Abstract The article explores the rationale for imposing taxes on decentralized autonomous organizations (DAOs) while highlighting the unique challenges posed by their lack of centralized structure and geographical location. Despite similarities to traditional corporations, the decentralized nature of DAOs complicates taxation within existing frameworks designed for entities with identifiable locations. The first section argues for taxing DAOs based on principles of equality and the ability to pay, emphasizing parallels with traditional business operations and the need for income tax on generated profits.
The second section delves into the challenges of taxing DAOs within the current international tax system, considering the limitations of existing frameworks for brick-and-mortar businesses and the complexities introduced by the digital economy. The article anticipates increased scrutiny of DAOs in the future despite their stateless and decentralized operation. The third section proposes potential methods for taxing DAOs' income, evaluating the feasibility of taxing the DAO directly or its participants. However, enforcing taxation on participants in different sovereign countries poses significant challenges, requiring international cooperation and effective audit mechanisms. In conclusion, the article acknowledges the compelling case for taxing DAOs but emphasizes the inadequacy of current tax systems for entities operating in a decentralized manner, presenting a complex issue that demands innovative solutions within the global regulatory landscape.
I. The Case for Taxing DAOs
We believe there is a strong case to tax DAO's profits.
Let's start with the general principle of equality between the members of the community. This requires that the tax burden (revenue used to fund public services, infrastructure, social programs, defense, and other essential functions of government) be shared equally among them. This means, in practice, that everyone must contribute, but that the contribution should be based on the capacity of each member of the community. In technical words, taxes should be borne equally by those with the same ability to pay (horizontal equality), but unequally by those with different ability to pay, in proportion to this difference (vertical equality).
The need to raise resources from the members of the community and the obligation to share the burden equitably forced governments to: (i) find manifestations of the community members' ability to pay (what is taxed), and (ii) define who pays the tax (the taxpayers).
1. Manifestations of the Ability to Pay (Taxing Business Profits)
The first task is to find manifestations of the ability to pay that justify the transfer of private resources to the public sphere. The relevant manifestations of the ability to pay are to be found in the different phases of the wealth cycle: in its creation (income), in its maintenance (assets), and upon its destruction (consumption). Income taxes are taxes on the creation of wealth.
Business enterprises consist of factors of production organized by entrepreneurs for profit. Economically, profits are income and represent the creation of wealth to the entrepreneur. Profit is, therefore, identified by the tax system as a manifestation of the entrepreneur's ability to pay. This is why business profits are subject to income tax.
Similarly to other forms of organizations, DAOs' purpose might be carrying out a business enterprise for profit. The business income may result from providing services, earning transaction fees, or holding assets that appreciate. Successful businesses will generate profits. If a certain government has decided to tax business profits, there are no reasons to exempt the DAO's profits from income tax.
2. Who Pays the Tax (Taxpayers)
The second task is to define who should pay the tax on the business profits. The issues here are: (i) should some business organizations (entities) be taxed separately from its owners and, if so, (ii) which should be taxed autonomously?
a) Does it make sense to tax entities?
To answer this question, we must first understand what business entities are and why they are autonomous from their owners.
Let's start with the simple case of sole proprietorship. Sole proprietors of businesses are the owners of the enterprise's assets. It is the individual proprietor that owns the business assets and that carries out the business activity. The business profits are integrated into their individual income.
However, modern business is mostly carried out by large groups of owners, not sole proprietors. In most businesses (think of listed entities or even DAOs), the owners and the business assets are patrimonial and functionally separated. The business is an autonomous economic unit, separated from its owners, that is susceptible to being the legal owner of its assets, activities, and income. These forms of business organizations are generally referred to as "business entities".
The tax system recognizes this functional and patrimonial autonomy. As a result, business entities have tax personalities, i. e. they are taxpayers in their own capacity. The recognition of the separation of owners and businesses, through the "interposition" of an entity, is the first reason why business entities are autonomously subject to tax.
It is true that, sooner or later, all the business profit realized by these entities will be appropriated by their owners, which usually occurs through its distribution (in the case of companies via dividends). So, why not wait until such distribution to tax the business profits?
The reason is that the "interposition" of the entity causes a tax deferral effect for the owners, which has serious consequences in terms of equality and government revenue. If the owners kept the profits in the entity, the tax would be indefinitely postponed. This would incentivize businesses to retain profits at the entity level, even if they could be employed in more profitable investments
b) Does it Make Sense to Tax All Entities Autonomously?
So, now that we know that it makes sense to tax entities autonomously, the question is if it makes sense to treat all forms of business entities equally.
The fact is that not all business organizations separate the business from the owners. That separation varies according to the specific circumstances of the business and the agreement between the owners. And that effect has little connection to the legal form of the business or its legal personality. The interposition of a business entity with legal personality does not necessarily mean that there is a high degree of separation between the entrepreneur and the business, just as such a relevant separation may well exist as an effect of a depersonalized entity (think of investment funds, where all the investors are co-owners of the investment assets but have no control over them).
Shareholders in listed companies, for instance, acquire and hold their shares as a financial investment, with a view only to obtaining dividends or capital gains. These shareholders are not seeking a vehicle for carrying out their own business activities. They have little influence over the company's business decisions or the timing of the appropriation of its profit. These powers are concentrated in the management body of the company, often controlled by a small but compact core of shareholders. In these cases, there is a large gap between the owners and the business.
