Accounting and tax compliance in crypto is much more complicated for institutions, such as funds, exchanges and prime brokerages, due to the volume of transactions that require record-keeping. Failing to file taxes properly can result in substantial fines and, in some cases, audits.
These high financial stakes combined with the difficulty of tracking so much complex transaction data has kept many institutions out of crypto to date. Understanding tax requirements and implementing programmatic record-keeping can be a good starting point for institutions to demystify crypto tax laws and reap the rewards of participating in this fast-growing ecosystem.
What are taxable events in crypto?
With the inception of crypto marked by the publication of the bitcoin white paper in October 2008, the industry is only 14 years old. However, the historically slow pace of regulatory change is finally catching up to where the ecosystem is today, with governments like the United States, Singapore, Australia and others issuing new frameworks and guidelines for how cryptocurrencies will be taxed in their jurisdictions.
In the U.S., the Internal Revenue Services (IRS) treats cryptocurrency as property, and so cryptocurrency transactions are subject to the same short-term and long-term capital gains taxes. A gain can be realized by selling cryptocurrency, trading or by purchasing an item like a car with cryptocurrency that has appreciated in value since the time it was originally purchased.
By the same token, losses from cryptocurrency investments can be written off as deductions. Cryptocurrency is taxed as regular income if it's received as payment for providing a service or earned from mining or staking. Interest earned from lending is also treated as income.
Perhaps most surprising of all, in the U.S. any movement of tokens or digital assets between wallets, centralized exchanges or individuals (without any sale or purchase taking place) is regarded as a taxable event as well.
This concept is completely foreign to most traditional financial institutions, as they are not used to paying fees if they send money between bank accounts. When even the smallest details become complex to track, one starts to weigh the value proposition of engaging in the first place. Luckily, with access to the right tools and data, this complexity can be managed.
Why crypto taxes get complicated
These categories for how cryptocurrencies are taxed in the U.S. may sound relatively simple: pay taxes on capital gains and deduct losses while counting other forms of crypto earned as regular income. But the challenge isn't knowing how cryptocurrency transactions are taxed – it's keeping track of all transactions.
In particular, financial institutions, such as exchanges, hedge funds, prime brokerages and trading desks could have millions of transactions to record, report and pay taxes on.
Additionally, stakes are high for entities failing to meet their tax and accounting requirements. Failing an audit due to poor accounting practices could result in the organization having to pay back taxes and face additional large fines.
The importance of granular tax compliance data
The high stakes combined with the challenges of accounting for millions of transactions necessitates the implementation of programmatic software for accessing and tracking granular data. Financial institutions depend on comprehensive APIs that can be integrated into their platforms to capture every transaction nuance so that balance sheets, income statements, cash flow statements and other essential accounting documentation can be quickly and easily generated.
In addition to wallet balances, deposits and net worth, institutional investors are also required to account for every transaction for every wallet under management.
Participating in decentralized finance (DeFi) protocols can make tax accounting even more complex. For example, if an institution is providing liquidity on a decentralized exchange (DEX), it also needs current and historical liquidity provisioning positions (in other words an exchange's assets and liabilities), current and historical percentage of the total pool owned, fees earned, claimed and unclaimed, as well as the percentage fee provided by the pool.
Institutions must also track their profits and losses while participating in DeFi. This includes marking any "impermanent losses," a crypto industry term for slippage, they incur as a liquidity provider on lending platforms like Aave and Compound. This is in addition to tracking important information like a platform's net annual percentage yield (APY), current loan-to-value ratio (LTV) and total value locked (TVL), which can often change in a blink of an eye in the fast-moving world of DeFi.
This comprehensive documentation is essential for financial institutions to meet all tax obligations and file correctly. Beyond tax law compliance, effective accounting also provides institutions with the benefit of better understanding their organization's tax exposure so that actions can be taken to reduce liability.
Regulatory clarity and institutional involvement
Any institutional player considering getting involved in the digital asset space is well aware of the need for tax law compliance (and the consequences for failing to comply), and many would cite regulatory risk as the biggest roadblock for participating in the digital asset economy. The good news is that regulatory clarity has improved dramatically over the past couple years.
Just last month, the Organization for Economic Co-operation and Development (OECD) published a new tax reporting framework, the Crypto-Asset Reporting Framework (CARF), to offer governments clarity on how transactions conducted across borders should be treated by tax authorities.
Notably, the reporting obligations include stablecoins, crypto derivatives and NFTs (non-fungible tokens), adding more layers to the record-keeping requirements institutions must undertake. This also reinforces the need for easy access and interpretation of granular data across transaction and asset types.
As tax laws are clarified globally and institutions realize the treasure trove of untapped opportunities in the digital asset ecosystem, expect to see greater numbers of TradFi players take the leap into the space – a trend that will only further contribute liquidity to markets and bolster opportunities for all.
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