DeFi Will Be Taxed? U.S. IRS Holds Hearing

Is DeFi Subject to Taxes? U.S. IRS Conducts Hearing

Author: Matthew Lee

On November 15th, Beijing time, the Internal Revenue Service (IRS) of the United States held a highly anticipated hearing to discuss expanding the scope of taxation for cryptocurrency assets. This hearing covered many key issues, including user privacy, the scope of encrypted entities required to report transaction information, the inclusion of stablecoins, applying proposed regulations to participants in decentralized finance, and reporting wallet addresses.

The rapid development of DeFi has made it the focus of regulators’ attention. According to a study by Barclays Bank, the cryptocurrency tax gap is at least $50 billion. This move is aimed at the vague definition of DeFi projects, the lack of taxable history, the lack of experience in dealing with on-chain transactions, and the difficulty of regulating entities impersonating DeFi entities, so the IRS is trying to ensure tax transparency and integrity by including them in the regulatory framework.

The main focus of the hearing revolves around the definition of “brokers”. According to proposed regulations formulated in August, the definition of brokers could be expanded to include “digital intermediaries that directly or indirectly impact the sale of digital assets”, which would directly include DeFi, non-custodial wallets, and wallet developers in the scope of brokers. Brokers would be required to be responsible for the following:

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• Taxpayer’s name, address, and taxpayer identification number;

• Name, type, quantity, date, and time of the digital assets sold;

• Total proceeds received by the seller from the sale (including exchange proceeds and on-chain proceeds);

• Total proceeds received by the broker as transaction fees;

• Wallet address where the seller transferred the digital assets;

• Transactions occurring on the blockchain related to the sale or transfer into the account, along with transaction identifiers or hashes related to the sale.

In simple terms, the IRS requires decentralized projects that rely on code operations such as Uniswap, Sushi, Metamask, etc., to conduct KYC on all users, including tracking transactions that occur on exchanges and on the blockchain, as well as determining the users’ on-chain transaction trends and profits.

Although this hearing has been criticized by the public, there are some existing issues in the current market: 1. The significant growth in trading volume on decentralized exchanges; 2. The inability to track funds transferred in non-custodial wallets; 3. Private wallets (lack of third-party reporting) leading to increased illegal activities. This has led many market experts to believe that expanding the scope of taxation will become inevitable, with the formal bill expected to be introduced in 2025.

What will be the impact of expanding the scope of taxation?

Users

In addition to reducing a certain amount of income, users will also face the burden of complex data processing and paperwork. The provisions in the 2021 Infrastructure Investment and Jobs Act in the United States previously directed the IRS to implement new rules for cryptocurrency brokers. If the scope of taxation is expanded, digital brokers will be required to report tax cost basis, and the complexity of calculating cost basis will bring more problems for brokers, taxpayers, and the IRS. Taxpayers have two options when calculating cost basis:

1. First in, First out (FIFO, default): If you bought Bitcoin at prices of $1000 and $2000, and then sold it at $4000, FIFO assumes that you sold the Bitcoin purchased at $1000.

2. Specific Identification: This method allows taxpayers to choose which digital assets to sell, minimizing tax burdens selectively. However, it requires taxpayers to provide clear identification and tracking for each transaction.

Based on specific identification, taxpayers need to dig deep into not only the exchange but also the on-chain transaction records that can be traced back several years. They must mark specific Bitcoin in their inventory that they intend to sell, even if they delegate the task to a broker. It must be identified in the on-chain or exchange history which specific assets they want to sell.

Simple FIFO may lead to additional taxation because the United States has two types of applicable tax rates: long-term and short-term. Short-term rates apply to assets held for less than a year and are subject to progressive tax rates. Long-term rates apply to assets held for more than a year and even the highest tax bracket only requires a 20% tax payment, whereas short-term rates require 37%.

The IRS also acknowledges that collecting cryptocurrency taxes would involve massive paperwork. The massive on-chain data could increase the 1099-DAs of 13 to 16 million taxpayers by 8 billion. Currently, brokers do not have the ability to support specific transaction identification. Users currently have to rely on systematic learning of basic tax knowledge and use on-chain data tools to track and record transactions, transfers, and holdings of digital assets for targeted tax reporting.

Industry

Complete transaction records are needed for tax purposes to calculate Cost Basis, capital gains, fair market value, etc. However, tracking asset changes on exchanges, wallets, and decentralized protocols is a complex task. The IRS has difficulties producing tax reports directly. According to relevant institutions, tax reports from over a million cryptocurrency investors are inaccurate.

IRS discloses cryptocurrency tax investigation methods; Source: Cointracker

In the future, businesses and tax authorities will rely on on-chain and centralized data to build more intelligent automated tax systems similar to TurboTax and H&R Block. This system will integrate on-chain records including purchases, sales, airdrops, forks, minting, swaps, and gifting. However, this mechanism may result in a large amount of public information becoming available, undermining the “decentralization” ideal that the industry strives for.

Public Opposition

Tens of thousands of people have voiced their opposition to this hearing. Most people believe that such excessive regulation will violate personal privacy rights and undermine individual freedoms. This concern also reflects the public’s worry about excessive government intervention and the belief that regulations should protect basic rights of citizens while maintaining social order. Congress has attempted to include “any decentralized exchange or peer-to-peer market” in the definition of intermediaries, but it was ultimately rejected. Now, the IRS is reinterpreting the definition of “broker” using language similar to the concept of intermediaries, going beyond the statutory definition. As a result, these actions have raised questions regarding potential violations of administrative law.

In the author’s opinion, taxation of DeFi is unrealistic. Over 95% of projects in the market do not generate positive cash flow and are in very early and fragile stages. Imposing taxes would burden DeFi projects further.Expanding the scope of taxation (to non-custodial wallets) would also put tremendous pressure on the market. After Biden increased capital gains tax for the wealthy in 2021, Bitcoin experienced a significant drop. If a new tax system is implemented, extending to on-chain assets, there will be more users engaging in tax-loss trades, selling for profit before officially paying taxes to reduce the tax burden.

Taxation still has a long way to go involving multiple government agencies, and there are still many areas of ambiguity: such as whether stablecoin transactions need to be reported and how non-financial assets are confirmed. The Vice President of Tax at Coinbase said during a hearing, “Reporting taxes without profit or loss (including stablecoins) will result in a large number of low-value reports.” A senior advisor to the Blockchain Association also stated that the proposal is too broad, forcing decentralized projects to face two options: 1. Abandon decentralization technology; 2. Stay away from the United States.

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