The opposite is professional partnerships, owned by a small number of partners united by close professional or personal relationships, who use a simple partnership agreement as a mere instrument for the joint exercise of their business or professional activity. In this case, the business or professional activity of each of the shareholders is of fundamental importance and, in practice, reflects their inseparable connection with the company. Here, unlike in the previous case, the shareholders exercise effective decision-making power over the destinies of the company, including the moment of appropriation of the respective profits. The business and the income of the company are intertwined with the business activity and the income of the shareholders. Due to this extreme proximity, entrepreneurs and the company form an economic unit, which may justify the disregard of the entity for tax purposes, in the sense that its activities and income are directly attributed to the shareholders.
For this reason, most tax systems tax the income of corporations as per se entities and partnerships as "pass-through" entities, meaning that the business profits are directly attributed to the owners for tax purposes.
3. There is a Case for Taxing the DAO
A surprising (to someone, not a tax practitioner) aspect of analyzing any DAO for tax purposes is that it can be a taxable entity1. In some sense, it appears like a disembodied creation floating in cyberspace, with no apparent form. Take the original DAO, for instance. Its group of investors intended to consult together to decide on investments, to make the investments, and to share in the profits. They, and those on the Ethereum blockchain, ultimately worked together to resolve the problem created by a rogue investor. Despite the disclaimers in the material presenting the original DAO to potential investors, the structure operated very much like a partnership contract2.
DAOs are, by definition, sufficiently separated from their owners. They "own" assets in the blockchain and their profits are not immediately paid to the participants. A collective decision, through consensus mechanisms, and token-based governance is required for that and any other purpose that affects the DAO (such as protocol upgrades, funding for projects, changes in rules, or adjustments to token economics).
In addition, although DAO's purpose and structure are not inherently tied to being either for-profit or non-profit, most operate with the goal of generating a profit and distributing it among its token holders or stakeholders. The profits might come from various sources, such as revenue generated by products or services offered by the DAO, investment activities, or other business ventures. It seems clear that these profits, like any other business profits, are manifestations of the ability to pay taxes.
Based on the above considerations, in our opinion, there is a strong case for taxing DAOs. They are autonomous entities that may generate taxable income.
II. The Challenges to Tax DAO's Income
Having a strong case does not mean that taxing the DAO will be an easy task, or even feasible under the current tax system.
The international tax system is built on a combination of domestic tax laws, bilateral and multilateral agreements, and international organizations that help establish guidelines and standards for taxation.
Each country has its own set of domestic tax laws that determine how income taxes are levied on individuals, businesses, and other entities within its borders. On top of this domestic structure, countries enter bilateral tax treaties with each other to establish rules for taxing cross-border activities.
According to this international tax order, in cross-border situations, the jurisdiction where the business owner is domiciled has the right to tax its worldwide profits and the country where the income is sourced has the right to tax the portion of the foreign entity's income that was generated in its territory.
The problem, insofar as taxing DAOs is concerned, is that the international tax system assumes that businesses are not only owned by individuals or entities that have a domicile in a specific country, and that their income may be pinpointed to a certain jurisdiction.
However, that is not how the global economy has evolved and technology has advanced.
1. Challenges of the Digital Economy
With the rise of digital technology and the growth of multinational corporations, the international tax system has faced many challenges. Digital businesses operate globally without a significant physical presence in each market they serve. This has led to debates about how to tax their profits, as traditional tax rules were not designed to address such scenarios. In addition, the digital economy relies heavily on data, and there are debates about how data should be treated in terms of taxation and value creation.
Also, multinational corporations, including digital giants, have been accused of using complex structures to shift profits to low-tax jurisdictions, minimizing their tax liabilities in higher-tax countries. This practice is known as base erosion and profit shifting (BEPS).
In response to these challenges, efforts have been made to update and reform the international tax system to better capture the realities of the modern economy, including the BEPS Project (launched to address the challenges of profit shifting and tax avoidance); the Digital Services Tax (levied on revenue generated from certain digital services, which sparked international debates and concerns about double taxation); and the Pillar One/Pillar Two Initiative (that addresses the allocation of taxing rights for digital businesses and establish a global minimum tax to prevent profit shifting).
2. DAO Specific Challenges
However, taxing DAOs is one step further from the complexity of taxing digital companies. These new taxes and initiatives, even if implemented, will not be sufficient to impose taxes on DAOs profits.
The main difference between digital business and business in the blockchain is that the first happens (digitally through the internet) between traditional legal entities, all of them domiciled in certain jurisdictions. The discussion is focused on where the income is sourced and where the business entities are really located, particularly because some companies are "redomiciled" to low-tax jurisdictions, but their customer base remains in high-tax countries.
The DAO, however, completely eludes this discussion. Contrarily to digital companies, the DAO is not domiciled anywhere, it operates based on blockchain technology and smart contracts, without employees, physical presence, or even legal status. DAOs are code. The DAO "exists" in cyberspace.
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Footnotes
1. Shakow, The Tax Treatment of Tokens: What Does It, 2017, 1387
2. Shakow, The Tao of the DAO, 2018, 11
Originally published by Mohr Siebeck
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.
