Decentralized Autonomous Organizations (“DAOs”) continue to grow in popularity and provide utility to their members. As of May 2023, there were approximately 13,000 DAOs with a collective total treasury of almost $32 billion.[1] However, the uncertainty in the tax treatment of DAOs and the activities of their members persists. This article will examine the Canadian tax consequences of DAOs, with particular emphasis on the activities of individual DAO members (hereinafter referred to as “Members”).
DAOs are entities operating without a traditional hierarchal structure or centralized leadership. Decision-making and governance is determined democratically by token holders. The more tokens a Member has, the more impact their vote has on a decision. The decisions made by the Members are automatically implemented by smart contracts which operate on a set of rules programmed by a core team of developers who create the DAO.
DAOs can be for-profit or non-profit entities. There are various categories of DAOs, including:
Protocol DAOs;
Investment DAOs;
SubDAOs;
Service DAOs;
Social DAOs; and
Philanthropy DAOs
In Canada, there is no legal structure that precisely captures all the characteristics of a DAO. Depending on specific activities of the DAO, it may be a corporation, joint venture or even a partnership or trust as a flow-through entity. Internationally, there is no common approach to the classification of a DAO. Some U.S. states (including Vermont, Wyoming and Tennessee) recently enacted legislation to allow DAOs to register as a customized limited liability company[2], while other jurisdictions, such as the Cayman Islands, have incorporated DAOs as foundation companies.[3]
To achieve legal certainty and limit the liability of Members, a DAO should be carefully “wrapped” or registered as a traditional legal entity. The taxation of the DAO will depend on its business structure and the activities it undertakes. While the following analysis focuses on the activities of Members, we will elaborate on the taxation of a DAO itself in a later article.
Taxable Events for Individual DAO Members[4]
The activities of individual Members may be taxable events under the Income Tax Act (Canada) (the “ITA”) for Canadian residents.[5]
According to the Canada Revenue Agency (the “CRA”), a capital gain exists when you sell, or are considered to have sold, a capital property for more than the total of its adjusted cost base (“ACB”) and the outlays and expenses incurred to sell the property.[7] A capital loss exists when you sell, or are considered to have sold, a capital property for less than the total of its adjusted cost base and the outlays and expenses incurred to sell the property.[8]
A taxpayer realizes business income rather than a capital gain when deemed to have earned income from a “profession, calling, trade or undertaking of any kind whatever” or an “adventure or concern in the nature of trade”.[9]
In general, consistent and sustained activities undertaken with a view to profit will be labelled as a “business” activity within the meaning of the ITA. However, an “adventure or concern in the nature of trade” may still be captured by an isolated transaction in which a taxpayer makes a single, speculative purchase and ultimately sells the property.[10] Under these circumstances, as long as the transaction was intended to yield a profit, the transaction would likely be considered to be in the nature of business.[11]
There is a litany of case law which discusses whether income should be characterized as received on account of business or capital; however, the following is a list of factors which the CRA considers indicative of carrying on a business:
the taxpayer carries on the activity for commercial reasons and in a commercially viable way;
the taxpayer undertakes activities in a businesslike manner, which might include preparing a business plan and acquiring capital assets or inventory;
the taxpayer promotes a product or service;
the taxpayer’s conduct shows that they intend to make a profit, even if they are unlikely to do so in the short term; and
the taxpayer is engaged in an adventure or concern in the nature of trade.[12]
The CRA has further opined that the most relevant factor it will consider when distinguishing between business and capital gains treatment is the intention of the taxpayer.[13]
Ultimately, whether a DAO-related taxable event will receive capital gains treatment or business income treatment, among other possibilities, will depend on the circumstances at play. Notably, one-half of a capital gain must be included in a taxpayer’s income. Furthermore, one half of a capital loss (referred to as the allowable capital loss) may be deducted from capital gains. Capital losses may generally only be offset by capital gains, not other income. If the taxpayer does not have any capital gains against which to offset capital losses, the taxpayer can carry the net capital losses forward indefinitely, or alternatively, can carry the losses back for any of its preceding three years.[14] Conversely, all business income must be included in the taxpayer’s income and is subject to tax at the applicable marginal rate.[15]
Analysis of Taxable Events
DAOs may require the purchase of DAO Tokens or an NFT to join the DAO. Purchasing DAO Tokens or NFTs with fiat is not a taxable event. However, purchasing tokens or an NFT for membership with cryptocurrency is a taxable event which will ordinarily attract capital gains treatment, as the taxpayer will have disposed of the cryptocurrency used to buy the tokens or NFT for proceeds equal to the purchase price. The individual will realize a capital gain upon disposition of their cryptocurrency if the proceeds of the disposition are in excess of the ACB.[16] Purchasing tokens or an NFT membership with cryptocurrency may result in business income treatment as well if the proceeds of disposition on the purchase are deemed to have been earned from a “profession, calling, trade or undertaking of any kind whatever” or an “adventure or concern in the nature of trade”, per the analysis above.[17]
Selling DAO tokens for other cryptocurrency or fiat will be subject to either capital gains tax or business income tax depending on the nature of the Member’s activity. Holding tokens long-term may help in classifying the proceeds from their sale as a capital gain or capital loss, whereas holding tokens for short periods and selling them frequently may reflect an intention to profit, classifying the proceeds as business income.[18]
Profit distributions through the receipt of additional tokens to Members could be business income.[19] Members could be rewarded for their participation and contribution to the DAO which may include setting up the DAO, improving the DAO’s code and assisting with the administration of the DAO.
