Introduction - What Exactly is a "DAO"?
A decentralized autonomous organization ("DAO") in its most basic sense is an organizational model that rejects a centralized decision-making body, like the Board of Directors of a corporation, in favour of a decentralized structure of decision-making authority through the use of blockchain and smart contract technology. Governance of a DAO is organized through ownership of the DAO's native token, which entitles holders to vote on matters concerning the DAO. The typical outcome is that a token owner's number of votes in the decision-making process is directly tied to the number of tokens that holder has. The DAO's system of direct democracy is enforced either through smart contracts which automatically respond to token holder votes, or by developers spurred to act where token holder votes compel them to.
Cryptocurrency developers and enthusiasts have toyed for years with possible applications of DAOs within the cryptocurrency sphere. For example, one of the best-known operating DAOs is the decentralized cryptocurrency exchange "UNISWAP", enabling transactions between token holders on the Ethereum blockchain. UNISWAP's governance token, UNI, is freely tradeable between token holders, purchasable on crypto exchanges, and earnable through staked liquidity pools which enable the decentralized exchange to function. UNI token holders are entitled to vote on and propose changes to the underlying UNISWAP protocol through a series of off-chain governance tools and smart contracts enabling voting on-chain. Proposals which are adopted under UNISWAP's governance model are then prioritized by developers to create and publish as server updates. In this way, UNI token holders can play a direct role in determining how UNISWAP develops and functions. Since reaching a peak value of over CAD $62, UNI tokens have since substantially deflated in value to roughly CAD $9. Even so, with a recent valuation of over USD $1 billion and a resurgence in the popularity of Ethereum, UNISWAP has been generating considerable interest from equity investors to expand operations and has become the dominant force among decentralized exchange services for cryptocurrencies.
Another example was the project self-styled as "The DAO", launched in 2016 as an experiment in providing stakeholders direct influence over a venture capital fund. Initial purchasers of The DAO's token contributed millions of ETH to a single treasury fund. Holders of The DAO's native token were then entitled to propose and vote on investment plans, and successful project proposals would receive funding from The DAO's treasury. The DAO was eventually paralyzed by security vulnerabilities in the underlying code of The DAO, which were exploited shortly after The DAO's launch to misdirect millions of ETH from the fund. The DAO tokens were shortly de-listed from exchanges, and it has since become defunct.
These two examples showcase just why a DAO is an inherently difficult system to define for tax purposes. Tokens of a DAO differ from other crypto tokens in that they can serve as commodities, sources of investment income and tools for governance, similar to the common shares of a corporation. In addition, a DAO is not exactly an entity in its own right. A DAO does not have a physical address or formal leadership system. A DAO may benefit from the efforts of developer teams who publish updates to the DAO's underlying code, and by consensus help to shepherd the DAO, but this is not itself a formal leadership structure. By nature, there is ultimately no single leadership figure or group responsible for operating a DAO. Even more complicated may be cases where a DAO is created for a specific purpose that is not clearly profit-oriented.
In Canada, no jurisdiction has passed substantive legislation concerning the tax treatment of cryptocurrencies or NFTs, and the Canada Revenue Agency ("CRA") has not officially pronounced how it views participating in a DAO for tax purposes. Very few jurisdictions, such as the Republic of the Marshall Islands and the US states of Vermont and Wyoming, have passed legislation allowing for incorporation of and formalizing tax treatment of DAOs. As well, no Canadian court has yet heard a case with respect to taxation of cryptocurrencies. Given these complexities, the tax consequences of participating in a DAO must be drawn from existing legal principles and case law. If you intend to participate in or develop your own cryptocurrency or DAO, then you should speak with one of our expert Canadian crypto tax lawyers to evaluate the tax consequences of your endeavour.
How Might Participation in a DAO be Characterized for Canadian Tax Purposes?
A DAO may share many characteristics in common with other business vehicles under Canadian common law but does not fall squarely into one definition or another. Three principal examples of organizing business under Canadian law will be explored to discuss how Canadian tax law may view a DAO for tax purposes.
A corporation is a separate legal and fictional personality recognized under Canadian law, as well as the laws of most jurisdictions.. A corporation can contract in its own name, hold assets, be liable for breach of contract, buy and sell goods, and borrow and lend just as any natural, living person. Equity investors in the form of shareholders purchase and hold shares of the corporation, which carry rights that can be asserted against the corporation. Shareholders can generally trade their shares with others freely, except as is the case for many privately-held corporations that are not listed on stock exchanges.
