The potential tax trap of DeFi

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Decentralized finance (DeFi) is a catch-all term that refers to a category of business where decentralized applications provide financial services using a blockchain for transaction settlement. The defining characteristics of DeFi are the operation without centralized intermediaries (i.e. they operate on smart contracts), the execution of peer-to-peer transactions and the use of open protocols which allow combinations flexible of different protocols.

There are many different DeFi applications – this article will focus on DeFi lending transactions. Users often engage in many different loan transactions on many different platforms, trying to maximize the fees or rewards earned on those transactions. These users may not be surprised to learn that the fees or rewards are taxable, since interest earned on lending money would normally be taxable. But the possibility of Uncle Sam collecting taxes on every cryptocurrency loan and repayment may surprise users, creating a tax trap that could harm the booming DeFi industry.

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Many tax advisers have argued that according to decades-old tax guidelines applicable to securities lending, cryptocurrency lending should not constitute taxable exchanges. However, this argument may be stronger for centralized cryptocurrency (CeFi) lending than for DeFi lending. The IRS has not provided guidance on this issue, so taxpayers are left in limbo.

CeFi versus DeFi transactions

In a centralized crypto lending transaction, a centralized party lends cryptocurrency to users. For example, a client can use the loaned BTC to complete a short sale. After a certain time, the client will repay the loan, along with a commission or reward based on the loan amount and the length of time between the advance and loan repayment (similar to an interest payment).

In a DeFi lending transaction, there is no centralized trusted party to act as the lender. Instead, any holder can deposit the cryptocurrency they intend to lend into a pool using a smart contract. Borrowers can then borrow the cryptocurrency held in this pool. As part of the smart contract, the lender will receive the native token of the platform (e.g. DAI, COMP or aTokens). These native tokens can then be traded so that the holder can get back the cryptocurrency they provided to the pool plus a fee or a reward similar to the interest payment.

Securities lending as a model

The IRS has concluded that cryptocurrency is treated as property for tax purposes and not as cash. Although the loan of money and its repayment are generally not taxable, a loan of property may be. The IRS has not provided any guidance on the tax treatment of crypto lending transactions, so taxpayers and their advisors should look for analogies to determine the tax treatment.

Securities lending transactions proceed in much the same way as centralized crypto lending transactions, so they are a natural analogy. Under Section 1058 of the IRS, taxpayers providing securities lending can generally avoid recognizing a taxable gain if they meet certain conditions. However, a “security” for this purpose is defined as “any share of a company, stock certificate or interest in a company, note, bond, debenture or evidence of indebtedness, or any evidence of an interest or a right to subscribe or purchase any of the above. Since cryptocurrencies generally do not fall under this definition of a security, taxpayers generally cannot rely on Section 1058 for cryptocurrency lending transactions.

In the absence of a statutory rule, taxpayers and their advisers have turned to the common law rules that governed securities lending transactions prior to the enactment of Section 1058 in 1978. In a 1926 case titled Provost vs. United States, the Supreme Court held that a securities lending transaction should be treated as an exchange rather than a loan, at least in the typical case where the borrower obtains unlimited power of disposition over the advanced securities.

Read more: You Might Have To Pay Crypto Taxes On These Surprising Things In 2022

Normally, treatment as an exchange means the transaction is taxable. However, the IRS has always treated typical securities lending as tax-exempt transactions by broadly defining the parameters of the exchange. The IRS treated the securities lending as a deferred exchange, viewing the lender as exchanging the loaned shares for different shares of the same security which were then repaid. Since the property lent and the property repaid were not materially different in kind or extent, this deferred exchange did not result in the recognition of a gain by the lender.

If the IRS had split the transaction into two separate exchanges – first an exchange of the loaned securities for the borrower’s promise to repay, then a separate exchange of that promise for the repaid securities – it likely would have resulted in an exchange taxable on the loan and repayment because the promise to pay is materially different from the underlying securities.

A crypto lender may rely on these same authorities to avoid recognition of gain on a crypto lending transaction that is otherwise structured to comply with Section 1058. The lender may be considered to be entering into a deferred exchange where, for example, the 3 BTC loaned are exchanged with another 3 BTC refunded later. As long as the borrower makes the repayment using the same cryptocurrency, it could be argued that this deferred exchange should not lead to the recognition of a gain.

However, as mentioned above, in DeFi lending transactions, the lender can receive the platform’s native token, which can then be exchanged for the loaned cryptocurrency, but can also be exchanged in its own right. As such, it may be more difficult for a DeFi lender to assert that they have engaged in a single deferred exchange of the cryptocurrency lent against the cryptocurrency repaid, rather than a pair of exchanges. separated – a transfer of the cryptocurrency for the native token, and then the transfer of the native token for the repayment of the lent cryptocurrency.

Bigger implications

Taxing cryptocurrency lending and redemption would add a significant amount of tax friction to DeFi lending transactions and could stunt the growth of this emerging industry. Although the IRS has not provided guidance, a few other countries, including the UK, Norway, and Australia, have concluded that issuing and repaying a DeFi loan can result in a taxable income, triggering a negative trend.

Congress should step in and create a legislative exception for crypto lending similar to the one for securities lending in Section 1058. Such an exception would create certainty for cryptocurrency lenders and for the DeFi industry as a whole.

Further Reading from CoinDesk’s Tax Week

The automatic tax is coming

Crypto won’t save you taxes, but it could possibly make them easier to pay, says futurist Dan Jeffries.

How to Avoid Getting Rekt Through Crypto Taxes

Tax advice is lagging behind innovation. The same goes for tax software. Meanwhile, misconceptions abound. If not careful, investors may end up owing more taxes than expected and having to offload the crypto to pay the bill

Taxes Are A Wildcard For Public Companies Holding Crypto

Investors in MicroStrategy, Tesla, Block and Coinbase need to consider how wild price swings will affect results, not only directly but indirectly due to complex tax accounting rules.

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