How Crypto is Changing Wealth Creation and Impacting Tax Authorities

The crypto ecosystem is evolving rapidly, transforming not just financial markets but also mechanisms of wealth creation and, by extension, taxable events. As digital assets continue to gain traction, they introduce novel avenues for generating income, and simultaneously present unique challenges for tax authorities.

Five income streams from on-chain activities

For many tax authorities, it has been difficult to identify taxpayers with digital asset transactions. This stems from a variety of reasons, including lack of self-disclosures, lack of third-party reporting, and lack of education directed at taxpayers. In this post, we’ll explore five key ways taxpayers may be earning income through on-chain activities, and how these activities may be identified through a variety of tools and processes.

The tax implications of on-chain activity may vary widely from jurisdiction to jurisdiction. Here, we’ll cover a range of on-chain activities—but, ultimately, tax authorities in each jurisdiction should have an understanding of the tax implications of each of these activities.

1. Trading

The most common form of income generation in the crypto space is through the buying and selling of crypto assets, with the aim to profit from price fluctuations. These assets may extend from the most well known cryptocurrencies like Bitcoin and Ether, but may also include a long tail of other assets such as NFTs, governance tokens, algorithmic stablecoins, and others. While this practice may have initially begun with retail speculators, it has now spread to investors of every kind—including large asset management firms, hedge funds, high-speed trading firms, and financial institutions with crypto assets on their balance sheet.

Depending on your country’s specific tax code, each crypto-to-crypto trade or crypto-to-fiat exchange may trigger a taxable event, requiring meticulous record-keeping for capital gains calculations. Similarly, the tax treatment of capital gains from digital assets can vary widely: Some countries may offer favorable tax rates or exemptions for long-term holdings, while others may apply standard income tax rates regardless of the holding period.

How to identify crypto asset trades

Tax authorities have a variety of ways in which they may receive indicators that a taxpayer is trading in crypto.

Trade data may stem from third-party reporting from exchanges as part of a tax regime, voluntary disclosures, or legal processes (e.g. subpoenas, John Doe Summons, etc.) delivered to crypto businesses requesting data. It may also surface in the process of an audit, in which the tax authority official may come across a piece of information (e.g. a wallet address, banking transactions to exchanges, employment compensation paid in crypto, etc.) indicating a potential nexus to crypto trading. Certain types of trading in assets like NFTs may also be discoverable in transaction logs, where one may see incoming deposits from known NFT auction houses such as OpenSea.

2. Mining, validating, or staking

Mining is the process of validating transactions and securing the blockchain network, for which miners receive newly minted coins. Similar to mining, validators in proof-of-stake networks are chosen to create new blocks and confirm transactions. Staking involves locking up a certain amount of cryptocurrency to support the operations of a blockchain network. In return, stakers earn rewards, which may be considered taxable income at the time they are received or converted to fiat assets.

While there are key technical differences between these three activities, they may share similarities in terms of creating potential income for taxpayers and common ways tax authorities can identify these activities in a taxpayer’s profile.

How to identify mining, validating, or staking activity

While some crypto exchanges and centralized services may offer programs where users can engage in these activities through the intermediary (with rewards deposited back to the centralized account), these activities and subsequent rewards may also be paid out directly to private wallets held away from centralized services.

In either case, tax authorities should be generally aware of these types of activity so that they can more easily identify withdrawals and deposits that are regularly received from activities like staking services within a decentralized protocol or validators—which may follow predictable intervals and amounts. Tax authorities reviewing transactional statements may also find outgoing transactions that indicate the taxpayer has engaged in these services, such as identifying a transaction of 32 ETH (i.e. the requisite amount to become a validator on the Ethereum network) sent to a deposit contract. Similarly, deposits from mining pools or services would indicate additional streams of income from mining activities that may need disclosure.

3. Lending

Lending in the crypto space allows users to lend their crypto assets to others in exchange for interest payments—providing a way to earn passive income. The assets being lent may range from Ether to stablecoins to alt-tokens. This process can be facilitated through various platforms and services, such as Aave, Compound, and BlockFi, each offering unique features and terms. Depending on the platform, the lender might have the option to set the terms of the loan, including the interest rate, duration, and type of crypto asset used to pay the interest.

