DeFi uses and their tax implications

Whether by coincidence or consequence, the COVID-19 pandemic period was accompanied by an explosive growth in the use of decentralized finance protocols. After the total amount of value of this sector grew to 14 times its size from the start to the end of 2020, the sector quadrupled in size through 2021. Clearly, more investors are finding value in what was once a fringe investment option.

Decentralized finance, or DeFi, is a way to use blockchain-enabled protocols and cryptocurrencies to undertake financial transactions, in many ways substituting for the roles traditional financial institutions typically play. The attraction of DeFi is that doing so doesn’t require the regulated steps involved in traditional financial transactions, giving users a higher level of control and speed. DeFi enterprises also tend to forgo fees and other charges for transactions associated with banks. The use of DeFi protocols also often results in better returns than users can obtain as compared to using traditional financial institutions for similar transactions (which is also accompanied by some increased inherent risks in the use of the technology).

“When you go to a bank or a securities broker, you have to fill out personal identification information, go through a client acceptance process, etc.” said Leo Chomiak, a partner in International Tax for Grant Thornton. “In crypto, you don’t have that.” Increasingly, companies may turn to blockchain and DeFi options to handle some business financial operations, like basic treasury functions. It also means, Chomiak said, that it can be more difficult to account for when complying with a company’s tax obligations.

A wealth of options

To see why, it helps to have a sense of what is possible in DeFi. Eric Coombs, Grant Thornton’s national tax leader for Asset Management, said a typical DeFi transaction could go like this: Let’s say there is $50,000 sitting in a savings account earning less than 1% interest a year. Using that $50,000, a user could purchase a digital asset – buying the equivalent of $50,000 in stablecoins (which are meant to replicate the value of a dollar on the blockchain), and depositing those stablecoins onto a DeFi platform to earn somewhere in the neighborhood of 3% annual interest, thus tripling the return.

What makes this all possible are centralized crypto platforms such as Coinbase, Binance, FTX, Kraken, and many others, that allow investors to open accounts with fiat currencies.  These centralized exchanges (CEXs) then provide the means to swap fiat currency for a wide variety of cryptocurrencies, and some even allow users to “stake” cryptocurrencies in accounts that generate yield.

Coombs said decentralized cryptocurrency exchanges (DEXs) are also gaining in popularity due to their ability to provide more control over crypto transactions. Uniswap is the dominant DEX at the moment, though competitors are emerging.

But Garrett VanHoutteghem, a senior manager in Tax Reporting and Advisory in Grant Thornton, said one of the risks to crypto platforms is they don’t have the federal backing provided to banks to counter failed loans. VanHoutteghem said in order to counter this, DeFi companies are exploring some innovative ways to create usable collateral in crypto from tangible assets such as real estate. The goal is to be able to “tokenize” the value of the property to make it usable as collateral that is able to have a cryptocurrency value assigned to it.

Where are the controls?

When it comes to tax obligations, Coombs said, at present there really isn’t a mechanism for taxing bodies – federal, state or local – to monitor DeFi accounts – the concept is just too new. Right now, governments have to work on trust -  trust that a taxpayer that transfers its assets from a bank to a blockchain will have auditable records of that transaction and any subsequent transactions that occur on the blockchain thereafter.

Perhaps the largest outstanding issue in DeFi regulation in the U.S. is deciding which federal body should actually regulate cryptocurrencies as a whole. Some commentators argue that the SEC should have regulatory authority over cryptocurrencies. However, recent legislative proposals have suggested that the Commodity Futures Trading Commission (CFTC) may ultimately be given the authority to govern the space.  

Regardless of which body ultimately has regulatory authority over cryptocurrencies in the U.S., it’s quite clear that guidance needs to be provided regarding the tax treatment of various transactions that are currently possible using DeFi.

As an example, in the transaction described above where a user deposits (or “stakes”) cryptocurrency onto a DeFi platform and generates yield, there is currently no clear guidance on how that transaction should be taxed. Until recently, most practitioners would likely argue that it should be reported as interest income, as the mechanics of the transaction replicate that of a user depositing funds into a bank in order to earn interest income. However, the recent case of Jarrett v. United States left an open question as to whether the earnings of a staking transaction are currently taxable, as the IRS ultimately refunded a taxpayer for earnings generated through a staking transaction.

What is clear is that as DeFi continues its explosive growth in use, pressures will only increase for it to be used in more sectors of the economy, along with consequent pressures for more regulation. Those responsible for a company’s finances need to closely follow court cases and legislative initiatives concerning cryptocurrency rules. DeFi is here for good, but how it will be integrated with the existing financial system, particularly when it comes to tax and accounting obligations, is anyone’s guess right now.

Grant Thornton will continue to explore this new investment option in future articles, where we will examine more thoroughly the mechanics of DeFi transactions and describe some of the tax consequences for taxpayers.