Shareholders do not usually control management of the corporation. The brain of the corporation and management of any related business typically originates with a Board of Directors, who are elected by shareholders with voting rights that flow from their share ownership. This need not always be the case, however. The corporate structure is very flexible, and corporations can certainly be organized with a decentralized structure of management facilitated between individual shareholders. It is important to emphasize, however, that this governance model is not normally used for corporations given the complexity involved in structuring and operating such an arrangement.
For tax purposes, corporations are treated as legal persons in their own right. Corporations are taxed at a flat rate compared to a natural person taxed at the progressive marginal rates, and may benefit from even further reduced tax rates such as Canadian-Controlled Private Corporations ("CCPCs") and the Small Business Deduction ("SBD"). After-tax earnings of the corporation may be distributed to qualifying shareholders as dividend payments. The principles of tax integration, built into the Canadian Income Tax Act, ensure that dividend income paid to shareholders is taxed at a rate that avoids double taxation in the hands of individual shareholders and ensures that tax paid on income earned by the corporation reflects what would have been paid if the income were earned directly in the shareholder's hands.
DAOs and corporations clearly have many characteristics in common, in terms of control exercised by shareholders and token holders over the organization and the ability to trade those voting shares or tokens with others for value. Under Canadian law, however, a DAO will not be recognized as a corporation without some additional organizing effort. A corporation cannot be accidentally created under Canadian law, and requires a deliberate choice to file incorporation documents under enabling legislation as well as following formalized creation procedures. A corporation simply cannot exist by operation of law.
As it stands, Canadian corporate statutes do not provide any specific rules recognizing DAOs as corporate bodies. Some other common law jurisdictions, however, have taken steps to do exactly that. In Wyoming, legislation has been passed to provide a means for developer-led DAOs to obtain legal status as limited liability companies ("LLCs"), which are treated as corporations generally for Canadian tax law purposes. Similar legislation has been passed in Vermont and the Republic of the Marshall Islands, in a gamble to attract more blockchain-based businesses and investors. It is possible Canadian legislators will take similar steps in the future, given the analogous qualities of DAOs and corporations, but as it presently stands DAOs will not benefit from corporate tax treatment unless actually incorporated.
Partnerships and DAOs
A partnership under Canadian law is generally defined by both common law and provincial statutes as a relationship between two or more persons carrying on business in common with a view to profit. Whether a partnership exists depends on the particular facts and circumstances of each case, and the intent of parties. A partnership can exist without any formal written partnership agreement or even a verbal agreement, where parties are engaged in a common pursuit of profit. Important indicators that a partnership exists often include contributions of money, property, effort, knowledge or skill by parties to a common objective, joint ownership of property related to the business, the sharing of profits and losses, and mutual rights of management and control over the business.
For tax purposes, a partnership is treated as a "flow-through" entity. A Canadian partnership is not in and of itself an entity recognized by the Canadian Income Tax Act and is not itself taxed. Instead, for tax purposes, it is treated as though it is a taxpayer for purposes of calculating the partnership's net profits, losses and contributions and allocations to and from the partners. That income or loss is then allotted to partners, and becomes the exclusive responsibility of those individual partners to pay (that is, income or loss "flows through" the partnership arrangement to the partners).
Classifying DAOs as partnerships broadly would be inappropriate for three clear reasons. First, DAO token holders are not required to agree in a written or verbal agreement to act in common to participate in a DAO or to hold those tokens. A partnership is based on the existence of a contract, written or oral, between partners to engage in business in common. The absence of any agreed-upon rules to engage in business with the DAO, or as part of an initial offering to establish a DAO, is a strong factor pushing against qualification of DAOs generally as partnerships. Even if DAO token holders were to agree to rules of conduct, it is not clear those rules alone could rise to the level of forming a partnership agreement. Not every purchase of a product or investment necessarily requires an intent to engage in business in common.