Rewards from DAOs can include staking rewards, airdrops or unsolicited gifts.
The receipt of rewards from staking DAO tokens would generally be taxed as business income, just as the traditional staking of cryptocurrencies.[20] The CRA has not released clear guidance on the tax treatment of staking, however, it has released guidance on the tax treatment of cryptocurrency mining. The CRA has stated that the income tax treatment of mining will depend on whether the mining activities are a personal activity/hobby or business activity. To note, the CRA maintains that a hobby pursued in a businesslike manner may still be taxed as business income.[21] If the CRA’s mining guidance applies to staking, there is a possibility to argue that a Member’s staking is a personal activity or hobby rather than a business activity, giving rise to a capital gain.[22] Ultimately, the CRA has not issued clear direction on the matter, and may argue in an audit that staking activity is business income.
Receiving airdrops or gifts of DAO tokens can result in varying tax treatment. The receipt of unsolicited airdrops or gifts of DAO tokens, granted that the taxpayer does not intend to carry on the activity for profit, should not be considered a source of income; it could arguably be considered a personal endeavour and not a taxable event.[23] However, receiving multiple airdrops or “gifts” may be considered business income.[24] The receipt of multiple DAO tokens in this manner could constitute a pursuit of profit and thus be considered a source of income.[25]
Similarly, proceeds from the sale or trade of gifted or airdropped tokens (including gifts to a person with whom a Member is at arm’s length[26]) may be subject to capital gains tax or business income treatment, depending on whether the activity is for a pursuit of profit and accordingly a source of income.[27]
Although regulators have yet to release clear guidance on the taxability of DAOs and the activities of Members, the author has presented his view of the likely taxable nature of these activities. It is important to proactively consider your crypto activity. Maintaining records and working with a tax professional will help avoid negative tax consequences.
Our team of lawyers and accountants are experienced in crypto audits and offshore tax planning. If you need assistance with your cryptocurrency-tax concerns, please contact us.
[1] All amounts referenced in this article are in Canadian dollars; EY Global, “How to navigate tax and legal complexity associated with DAOs” (August 2, 2023), online: <https://www.ey.com/en_gl/tax/how-to-navigate-tax-and-legal-complexity-associated-with-daos>.
[2] See the following for discussion on the state-level legislation in the United States allowing DAOs to register as modified limited liability companies: DeFi Education Fund, “DAO Legislation at the State-Level: Overview” (January 30, 2023), online: <https://www.defieducationfund.org/post/dao-legislation-at-the-state-level-a-brief-overview>. Wyoming and Tennesee have both enacted legislation creating DAO-specific LLCs, while Vermont has allowed DAOs to register as blockchain-based LLCs.
[3] See the following for discussion on the use of the Cayman Islands’ Foundation Company structure for DAOs: Carey Olsen, “Cayman Islands Foundation Companies for DAOs, Defi and NFTs” (April 6, 2022), online: <https://www.careyolsen.com/briefings/cayman-islands-foundation-companies-daos-defi-and-nfts>. Like a traditional corporation, the foundation company has a separate legal personality and limited liability, affording DAOs abilities such as being able to execute contracts. The foundation company may also be an appealing option for DAOs as the structure can function without shareholders, making it ownerless, and powers can be wielded by persons other than directors.
