We explore some of the many U.S. tax considerations around the formation and operations of decentralized autonomous organizations (DAOs) in the blockchain and digital assets spaces.
The number of DAOs created on Web3 platforms is rising quickly in the blockchain and digital assets spaces. A DAO is an organization formed by a defined community of members who act as a governance body and make decisions collectively as a group. In this structure, no one person or entity controls the organization, and it is established with the mandate to perform perfunctory tasks that serve in the best interests of the community members.
Attractive to many decentralized finance (De-Fi) platforms and made possible through blockchain technology, this was spurred and encouraged by the movement to create a fully decentralized network of native token holders on a particular blockchain protocol.
It is critical for founders of blockchain companies with any connection to the U.S. to consider that tax issues arise almost immediately after the initial formation of an entity. Important considerations related to the formation of the parent company — including the residency of the company founders, jurisdiction of the intellectual property (IP)/DeFi platform rights, on-chain operational activities, and the hiring of employees or contractors — all have potential U.S. tax implications.
These tax impacts should be at the forefront of the decision-making process, especially if the goal is to establish a DAO with no or limited exposure to potential U.S. taxation. Where to hold IP rights, whether activities of a non-U.S. entity give rise to U.S. tax implications, how the business and its ecosystem anticipate generating revenues, as well as the functions and the locations of employees and contractors, should be addressed from a global tax perspective for efficient structuring.
Ownership of IP rights
Often, there is a desire by company founders to transfer IP to an entity or foundation that functions and operates independently of any central authority, such as a DAO. Ownership considerations of the underlying IP platform or blockchain protocol are a key factor in determining whether the operations of the business or a transfer of IP rights will trigger U.S. tax implications.
IP developed in the U.S. may likely trigger U.S. tax once commercialized or transferred outside the U.S., based on factors such as the fair market value or the revenues generated. Likewise, if there is a preference to have the IP held by the DAO or other offshore entity, valuation of the assets to be sold or transferred is part of the strategic planning to determine how best to migrate those assets.
Consider an alternative scenario where IP is developed offshore, yet is managed from the U.S. business activities. Under this structure, the IP may be deemed to generate income connected to a U.S. trade or business, resulting in potential tax liabilities for the DAO or the non-U.S. operating company.
Non-U.S. entities creating U.S. tax implications
The classification of whether a business is operating in the U.S. or abroad is not just simply defined by the jurisdiction of where the FinTech or blockchain company is registered. A company registered and incorporated outside of the U.S., but with U.S. resident company founders, could still be considered engaged in a U.S. trade or business and thus subject to related income tax reporting obligations.
The issues triggered by the jurisdiction of entity incorporation versus place of management or operations have become particularly relevant in the FinTech, blockchain and digital assets industries where founders may be U.S. citizens or permanent residents, but reside abroad; or, alternatively, where a non-U.S. entity has management or certain other functions occurring in the U.S. In these scenarios, the determination of whether the company is engaged in a U.S. trade or business will depend on several factors including the level of decision-making exercised and performance of revenue-generating functions.
In determining whether a business will operate under a service model or generate revenues through transaction fees or licenses, a company should consider the tax implications relevant to its anticipated business model. Whether the revenues are characterized as derived from services, royalties or interest, each characterization for tax purposes may result in the application of potentially different rules. These rules may trigger withholding taxes, affect the creditability of foreign taxes against U.S. tax liabilities or determine whether certain income is subject to U.S. tax depending on applicable sourcing rules.
Specifically, intercompany transactions among related parties in the group of companies raise transfer-pricing issues that require consideration. These rules aim to ensure an arm’s length price on transactions between related parties. Proper analysis helps establish defensible positions for tax purposes, mitigates the risk of a tax authority reallocating revenues and expenses between related parties, and helps avoid unintended tax consequences. In other words, neglecting the implementation of a transfer pricing policy with respect to related-party transactions may result in an unexpected increase in taxable income from the IRS or other tax authority. Obviously, this could have significant implications, depending on the applicable corporate tax rates in the jurisdiction where the company operates.
Functions and locations of employees or contractors
Remote working has become the norm and has created new operational and tax planning concerns. Many foreign companies hiring workers from or based in the U.S. should be aware of potential activities and ongoing operational support that may trigger U.S. tax implications. In the case of blockchain companies, activities such as minting and/or issuance of tokens and validating nodes occur seemingly without human intervention or a central taxable entity. However, tax authorities may look to source the origin of these activities and whether they are performed by employees or contractors performing trade or business on behalf of the company.
Further, understanding the U.S. tax reporting and payment obligations of hiring employees versus contractors is crucial as there could be significant fines for not appropriately registering and fulfilling employer-paid obligations. Even after a DAO structure is introduced, the ongoing operations and support services of the blockchain platform need to be carefully examined to determine whether there are ties between the operating entity and the DAO.
Tax credit opportunities in R&D
Potential tax credit opportunities also exist for businesses in this space. FinTech and blockchain companies often invest in research and development (R&D) activities and IP creation from the start of business operations. These R&D expenditures might include hardware and salaries paid to personnel or engineers to develop proprietary algorithms and software. R&D tax credits, a dollar-for-dollar tax reduction of a company’s tax liability, may be available for such activities performed by a U.S. trade or business, if structured properly.
Talk to the BPM tax team
These topics represent just a few of the myriad U.S. tax implications and considerations related to companies operating in the FinTech, Web3, blockchain and digital assets spaces. This fast-growing, yet still relatively nascent industry, can seem difficult to navigate from a tax perspective. Our experienced tax professionals can guide you through these challenges every step of the way.
Javier Salinas is a Partner in BPM’s International Tax Group and the leader of its Blockchain and Digital Assets Industry Group. Javier advises clients on U.S. international tax matters, including global tax planning with respect to their structures, operations and transactions.
Michelle Choy is a Director in BPM’s Tax Group, specializing in planning and compliance for pass-through investment vehicles, corporate entities, foreign special purpose vehicles and hedge funds. Michelle has a particular focus on serving clients in the Blockchain and Digital Assets and Financial Services industries. She is currently attending the Graduate Institute in Geneva, Switzerland. There, she is pursuing a master’s degree in international leadership and strategy with a focus on building and improving policy around financial inclusion using blockchain and digital asset financial instruments.