How to identify lending activity

Tax authorities can identify crypto lending activity by identifying outgoing transactions to lending platforms without corresponding asset swaps, potentially indicating the transfer of assets for lending purposes rather than trading.

Additionally, blockchain intelligence platforms like TRM can be employed to identify these type of counterparties in transactional statements to help uncover patterns and pinpoint potential lending activities.

4. Yield farming

Yield farming—or liquidity mining—involves providing liquidity to decentralized finance (DeFi) protocols in exchange for rewards. These rewards are often paid in the form of additional tokens, which can accumulate significant value over time. It is not uncommon for yield farmers to move their assets across various protocols to maximize returns, taking advantage of high interest rates and incentives offered by new and existing DeFi projects. The benefits of yield farming include earning passive income, gaining exposure to new and potentially volatile tokens, and enhancing the overall liquidity and stability of DeFi platforms.

How to identify yield farming activity

Because yield farming typically involves transactional activity with DeFi protocols, tax authorities can look for patterns of regular deposits into and withdrawals from known liquidity pools. These transactions often involve significant amounts of various tokens being moved to smart contracts associated with DeFi platforms. By leveraging blockchain intelligence tools, tax authorities can trace these deposits and correlate them with the corresponding reward tokens received. Reporting requirements for DeFi platforms and exchanges can further aid in identifying yield farming income by providing detailed transaction records and user activity. Additionally, sudden spikes in token balances or the presence of newly issued tokens in a taxpayer's wallet can indicate yield farming activities.

5. Airdrops

Airdrops involve distributing free tokens to holders of a particular cryptocurrency. These tokens are often given as part of promotional efforts, rewards, or community-building initiatives. For example, a new project might Airdrop tokens to users who hold a specific cryptocurrency as a way to generate interest and create a user base. Airdrops can also serve as a method for distributing governance tokens, enabling recipients to participate in the decision-making processes of a decentralized platform.

How to identify Airdrops

Again, blockchain intelligence tools are invaluable in helping tax authorities track and identify large distribution events like airdrops. These tools can analyze blockchain data to detect when, for example, a smart contract distributes newly created tokens to hundreds of private wallet addresses. Those tokens may then be traded at exchanges or in DeFi protocols for taxpayers to reap rewards from the Airdrop. Additionally, tax authorities can rely on third-party reporting from cryptocurrency exchanges, which often support these events and provide transaction data related to the distribution of new tokens.

Challenges for tax authorities

As more consumers adopt crypto in their wealth portfolios, tax authorities need to be vigilant about monitoring these new forms of wealth creation. This diversification of taxpayer income streams from crypto activities introduces several challenges for tax authorities:

1. Complexity in tracking and valuation: Tax authorities must develop robust systems to track various crypto transactions, and accurately value digital assets at different points in time to assess tax liabilities.
2. Reporting requirements: Ensuring taxpayers and crypto intermediaries accurately report their crypto-related income necessitates clear guidance and reporting standards.
3. Detection of noncompliance: More diverse income streams create more ways that taxpayers may be non-compliant. Tax authorities need to leverage blockchain intelligence to uncover undisclosed transactions, assets, and sources of income to ensure they capture all of a taxpayer’s wealth portfolio.
4. Education and awareness: As the crypto ecosystem is still nascent, many taxpayers may be unaware of their tax obligations. Tax authorities must invest in campaigns to educate taxpayers to promote higher rates of voluntary compliance.
5. International coordination: Given the global nature of digital assets, international cooperation when it comes to crypto tax compliance is crucial. Tax authorities must work together to share information and enforce compliance across borders.

Crypto assets are reshaping the landscape of wealth creation, presenting both opportunities and challenges for investors and tax authorities alike. As the ecosystem continues to grow, it is imperative for tax authorities to adapt—leveraging technology and fostering international cooperation—to ensure effective taxation and compliance, and to safeguard the integrity of the tax system.