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Proposed tax laws will chase DeFi out of the US, create privacy nightmare, crypto industry says

Proposed tax laws will chase DeFi out of the US, create privacy nightmare, crypto industry says
Mandatory Credit: Photo by WILL OLIVER/EPA-EFE/Shutterstock (13878759a) Internal Revenue Service (IRS) Commissioner Daniel Werfel testifies before the Senate Finance Committee at the US Capitol, Washington DC, USA, 19 April 2023. The committee was hearing testimony on President Biden's Fiscal Year 2024 IRS Budget and the IRS 2023 Filing Season. IRS Commissioner Werfel testifies before Senate Finance Committee, Washington Dc, USA - 19 Apr 2023
  • The IRS wants to stop American crypto investors from dodging taxes.
  • It's worried about a potential $50 billion a year crypto tax gap.
  • But its new rules are so vague and broad they will kill the DeFi industry and present a massive administrative problem for the IRS itself, the crypto industry says.

The United States tax authority hopes that proposed tax reporting rules for digital assets will rake billions into the public coffers.

But in a hearing held by the Internal Revenue Service on Monday, the crypto industry said that the rules contain overly broad definitions that would sweep a range of participants — including crypto exchanges, non-fungible token marketplaces, and decentralised finance developers — unnecessarily into the mix.

Under current tax laws, brokers in financial instruments such as stocks and bonds report their customers’ gains and losses using Form 1099. They send the form to taxpayers, who then transfer the information to their tax return and send it on to the IRS.

Under the new rules proposed by the US Treasury and IRS in August, however, the definition of “broker” would be widened to include the category of “digital asset middleman.”

And since “digital asset middleman” means those that “directly or indirectly effectuate” sales of digital assets, the industry is afraid that pretty much any facilitator of the digital economy will have to find information on its users, store it, and report it to the government.

That broad definition of broker pulls DeFi and noncustodial wallet developers into the scope of the rules, Marisa T. Coppel, senior counsel at advocacy group the Blockchain Association, said at the hearing on Monday.

These groups simply aren’t capable of complying with the new rules because the software they develop by nature eliminates middlemen, Coppel said.

Users of the software engage with one another in peer-to-peer transactions, or with underlying smart contracts — not with a centralised operator.

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“Given the impossible nature of compliance, these software developers will be forced to shut down their project, move outside the US or so fundamentally change the nature of their project that they eliminate the benefits of decentralised and noncustodial technology entirely,” Coppel said.

The industry is also concerned that assets such as stablecoins, payments tokens, and non-fungible tokens will fall under the new rules, even though they’re not necessarily investment instruments in the way that stocks and bonds are.

Concerns about NFTs

Gina Moon, general counsel and corporate secretary at NFT marketplace OpenSea, said at the hearing that NFTs generally represent the rights to collectibles, art, or concert tickets. They can represent financial assets, but that’s not a common use for them presently.

Yet under the new proposed rules, OpenSea could be designated a broker and be obliged to report tax information for even the smallest purchases of NFTs, since there’s no value threshold for what has to be reported.

“For NFTs, this is the equivalent of wanting to sell a concert poster on Craigslist and then being required to share your name, your home address, Social Security number, and entire Venmo history with Craigslist,” Moon said.

The required reported data would also include digital wallet addresses, enabling “both the information collector and the government to track the entire transaction history of that individual regardless of whether other transactions in that history are required to be reported,” Moon noted.

According to Moon, most NFT transactions are quite small. From April 1 to October 1 of this year, she said, the median NFT transaction value was $37.09. Twenty-five percent of NFTs sold for less than $25, while 82% sold for less than $500.

‘This is the equivalent of wanting to sell a concert poster on Craigslist and then being required to share your name, your home address, Social Security number, and entire Venmo history with Craigslist.’

—  Gina Moon, general counsel at OpenSea

Tsunami of data

Not only is that a privacy and data security concern for taxpayers, it’s also going to send a tsunami of paperwork the IRS’s way — a deluge it doesn’t currently have the capacity to handle, the agency itself has admitted.

Tax news site Taxnotes reported that Julie Foerster, director of digital assets for the IRS, said during a conference in late October that the tax authority is bracing for eight billion more Forms 1099-DA (digital assets) from 13 million to 16 million taxpayers as a consequence of the new rules.

“Our technology, the way it is today, will not support the data and the volume,” Foerster said then.

Coinbase vice president of tax Lawrence Zlatkin said Monday the proposals would ensure that “the IRS and taxpayers will be bombarded with data ... This does not promote effective and efficient tax reporting.”

Crypto tax gap

The IRS is concerned that it is missing out on significant revenue from crypto investors. That’s largely because the pseudonymous nature of the blockchain has enabled investors to dodge taxes.

Research from Barclays Bank reported by CNBC suggests that there is at least a $50 billion crypto tax gap — the difference between how much tax the IRS collects and how much it is owed each year.

Seeking to address this, provisions in the Infrastructure Investment and Jobs Act that became law in 2021 directed the Treasury and the IRS to implement new rules for crypto brokers, obliging them to report information on sales, gains and losses to the tax authority.

The IRS and Treasury published the proposals on August 29 this year. The proposed rules have so far attracted a staggering 124,141 comments from the public and industry, most from those opposed to the new rules.

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