Second, DAO token holders maintain discrete ownership of property and income derived from the DAO. Two of the most fundamental characteristics of a partnership in Canadian common law are the sharing of profits between partners, and an indivisible interest in property used by the partnership between those partners. Participants in a DAO may own tokens in a personal capacity, and absent an overriding condition will not share any profits or losses with other token holders when that holder chooses to dispose of those tokens. The absence of a sharing of profits or losses and joint ownership of property is strong evidence pushing against the existence of a partnership between DAO participants generally.
Third, participants in a DAO, and the DAO itself, may not possess a profit motive. A DAO, in essence, is simply a means of creating a system of direct democracy using blockchain technology and cryptocurrency. Non-profit associations with a cultural or social objective are generally not considered to be partnerships. A DAO could theoretically be structured for any number of projects that do not inherently involve engaging in business with a view to profit. A DAO could be created for users to finance a property purchase for preservation purposes, or to raise money for a political figure or social cause, or to fund other community causes that do not operate with a view to generating profit. This is in direct contrast with a DAO engaged in venture capitalism like The DAO, created explicitly to profit token holders.
We can see then that classifying a DAOs as partnerships generally is inappropriate. Within a DAO system, however, the partnership classification may still apply. For example, the development team responsible for creating and maintaining the code that enables the DAO may qualify as a partnership given an appropriate set of facts. A development team made up of a discrete number of programmers may launch a new crypto token for a DAO, and hold a certain percentage of released tokens jointly. That development team may continue to publish updates for the DAO source code, to maintain the value of the DAO and its underlying tokens, and may choose to sell those tokens for profit. It may be possible, given a similar set of facts, for a partnership to exist between those developers. Similarly, an organized group of DAO token holders contributing to the DAO through voting and trading those tokens with a view to mutual profit may also qualify as a partnership.
Joint Ventures and Unincorporated Entities
An unincorporated entity is an organizational structure with no unique recognized status or unique tax treatment under the Canadian Income Tax Act. The relationship between parties in an unincorporated entity is governed strictly by applicable contract law. Unincorporated entities are not flow-through entities like partnerships, and are not treated as separate from participants for tax purposes. Thus, each participant is taxed in an individual capacity, and any gains or losses earned from participating in the unincorporated entity are attributable to the taxpayer alone.
One such example of an unincorporated entity recognized by Canadian law is a "joint venture", which is a distinct business arrangement where venturers engage with each other in pursuit of a particular business objective. The Tax Court of Canada has identified three distinctive characteristics for determining the existence of a joint venture:
- There is a joint property interest in the subject matter of the venture;
- There is a right to mutual control and management of the venture; and
- The objective of the venture is limited to a single undertaking, or select number of related undertakings.
Although joint ventures and partnerships share many common characteristics, a joint venture is not a residual category for businesses that fail to qualify as partnerships. However, and for similar reasons concerning partnerships, it would also be difficult to classify DAOs broadly as joint ventures. Most examples of DAOs do not involve a discrete number of venturers participating in a business for a single purpose, or series of related purposes. A DAO is a dynamic structure of governance, subject to change where token holders may collectively decide on a new direction for the DAO. There are often no written agreements as well for DAOs that would indicate an intention to form a joint venture. It may be possible that the classification is appropriate where an organized series of venturers engage with each other through a DAO to complete a specific task, but like partnerships, this classification is inappropriate for DAOs in a general sense. Nonetheless, and for similar reasons concerning partnerships, it may be possible for DAO developers or organized groups of investors to form a joint venture where sufficient evidence of an intent to undertake business together exists.
A DAO, or groups of DAO token holders working in tandem, may be much more easily classified as unincorporated entities for Canadian tax law purposes. That a DAO allows for direct democracy between participants does not necessarily impart on a token holder an intention to form a particular business relationship with other token holders. DAO token holders would then form contractual relationships to trade and act as part of the DAO, and be taxable as individuals in their own capacity. The ultimate classification of a DAO, or DAO token holders, will still depend heavily on the underlying facts and specific relationships that exist between participants.
Tax Treatment of DAO Tokens
There are two ways in which a DAO token holder may be subject to tax for participating in a DAO. First, a DAO token holder may purchase, hold and trade DAO tokens for a gain or loss. Second, a DAO token holder may receive rewards for proof-of-stake ("staking") or proof-of-work ("mining") activities to secure the DAO network, or under any other system of rewards the DAO may offer to participants in the DAO. The following sections will discuss the tax implications of both.
