Aug 23, 2023 - Economy & Business

Coinbase proposes fix for DeFi tax reporting

Illustration of calculator buttons and a screen on one side of a glowing cube.

Illustration: Gabriella Turrisi/Axios

Coinbase has a proposal to make paying taxes on earnings from decentralized finance less cumbersome for everyone — the tax man included.

Why it matters: When financial transactions are run by robots on the internet, there's no one sending reports to the G-men.

Context: Decentralized finance (or DeFi) is a subset of the crypto industry where things like borrowing and trading and risk management are done by software running on a blockchain, autonomously.

  • Once the software is released, it doesn't need humans to run (really, zero, none... it's nothing like a normal business experience).

🧮 A new policy paper from the Coinbase Institute describes how this creates an issue for tax agencies like the Internal Revenue Service.

  • Until DeFi, all transactions went through some kind of firm, and those firms had reporting obligations under tax laws. The reports the IRS got from these firms helped it to make sure everyone is paying their taxes.

The intrigue: It's not like the information in DeFi is hidden. In fact, it's much more open than in normal finance. It can all be read out there on the blockchain.

  • Yes, but: A crucial piece of information is missing from that sea of data — which trades were done by whom? 🕵️‍♀️

Coinbase proposes that a token be created that could tie a user's real-world identity to different blockchain addresses he or she (or the company) is using.

  • The identity would not go on chain. It would just be something that could prove, using some off-chain system, that the wallet belonged to a certain someone.
  • That same off-chain tool could help to generate reports for users' activity. Reports that should be easily verifiable by checking its transactions against whatever blockchain it took place on.

Of note: It's unlikely that this would be a token for trading. In fact, we could imagine it being made as "soulbound" — that is, a token that can't leave a wallet after going there.

Quick take: This issue of intermediary reporting is a great example of the law having a hard time keeping up with the world as it changes.

  • It's not that the taxpayer data isn't there. It's just not readily popping out in the form that tax agencies are used to.
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