DeFi Accounting: A compliant and tax-ready tracking DeFi Activity

by | Sep 11, 2019 | AL, Blog, Event

DeFi Accounting: A compliant and tax-ready tracking DeFi Activity

by | Sep 11, 2019 | AL, Blog, Event

DeFi Summit London – 11.09.2019.

Alexandre Lourimi made a presentation alongside Antoine Scalia at the DeFi Summit in London to discuss DeFi Accounting and taxation.

His speech is reproduced below.

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As you know, cryptos raise many complex legal and tax issues.

The crypto legal problem

In 2017, regulators around the world began to address this issues when the ICOs appeared. The general public has heard about it and some have invested significant amounts of money. There have been many scams and many financial losses among small savers.

The regulator had to take up the subject. The tax authorities, always in advance, had taken positions as early as 2014, in France and the United States, but had remained cautious.

Before I talk more specifically about DeFi, I will quickly come back to the reasons of these issues.

The main reason, and perhaps the only one, is that cryptos are a new asset that cannot be compared to any other existing asset.

They therefore do not properly fall within any existing legal classification. However, the legal classification determines the application of regimes specific to the classification.

Cryptos are sometimes compared to financial instruments since they have speculative value and can be used as a financing tool. However, it does not include any ownership rights to the projects financed and only constitute financial rights. The application of the financial instruments regime would then be inconsistent. In tax matters, the application of a deduction for holding periods would make no sense unless it was intended to encourage users to hold.

Cryptos are also compared to gold because of their intrinsic value and economic functions. But their liquidity does not allow them to be treated as any kind of commodity.

The regulation attempt

To regulate this new asset, regulators around the world have adopted very different approaches as shown by the examples of the United States, the UK and France.

The United States has decided to regulate with existing law. The SEC has issued particularly conservative positions considering most tokens as security. The IRS has published guidelines providing that, for the purposes of tax law, cryptos are considered to be commodities and gains are taxed as capital gains. FinCEN has recently published extensive guidelines on the application of existing financial law.

The UK has also decided to regulate with existing law following the report of the Task Force bringing together the Bank of England, the FCA and the Treasury. However, a more flexible approach has been adopted. Within the sandbox, the FCA allows pre-selected projects to benefit from a non-restrictive regulatory framework to develop their technology without restrictions. HMRC has also decided to publish very comprehensive guidelines on tax treatment, which was initially very uncertain.

In France, it was decided to create an ad hoc legal framework dedicated to cryptos. The PACTE law has established a specific legal regime for ICOs and DASPs: this framework is mainly optional. It allows projects to apply for a licence to benefit from certain advantages (banking services access, whitelisting, etc.). Only exchanges and custodian wallet providers are subject to a mandatory registration procedure.

Whatever the approaches, the legal and fiscal issues raised by the first use cases of cryptos (such as ICO financing and simple trading) are now starting to be properly solved.

« But DeFi accounting already brings significant new regulatory challenges ».

The DeFi new legal problem

As in previous cases, DeFi disrupts existing legal regimes. The application of financial law and the taxation of financial transactions relies to a large extent on centralised and liable financial intermediaries.

Again, we also have a problem of legal classification.

DeFi is based on traditional financial mechanisms at the heart of which is the lending contract.

Firstly, there is therefore a challenge in classifying the contract. What type of lending contract is this? Does it involve a transfer of ownership? The answers to these questions may have tax implications.

Secondly, there is also an issue in the classification of the contract in terms of financial law. Some margin trading tools or CFDs, for example, are financial contracts under both US and EU law. However, allowing the negotiation of financial instruments requires a licence that requires a long and expensive procedure to obtain.

Finally, in DeFi accounting and tax matters, there is an important issue related to the qualification as a paying establishment of DeFi projects such as Compound or Maker and the application of withholding taxes.

In principle, institutions paying interest to clients must withhold withholding tax. This withholding is the amount of tax due by the interest beneficiary. It is paid directly by the establishment to the tax authorities. However, in the case of peer-to-peer lending, such as on a lending platform, there is a risk that the platform will be considered a paying establishment. In this case, the administration could claim the deductions at source even though they had not collected them.

Withholding taxes also raise questions about the territoriality of the tax. Indeed, the international tax treaty distributes the power to tax between states. For example, interest paid from the UK to a client in France is not treated in the same way and is not subject to the same tax rate as interest distributed in the United States. In the context of DeFi, the application of tax treaties therefore implies determining the beneficiary’s place of residence.

These concepts are decisive since they trigger the application of many obligations.

As I said, the qualification of a financial instrument involves heavy compliance obligations, financial documentation provided and complex procedures.

In addition, it also involves the implementation of anti-money laundering obligations and KYC procedures.
KYC is also essential to meet tax obligations if the platform is qualified as a paying institution. To pay the tax in the name and on behalf of their clients for the purposes of the above-mentioned withholding taxes, the paying institution must obviously know their identity but also their place of residence. This information must be communicated to the relevant tax authorities.

Finally, DeFi also raises difficulties in meeting reporting obligations.

In addition to withholding taxes, platforms qualified as paying institutions are subject to tax reporting obligations. In particular, they must communicate the total amount of interest received by them to the tax authorities.

On the user side, things are no easier regarding DeFi Accounting. Indeed, the amounts earned via lending platforms do not correspond to the same logic as capital gains realized on the sale of cryptos.

In the first case, the user receives a fee for the lending service he provides. In the second case, the user receives the benefit of a sale of an asset acquired at a lower price.

Interest and capital gains are therefore subject to different tax obligations and must be reported in different categories. In the UK, for example, capital gains are taxed at a flat rate of 10 or 18% and benefit from a tax allowance of 12,000 pounds per year. Interests, on the other hand, are taxed as ordinary income and the rate varies according to the level of income from 10 to almost 40%. The interest allowance is only 1,000 pounds per year.

However, it is currently difficult to differentiate in current lending platforms between what constitutes the capital lent and what constitutes the interest earned.

Reporting income received on DeFI platforms will therefore be particularly complicated.

At the moment, there is no perfect method to solve this problem. The idea is to one day obtain the implementation of a regime that takes into account the specificities of DeFi accounting.

In the meantime, it is particularly important to be able to accurately track transactions for both platforms and users.