noted that the anonymity of DAO members makes the enforcement of tax reporting obligations challenging. DAOs, then, are another area where there are more questions than answers.