DAOs – Tax and Legal Implications of the Web3 Organisation

In the world of blockchain technology, Decentralized Autonomous Organizations (DAOs) are gaining popularity. DAOs are virtual organizations that operate through smart contracts on the blockchain, allowing participants to make decisions collectively and share in the profits. While DAOs offer many benefits, such as giving creators ownership and direct returns on their work, they also present legal and tax risks. Ernst Young looked at the implications.

Lack of Regulation Creates Risks

Despite the growing number of DAOs, there is still no internationally agreed-upon regulatory approach to govern them. As of May 2023, there are approximately 13,000 DAOs with a combined total treasury of nearly $23 billion. Without proper regulation, participants in DAOs are exposed to high levels of legal and tax risk.

There is an ongoing debate about whether DAOs should sacrifice a level of autonomy and decentralization to fit within existing legal and regulatory frameworks. The lack of specific tax policies for DAOs means participants must adopt a pragmatic approach, using existing guidelines from the wider digital economy to manage risk.

Case-by-Case Risk Mitigation

Each DAO use case comes with its own set of legal and tax considerations, making it difficult to establish a one-size-fits-all approach to risk mitigation. Some successful DAO use cases include cryptocurrency exchanges, metaverse platforms, software development communities, NFT art collectives, and decentralized investment funds. Each use case requires careful analysis to determine the best risk mitigation strategy.

Although no universally recognized tax and legal approach to DAOs exists, some jurisdictions are taking unilateral steps to provide insights into potential tax approaches. For example, in the US, DAO governance tokens are treated as securities and subject to securities law. This decision holds DAO participants legally liable for the actions of the DAO. Some states in the US, such as Vermont, Wyoming, and Tennessee, have allowed DAOs to register as legal entities, providing them with legal protections and tax certainty.

Other countries, including Switzerland, the Cayman Islands, Hong Kong, Panama, Bulgaria, and the Marshall Islands, also allow DAO registration. However, country-specific regulations may not fully address the complexity of DAOs, as they often involve participants from around the world.

Establishing Legal Status

The first step towards determining tax treatment for DAOs is to establish their legal status. Depending on the circumstances, DAOs may be considered a legal partnership or a legal entity. Each legal framework provides specific rights and obligations, as well as protections for legal liability purposes.

While country-specific regulations offer partial solutions, an internationally agreed approach through organizations like the Organisation for Economic Cooperation and Development (OECD) could provide more confidence and clarity. Currently, a patchwork of country-specific legislation is emerging, creating complexities and potential legal risks for DAO participants.

Challenges at the Intersection of Blockchain and the Physical World

The lack of legal clarity for DAOs creates challenges when interacting with the physical, non-blockchain world. For example, commercially focused DAOs may be subject to sales or business income tax. However, without a recognized legal status, DAOs cannot register as businesses or open bank accounts, making tax filing difficult.

Governance token holders face difficulty in dealing with tax administrations, as few accept payment in digital assets. This creates challenges in properly reporting taxable income for both taxpayers and authorities. DAO participants are exposed to potential double taxation, tax risks, and liabilities due to the absence of an internationally agreed-upon legal approach.

Identifying Taxable Events

To calculate tax exposure, DAO participants need to identify the key taxable events within the DAO operations. These events can include the transfer of tokens from a conventional corporate entity to establish the DAO, selling native governance tokens for funding and hedging against volatility, realizing income or returns from activities, or establishing grant programs to fund general protocol infrastructure.

Calculating tax liability for governance tokens can be done similarly to other digital assets, but additional complexity arises when participants earn more governance tokens through contributions to the DAO. Taxation may depend on the use of treasury funds, such as investments or crypto staking, which may go unreported without proper guidelines.

Legal Wrappers and Centralization

One way to achieve legal and tax certainty for DAOs is to register a legal entity, also known as a legal wrapper, over the DAO structure. While this introduces a level of centralization, it brings accountability, clarifies tax and reporting obligations, and improves regulatory compliance.

However, some argue that accepting centralization is necessary for wider adoption of DAOs. The current situation allows DAOs to operate on the cutting edge, but it may not be sustainable in the long run. The interaction between blockchain-based entities and the physical world, including tax payments, requires a certain level of centralization to ensure compliance.

In conclusion, navigating the legal and tax complexities associated with DAOs is a challenging task. The lack of internationally agreed-upon regulation poses risks for participants, but unilateral steps taken by some jurisdictions provide insights into potential tax approaches. Establishing the legal status of DAOs is the crucial first step in determining tax treatment. Case-by-case analysis is necessary to assess the specific risks and tax implications of each DAO. While challenges remain at the intersection of blockchain and the physical world, legal wrappers can provide a basic level of certainty. Ultimately, DAOs may need to relinquish a degree of decentralization to comply with legal and tax requirements.