Let’s Explore DeFi: Taxes, Laws, Security and ARK
One of the most frequent questions we have been receiving as of late, concerns ARK and Decentralized Finance (“DeFi”). Whether ARK is DeFi or whether ARK offers any sort of DeFi functionality. In order to answer these questions, the topic of DeFi needs to be explored. We will be covering DeFi topics in a multipart series ranging from taxes, to laws, to security, and finally DeFi and ARK. Part one of this series will explore DeFi and Taxes.
What is DeFi?
For those who are unfamiliar with the concept of DeFi, it is built upon one of the inherent ideas behind cryptocurrencies — the ability for anyone to be able to access financial services in a transparent, secure and autonomous manner. Most recently DeFi has gotten a lot of attention in the form of “digital assets and financial smart contracts, protocols and decentralized applications (DApps) built on Ethereum”¹.
In traditional centralized financial systems, depositing funds, borrowing funds and trading in financial products has always required trusted intermediaries. While financial institutions in centralized systems allowed financial transactions to be carried out in an efficient manner, there are also drawbacks. In the article, Blockchain disruption and decentralized finance: The rise of decentralized business models, Yan Chen and Cristiano Bellavitis emphasize that by facilitating financial transactions, intermediaries “can grow to dominate economic activities.“²
Therefore, the result in a centralized financial system, is that the key intermediaries like Bank of America or JP Morgan end up with a disproportionate amount of influence and profit. In contrast, transactions in DeFi are not handled by key intermediaries but by decentralized peer to peer networks. By cutting out intermediaries, DeFi networks can cut transaction costs and create a transparent environment for all participants.
As we can see, inherently, DeFi applications and processes can help alleviate a lot of the problems with centralized financial systems. More importantly, it can provide a larger subsect of people with access to financial tools today than at any other time in history. We can see over the last year that DeFi in regards to cryptocurrency trading and investing has become immensely popular. At the time of writing, UniSwap has nearly $3 Billion USD worth of liquidity.
On Ethereum, where the lion’s share of DeFi takes place, we can see that it has contributed to a substantial amount of on-chain activity. Just last month, as reported by Flipside Crypto, over $300 million dollars is sent daily to DeFi apps and decentralized exchanges vs. $156 million dollars sent to centralized exchanges. This surge of activity has also created a surge in gas fees. Fees can be in upwards of $50 dollars per transaction and can take over 10 minutes to confirm.
We can see in the graphic above the flow of funds in the Ethereum Network While trades and investors have realized incredible profits and just as spectacular losses in the DeFi space one certain thing comes to mind — Taxes. The IRS has provided some clarity on how cryptocurrency is taxed, but there is a lot of gray areas left when it comes to DeFi. Lets look at some of the prevailing discussions among the industry regarding DeFi and taxes.
DeFi and Taxes
The world of DeFi is vast and there are a variety of activities that people undertake that can create taxable events. Let’s take a look at some of the most common activities and how they are treated according to industry discussions.
Disclaimer: I am not a tax professional and this is not financial advice. If you would like assistance determining your tax liability and preparing your taxes, you should consult a tax professional within your jurisdiction.
Cryptocurrency tax experts at TokenTax do a great job at breaking down several activities within DeFi and explaining how each of them are taxed. It is important to note, that the IRS and tax authorities from other countries have not given specific guidance on DeFi but the general guidance on how cryptocurrency is taxed will inform us on tax treatment regarding DeFi-related activities. Below are the most common types of activities.
Token Investments
Activities that fall within this bracket are the most common among cryptocurrency traders. For example, exchanging your ARK for fiat or trading your ARK to another cryptoasset triggers a taxable event. Trading and selling tokens warrants capital gains tax on any profits. If tokens are sold at a loss, taxpayers can claim a capital loss to offset against capital gains.
Lending Protocols
When it comes to lending protocols, we can highlight some of the most common ones in the space — Aave and Compound. Aave and Compound operate by generating interest income by tokenizing lending positions using aTokens and cTokens.
According to TokenTax, aTokens are created at a 1:1 ratio with the underlying, so when Aave lenders earn interest, their aToken balance increases. This is taxed as ordinary income, similar to most forms of earned interest.
With cTokens, the quantity held by a lender stays stable, but the amount of underlying collateral that can be claimed with each cToken increases proportional to interest rates. Because of this mechanism, cTokens gain value over time, and this is taxed as capital gains under U.S. tax law.
Liquidity Pools
In order to understand how engaging with liquidity pools are taxed, it is important to understand how they work. Liquidity pools like Uniswap, Balancer and Curve issue a stable amount of pool tokens to liquidity providers (LPs). Since this balance doesn’t change over time, but the pool tokens may represent a claim on more collateral than an LP deposited, gains in this domain are taxed as capital gains. If pool tokens held by an LP increased over time to reflect the ability to claim more of the underlying assets, additional tokens gained would be taxed as ordinary income.
Yield Farms
Yield farming has become a standout hobby among DeFi traders. Recently, one of ARK’s partners, Compendia, launched its Mainnet with the help of 47 validators. One of the validators, Bindfarmer operates a community-run yield farming service. Yield farms are taxed similarly to airdrops. The value of farmed tokens as of the time of claiming them is considered ordinary income and taxed as such. If the tokens are later sold for a higher price, the profits are taxed as capital gains. If farmed tokens are sold at a loss, it creates a capital loss that can be used to offset a capital gain.
Tokenized Asset Management
Recently, tokenized asset management has been viewed as a way to bypass taxes. According to TokenTax, manually executing trades forces investors to pay capital gains on each realized profit. Delegating this responsibility to an algorithm or third party absolves investors of being taxed on each and every trade. This is similar to ETFs and mutual funds where investors aren’t required to pay taxes on each of the fund’s realized profits. Instead, tax is calculated on each investor’s profits from holding shares in the ETF/mutual fund.
If you would like some extra reading on DeFi and Taxes, check out TokenTax’s DeFi Tax Guide.
When it comes to DeFi and taxes, the most important thing is to understand the type of activity you are undertaking and how that activity is treated under your jurisdiction’s tax authority. In the U.S., we will await clearer guidelines from the IRS but in the meantime, we have some working knowledge on how DeFi is taxed and how as individuals, we should prepare and plan for taxes.
Sources:
- What is DeFi? (2020, April 17). Retrieved from DeFi Pulse.
- Blockchain disruption and decentralized finance: The rise of decentralized business models. (2020). Bellavitis, Cristiano; Chen, Yan. In: Journal of Business Venturing Insights.
