Decentralised finance: how blockchain-based finance works and how it is treated for tax purposes (2023)

Michael Gallagher

Walkers (Ireland), Dublin

michael.gallagher@walkersglobal.com

Report on the session of the Taxation Section at the 12th Annual London Finance and Capital Markets Conference in London

Tuesday 17 January 2023

Session Chair

Niklas Schmidt Wolf Theiss, Vienna

Speakers

Pallav Raghuvanshi Greenberg Traurig, New York

Stefan Richter YPOG, Hamburg

Elise Tek CMS Francis Lefebvre, Paris

Bruno Ramos de Sousa Hashdex, Rio de Janeiro

Marcel Jung MLL, Zurich

Introduction

The panel on decentralised finance (DeFi) discussed how blockchain-based finance works and how it may be treated for tax purposes for individuals in the respective jurisdictions of the panellists. As an introductory remark, the panel noted the absence of specific tax legislation dealing with DeFi, and that the discussion would focus on explaining how typical transactions work and possible interpretations of how such transactions could be treated for tax purposes in the case of individuals only. The panel, which was chaired by Niklas Schmidt, discussed the following topics:

• What is DeFi?
• How are lending transactions on marketplaces like AAVE taxed?
• How is the provision of liquidity on decentralised exchanges (DEXes) like Uniswap taxed?
• How is the provision of insurance coverage on Nexus Mutual taxed?
• What are the tax consequences of DeFi ‘rug pulls’?

Panel discussion

What is DeFi?

Schmidt explained that DeFi can change the world of finance by replacing banks and intermediaries with apps and code running on blockchains.

How are lending transactions on marketplaces like AAVE taxed?

Schmidt explained that, on AAVE, lenders deposit crytpoassets to an address maintained by a smart contract and AAVE pays out interest to the lender.

Pallav Raghuvanshi explained that a user who lends cryptoassets to the AAVE protocol receives a token that represents a receipt for the token lent to the protocol. When the user sends the receipt token to the protocol, the user receives the original amount of cryptoassets lent to the protocol plus accrued interest. If a virtual currency is viewed as an exchange for another virtual currency that represents ‘value that functions as a medium of exchange’, the transaction will be taxable in the United States.

Raghuvanshi noted that because a DeFi loan in an AAVE transaction has no clear fixed maturity, interest rate, loan documentation or an obligation to pay ‘money’ (as cryptocurrency is property for tax purposes), it may not be a ‘loan’ for US tax purposes. However, because the receipt token only represents the right to reclaim the deposited tokens and has no value that functions as a medium of exchange, it is likely that the exchange of cryptocurrency for receipt tokens is not a taxable exchange. Additional tokens received as interest would be taxable as ordinary income. For borrowers, collateral posted on a DeFi platform could be treated as a taxable exchange of one virtual currency for another resulting in a gain or loss because the borrowed token would generally represent value that functions as a medium of exchange.

Stefan Richter explained that, in Germany, lenders retain economic ownership of the cryptoassets lent/deposited on AAVE, so there should be no taxable exchange. Interest on the lending of cryptoassets is taxed at marginal rates. The borrower depositing collateral is the economic owner of the asset, unless the asset was converted by the protocol on liquidation of the collateral.

How is the provision of liquidity on DEXes taxed?

Schmidt explained that DEXes such as Uniswap are computer programs that allow users to exchange crypto currencies. On Uniswap, liquidity providers (LPs) could, for example, supply Ether (ETH) and DAI Stablecoin (DAI) to a liquidity pool in exchange for LP tokens, which certifies that they can receive their ETH or DAI back at a later point in time. The ETH and DAI supplied by all LPs are used to carry out exchanges of ETH into DAI or DAI into ETH.

Richter explained that, in Germany, if you still bear the risk of loss of the asset provided to the DEX, you may still be the economic owner. However, it could be argued that the LP doesn’t know what it will get back, which indicates that it is not the economic owner. If so, this could be regarded as a taxable private sale transaction.

Raghuvanshi explained that, under Internal Revenue Service (IRS) guidance, the exchange of tokens for LP tokens is likely to result in a taxable exchange, as would the exchange of LP tokens against the underlying tokens at the time of redemption. This may provide the potential for tax planning to convert ordinary income to capital gains.

Ramos de Sousa explained that, in Brazil, there is very limited guidance, but the exchange of ETH and DAI for LP tokens is subject to capital gains tax. Profits from providing liquidity are subject to income tax.

How is the provision of insurance coverage on Nexus Mutual taxed?

Schmidt explained that Nexus Mutual provides insurance in a decentralised manner against hacks and bugs in DeFi smart contracts.

Marcel Jung explained that, in Switzerland, there are no rules in place for an insurance protocol such as Nexus Mutual. The insured party cannot pay premiums to a protocol such as Nexus Mutual under Swiss law because Nexus Mutual has no legal personality and cannot be a counterparty.

Jung mentioned that a decentralised autonomous organisation (DAO) such as Nexus Mutual could be a contractual construct between all participants or a simple partnership, so that a contractual agreement and thus a counterparty are provided. Nexus Mutual insurance cover protects against losses of tokens. For the insurance cover holder, the cover premium is tax deductible in Switzerland. A payout from the protocol is regarded as a tax-free indemnity. For the risk assessor, the treatment of cover premiums should be regarded as other taxable income.

Raghuvanshi noted that US federal tax rules do not recognise a DAO. If a DAO is formed outside the US, it is likely to be viewed as a corporation because all its members have limited liability, and such an entity could be treated as a passive foreign investment company, which may be subject to certain adverse US tax implications for US members.

Richter noted that the participants could be subject to insurance premium tax, including filing and payment obligations because blockchains could come within the meaning of an insurance contract while the DAO itself is not domiciled in the European Union.

What are the tax consequences of DeFi ‘rug pulls’?

Schmidt explained that rug pulls are hacks in which hackers target DeFi protocols, for example, by exploiting a bug in the software.

Ramos de Sousa explained that most rug pulls come from some form of deficiency in a smart contract that pulls value out of the tool. Trading investors who suffer losses in a DeFi rug pull may be able to claim a capital loss deduction to offset capital gains in Brazil.

Raghuvanshi noted that, in the US, a taxpayer can claim worthless securities deduction as a capital loss only if a specific cryptoasset is considered as a security for US tax purposes. Most cryptoassets may not be characterised as securities for US tax purposes. There are two types of losses: personal theft loss and business theft loss. Personal theft losses are only available for a federally declared disaster. Therefore, the only recourse could be a business theft loss, which could be claimed as an itemised deduction. Alternatively, a holder can dispose of the asset in a taxable transaction to claim a capital loss.

What should we know about DeFi regulation in the EU?

Elise Tek explained that the EU is moving forward with a first attempt to regulate blockchain through a proposed EU regulation on cryptoassets (MiCAR). MiCAR would apply to entities that issue cryptoassets or provide services related to cryptoassets within the EU, but it does not address DeFi.

Tek mentioned that the EU Directorate-General for Financial Stability, Financial Services and Capital Markets Union issued a report on approaches to DeFi regulation, proposing: (1) leveraging regulated entities to provide their addresses on protocols to enable a macro and micro prudential approach to regulation and risk management; (2) a voluntary compliance regime for DeFi actors; (3) a public observatory; and (4) relying on oracles who constitute the interface between DeFi and the real economy.

Conclusion and final remarks

Ramos de Sousa noted that, while regulated activities have a place, there is value in virtual assets that cannot be taken by a government and in protocols that cannot be stopped. He suggested that, if you have a central bank monitoring each transaction, it is a small step away from censorship and could create issues in terms of free speech and civil liberties.