Much as governments have struggled for centuries to harness income flows transcending national borders, today governments face the novel challenge of taxing income flows that transcend the boundaries of the tangible world. Specifically, blockchain technology has enabled cyberspace-based financial arrangements that trigger seemingly endless tax and regulatory quandaries. (See, e.g., here and here.) David Shakow tackles one such quandary in his recent Tax Notes article, considering the tax treatment of income earned through a blockchain entity known as a decentralized autonomous organization (DAO).
Shakow’s article begins with a mercifully clear explanation of the formation, structure, and eventual demise of a specific DAO, called “The DAO.” Formed in 2016 on the Ethereum blockchain platform, The DAO collected $150 million to invest in startup enterprises. Under The DAO’s terms, anonymous investors would vote on which enterprises to invest in and would share in the profits. All transactions occurred without the need for human involvement via the operation of “smart contracts” recorded in the Ethereum blockchain. Human interveners were only necessary to confirm the identities of startup companies that submitted proposals for investment by The DAO.
The DAO was an early attempt at decentralized investing that ultimately failed due to a programming error that allowed a rogue investor to divert one-third of The DAO’s funds. Although some investors felt that the diversion should remain unchanged, the vast majority disagreed. Ultimately, members of the Ethereum blockchain voted to roll back the blockchain to a point before the theft occurred—known as creating a “hard fork.” The result was essentially to undo the theft transactions. Because this action took place on the Ethereum blockchain, it required a majority decision and action by the Ethereum community. The community likely acquiesced to the wishes of The DAO because the investment entity had accumulated a sizeable percentage of all outstanding “ether” (Ethereum’s cryptocurrency). The DAO ended soon thereafter, but other DAOs have since emerged.
This story is more than mere background. The structure and behavior of The DAO lend decisive support to Shakow’s argument that a DAO is an entity for tax purposes. Despite language in The DAO’s governing documents that no “legally binding contract” was created, such attempts to avoid classification under local law are ineffective under the tax law. As Shakow explains, tax regulations define a tax entity as any “joint venture or other contractual arrangement” in which “the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom.” Treas. Reg. § 301.7701-1(a)(1). This seems to plainly describe The DAO’s structure and operations. Shakow describes a DAO as operating like a contract between investors, using computer code in place of standard contract terms. The DAO was created to enable investors to jointly vote on investment enterprises and to share in their profits. Further, the investors were actively involved in The DAO’s decision-making, they worked in concert to prevent loss of assets, and they were in a position to share in both profits and losses of the endeavor. This sounds decisively like a business entity.
Shakow’s conclusion, albeit unsurprising to tax experts, has major implications for tax administration. Most notably, as Shakow notes, in a decentralized entity there is no one to file tax forms and withhold taxes. Adding compliance infrastructure to a blockchain enterprise would undermine some of its core functionality. Perhaps, however, compliance could be automated and written into the governing code in some way. Or perhaps a DAO could hire an accounting firm that would operate separately to ensure compliance. (If such an arrangement took place, would the DAOs be considered “computer overlords”? If so, I, for one, would welcome them.)
Further complicating the analysis, blockchain members and thus DAO investors are anonymous—or pseudonymous, as they rely on pseudonyms to protect their identities. This anonymity raises enforcement difficulties under FATCA, which requires foreign financial institutions to identify US investors and to withhold 30% from any investor that it cannot definitively identify as a non-US investor. However, this may not be an insurmountable barrier. Existing companies such as Elliptic and Chainalysis seek to root out illegality and compliance violations among cryptocurrency transactions, and presumably their efforts could be directed at tax compliance as well. Although Shakow notes that any compliance efforts are unlikely to succeed without significant international cooperation.
We have entered a brave new world of financial enterprises. Tax agencies are already behind. Shakow’s analysis, alongside the diligent work of others in the field, is vital to modernizing tax administration and ensuring that new technologies do not become tools of regulatory evasion.