Taxation of Dispositions of DAO Tokens
Under the Income Tax Act, income from all sources inside and outside of Canada factor into determining a taxpayer's income for a given taxation year. Certain sources of income are characterized and treated differently under the Income Tax Act, including income from employment, business and property. The Income Tax Act provides two plausible treatments of income earned from cryptocurrency assets, as either income from a business or an investment, or as capital gains from the disposition of property.
Business income or investment income derived from selling inventory or as a yield from property, respectively, are fully taxable sources of income for a taxpayer. Where a capital gain results from a disposition of property, only one-half of that capital gain will be taxable. Where a taxpayer earns income, characterization of that income as a capital gain is a significant tax advantage. Where a taxpayer experiences a tax loss, characterization of that loss as from a business is more beneficial. A business loss is fully deductible against all sources of income, while only one-half of a capital loss will be deductible against the one-half of other capital gains that are taxable.
Under the Income Tax Act, the type of income earned determines the nature of the asset disposed of, and so the analysis begins by characterizing the type of income earned or loss accrued. As mentioned, no Canadian court has ruled on taxation of cryptocurrencies, and the CRA has not provided any coherent guidance on characterization of cryptocurrency for tax purposes. However, a plethora of case law has developed through Canadian courts characterizing the differences between business and investment income, and capital gains, which would be applicable to cryptocurrency transactions. Although no one factor is determinative, relevant factors for characterizing a sale of property as a capital sale or a business include:
- The nature of the property sold;
- The length of period of ownership by the taxpayer;
- The frequency or number of other similar transactions by the taxpayer;
- The work expended on or in connection with the property realized;
- The circumstances that were responsible for the sale; and,
- Particularly important for cryptocurrency holders, the taxpayer's motive for both acquiring the property, and for making the sale.
Thus, both the factual circumstances surrounding a taxpayer's acquisition and disposition of a DAO token, in addition to the particular business vehicle the DAO token holder is operating under, will influence how that transaction will be taxed. Your particular motivations for participating in and level of participation in the democratic elements of the DAO, whether you deal in other related or unrelated cryptocurrencies or investments, and your motivations for selling will all be relevant to evaluating whether income from a disposition will be taxable as capital gains or as business income.
It is unclear how tax treatment of dealing in DAO tokens would be substantively different than dealing in any other cryptocurrency. Where you are transacting in an individual capacity or as part of an unincorporated entity, those profits and losses will be solely attributable to you. Where you are acting in a partnership with other DAO token holders, the income or losses generated will need to be calculated for the partnership collectively and divided between partners for tax purposes. This will require some intelligent decision-making among partners, and may offer additional crypto tax planning opportunities in how tax attributes are distributed.
Taxation of Acquiring Token Rewards for Participating in a DAO
The cryptocurrency sphere is constantly evolving and innovating. Historically, token holders could earn new tokens by participating in staking or mining activities to secure the related token's blockchain. A token holder could also benefit from distributions of treasury tokens through airdrops, or from other similar and unsolicited crypto gifts while owning a particular token. With the rise of DAOs, the increasing complexity of smart contracts, and the endless creativity of cryptocurrency developers, it is conceivable that new and novel systems of rewarding token holders for their participation (particularly in a DAO with direct token holder participation) may come to be. There are several considerations for evaluating how receipt of DAO reward tokens may be treated for tax purposes, which will be discussed below.
DAOs and Tax-Free Windfalls
Airdrops, undistributed coin rewards and other unsolicited rewards that are received without commercial intent by a taxpayer may not be treated as a source of income. Section 3 of the Income Tax Act follows the "source theory" of income, which imposes tax only on income derived from productive sources. Lottery winnings and gifts, therefore, are generally not taxable in Canada, because they are not derived from a productive source.
Where a token is received without any organized effort or pursuit of profit on the part of the token holder, the distribution is not one that is regular or recurring, and the holder is not given an enforceable claim against the distributor, the token may be treated as a pure windfall gain and thus will not form part of the taxpayer's taxable income. This seems an unlikely characterization, however, where a token holder receives new tokens because of active participation and voting as part of a DAO, given the direct link between participation and reward.
Fully Taxable Income from Holding DAO Tokens
Rewards-based distributions of DAO tokens may also be treated as fully taxable income from an investment or a business. Investment income includes passive yields from property like dividends from corporate stocks, yields from bonds, and rents from real property. Business income involves a higher level of activity from the taxpayer, and some sense of organized effort to earn income. This could include managing a portfolio of investments or actively seeking new opportunities to increase returns on investment.