[4] The analysis in this article only applies to individual DAO members. It does not apply to flow-through entities such as trusts or partnerships. These entities will have different tax treatment as members of DAOs.
[5] If the DAO is established in a foreign jurisdiction, there may be additional foreign tax considerations that have not been contemplated by this article.
[6] The author is attempting to highlight the likely income tax treatment for each of these activities that a Member may undertake. Depending on the specific circumstances of the Member, the applicable income tax treatment may vary. This article does not consider the excise tax considerations for each of these activities.
[7] Income Tax Act, RSC, 1985, c 1 (5th Supp), ss 39(1)(a) and 40(1)(a) [ITA]; Canada Revenue Agency, “T4037 Capital Gains 2021” at “Definitions” (January 18, 2022), online: https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4037/capital-gains.html.
[8] ITA, supra note 7, ss 39(1)(b) and 40(1)(b); Canada Revenue Agency, “T4037 Capital Gains 2021” at “Definitions” (January 18, 2022), online: <https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/t4037/capital-gains.html>.
[9] ITA, supra note 7, s 248(1).
[10] Jinyan Li et al, “Principles of Canadian Income Tax Law”, 9th Edition, (Thomson Reuters: Toronto, 2020), citing to: Minister of National Revenue v Taylor, [1956] CTC 189 (Can Ex Ct) 56 DTC 1125 and No 476 v Minister of National Revenue, [1960] CTC 384 (SCC) 60 DTC 1270.
[11] Ibid.
[12] Canada Revenue Agency, “Guide for cryptocurrency users and tax professionals” (June 26, 2021), online: <https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/compliance/digital-currency/cryptocurrency-guide.html> [Crypto Guide].
[13] Canada Revenue Agency, Interpretation Bulletin IT-459, “Adventure or Concern in the Nature of Trade” (September 8, 1980), online: <https://www.canada.ca/en/revenue-agency/services/forms-publications/publications/it459/archived-adventure-concern-nature-trade.html> [IT-459].
[14] Crypto Guide, supra note 12.
[15] ITA, supra note 7, ss 38(a) and 9(1); See our previous article on the Taxation of NFTs titled “Taxation of Cryptocurrencies: The Current Utility of NFTs and their Practical Future Use Cases” for a more detailed analysis of capital gains treatment and business income treatment.
[16] ITA, supra note 7, ss 39(1)(a) and 40(1)(a).
[17] Ibid, s 248(1).
[18] IT-459, supra note 13; Happy Valley Farms Ltd v Minister of National Revenue, [1986] 2 CTC 259, [1986] FCJ No 465 at para 14; Canada Revenue Agency, “Income Tax Audit Manual Chapter 29” (July 2020), online: <https://www.canada.ca/en/revenue-agency/services/tax/technical-information/income-tax-audit-manual-domestic-compliance-programs-branch-dcpb-29.html>.
[19] ITA, supra note 7, ss 9(1) and 248(1).
[20] ITA, supra note 7, ss 9(1) and 248(1); Michelle Legge, “Crypto Tax Canada: Ultimate Guide 2023” (April 12, 2023), online: <https://koinly.io/guides/crypto-tax-canada/> [Koinly].
[21] Crypto Guide, supra note 12.
[22] Ibid.
[23] ITA, supra note 7, s 3; Stewart v Canada, 2002 SCC 46 at paras 48–60 [Stewart].
[24] ITA, supra note 7, ss 9(1) and 248(1).
[25] Stewart, supra note 26 at paras 48- 60.
[26] ITA, supra note 7, s 69(1). An individual may be subject to capital gains tax when gifting a token to another person with whom they do not deal at arm’s length by operation of subsection 69(1) of the Act. Subsection 69(1) will deem the donor of the token to have disposed of it for proceeds equal to its fair market value on the date of the gift. In sum, subsection 69(1) requires that a donor recognize a gain upon gifting a token for tax purposes where the fair market value of the token exceeds its ACB on the date of the gift, even where no consideration was received by the donor. When such a gift is completed, the donee of the token will generally not be subject to tax on the gift, and the donee’s new ACB will be equal to the fair market value of the token at the time of the gift.
[27] Ibid, ss 39(1)(a) and 40(1)(a); Koinly, supra note 21; Stewart, supra note 26 at paras 48- 60.
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