A DAO token holder receiving token rewards could plausibly be treated as investment or business income, depending on the facts involved. For example, a token holder who purchases DAO tokens as a long-term investment and receives tokens, does not actively trade tokens, and who earns some staking income may be viewed as earning investment income. A token holder who accumulates DAO tokens for the purpose of voting and dictating the DAOs activities, or who is actively trading DAO tokens, may qualify as earning business income. In either case, both business income and investment income are treated as fully taxable income under the Income Tax Act, and the full value of the token received will form part of the recipient's taxable income at the time it is received.
Pro Tax Tip: Do Not Get Caught Off Guard by Unknown Filing Requirements
The uncertain tax treatment of DAOs does not diminish any possible crypto tax reporting requirements a taxpayer may have. For example, the accidental creation of a partnership can have serious implications for tax reporting requirements. Beyond the general complexity in calculating and allocating taxes in a partnership, the Income Tax Regulations require that non-exempt partnerships file a T5013 Information Return for every year the partnership carried on business in Canada. Each partner would have to report to the CRA information concerning each partner, the partnership's income and losses, sharing of profits and losses, and credits and deductions.
Failure to file when required can accumulate significant penalties for the non-compliant partnership and partners. Where a partnership or partner fails to meet its full obligation to file the return on time, it may be subject to a maximum penalty of $2,500 for every year the return is not filed. This penalty applies for every mandatory form not filed as part of the return, and additional penalties may accrue for repeated failures to file.
Ignorance is not a defense to your tax filing requirements. When engaging in uncertain territory, as is the case with a DAO, it is crucial you understand how you are forming working relationships with other taxpayers and how you are interacting with the DAO itself. Every decision you make can have consequences for your personal tax obligations and filing requirements. You should absolutely speak with an expert Canadian cryptocurrency tax lawyer if you are a Canadian taxpayer and intend to purchase and hold tokens of, participate in or establish a DAO, or if you already have participated in a DAO.
What is a Decentralized Autonomous Organization ("DAO")?
A DAO is a decentralized decision-making body enabled through blockchain and smart contract technology. A DAO does not involve a centralized decision-making body, like the Board of Directors of a corporation, and instead creates a system of direct democracy between DAO token holders. In a typical structure, a token holder possesses a number of votes equal to the number of tokens that the holder has. A DAO may be operated for profit-making or charitable puposes, and follows no definitive organized structure.
How Might Canadian Tax Law Treat a DAO for Tax Purposes?
A DAO is not itself recognized as a business vehicle in Canada, and how Canadian tax law may treat a DAO depends heavily on the context. For example, an organized development team working in common to maintain a DAO, to facilitate governance by token holders over the DAO, and to profit from those activities may be participating in a partnership or a joint venture. Organized groups of token holders voting on DAO-related matters by right of their holdings may also have formed a partnership or joint venture, depending on the totality of the circumstances. This may be the case for either developers or token holders regardless of whether they agreed in writing or verbally to form a partnership or joint venture. To determine the correct tax treatment of any given DAO structure, consult with an expert Canadian crypto tax lawyer.
Is a DAO a Corporation for Canadian Tax Purposes?
A DAO is not regulated as a corporation under any Canadian federal or provincial statutes. Some common law jurisdictions like Wyoming and Vermont have taken steps to afford DAOs status as corporations, given similarities in the two organizational structures. It is not unforeseeable that future regulations surrounding cryptocurrency tax in Canada will approach DAOs with a similar view, imposing similar tax filing and regulatory requirements on DAOs.
If I Vote as Part of a DAO, How Might That Affect Taxation of my Tokens?
Your voting activity will form one factor among many in evaluating the taxability of your cryptocurrency assets. Your motivation for acquiring the tokens of a DAO and your voting activities as part of a DAO may be factors that contribute to determining whether income from a sale of those tokens is treated as capital gains or fully taxable income. As well, your voting behaviours may contribute to evaluating whether your income earned from DAO reward tokens is treated as business or investment income, or even as a tax-free windfall. Consult with an expert Canadian crypto tax lawyer to determine your specific tax treatment of your DAO holdings.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.