Author: (1) Arindam Misra. Author: Author: (1) Arindam Misra. Table of Links Abstract and 1. Introduction Abstract and 1. Introduction Bitcoin and the Blockchain 2.1 The Origins 2.2 Bitcoin in a nutshell 2.3 Basic Concepts Crypto Exchanges Source of Value of crypto assets and Bootstrapping Initial Coin Offerings Airdrops Ethereum 7.1 Proof-of-Stake based consensus in Ethereum 7.2 Smart Contracts 7.3 Tokens 7.4 Non-Fungible Tokens Decentralized Finance and 8.1 MakerDAO 8.2 Uniswap 8.3 Taxable events in DeFi ecosystem 8.4 Maximal Extractable Value (MEV) on Ethereum Decentralized Autonomous Organizations - DAOs 9.1 Legal Entity Status of DAOs 9.2 Taxation issues of DAOs International Cooperation and Exchange of Information 10.1 FATF Standards on VAs and VASPs 10.2 Crypto-Asset Reporting Framework 10.3 Need for Global Public Digital Infrastructure 10.4 The Challenge of Anonymity Enhancing Crypto Assets Conclusion and References Bitcoin and the Blockchain 2.1 The Origins 2.2 Bitcoin in a nutshell 2.3 Basic Concepts Bitcoin and the Blockchain 2.1 The Origins 2.1 The Origins 2.2 Bitcoin in a nutshell 2.2 Bitcoin in a nutshell 2.3 Basic Concepts 2.3 Basic Concepts Crypto Exchanges Crypto Exchanges Crypto Exchanges Source of Value of crypto assets and Bootstrapping Source of Value of crypto assets and Bootstrapping Source of Value of crypto assets and Bootstrapping Initial Coin Offerings Initial Coin Offerings Initial Coin Offerings Airdrops Airdrops Airdrops Ethereum 7.1 Proof-of-Stake based consensus in Ethereum 7.2 Smart Contracts 7.3 Tokens 7.4 Non-Fungible Tokens Ethereum Ethereum 7.1 Proof-of-Stake based consensus in Ethereum 7.1 Proof-of-Stake based consensus in Ethereum 7.2 Smart Contracts 7.2 Smart Contracts 7.3 Tokens 7.3 Tokens 7.4 Non-Fungible Tokens 7.4 Non-Fungible Tokens Decentralized Finance and 8.1 MakerDAO 8.2 Uniswap 8.3 Taxable events in DeFi ecosystem 8.4 Maximal Extractable Value (MEV) on Ethereum Decentralized Finance and 8.1 MakerDAO Decentralized Finance and 8.1 MakerDAO 8.2 Uniswap 8.2 Uniswap 8.3 Taxable events in DeFi ecosystem 8.3 Taxable events in DeFi ecosystem 8.4 Maximal Extractable Value (MEV) on Ethereum 8.4 Maximal Extractable Value (MEV) on Ethereum Decentralized Autonomous Organizations - DAOs 9.1 Legal Entity Status of DAOs 9.2 Taxation issues of DAOs Decentralized Autonomous Organizations - DAOs Decentralized Autonomous Organizations - DAOs 9.1 Legal Entity Status of DAOs 9.1 Legal Entity Status of DAOs 9.2 Taxation issues of DAOs 9.2 Taxation issues of DAOs International Cooperation and Exchange of Information 10.1 FATF Standards on VAs and VASPs 10.2 Crypto-Asset Reporting Framework 10.3 Need for Global Public Digital Infrastructure 10.4 The Challenge of Anonymity Enhancing Crypto Assets International Cooperation and Exchange of Information International Cooperation and Exchange of Information 10.1 FATF Standards on VAs and VASPs 10.1 FATF Standards on VAs and VASPs 10.2 Crypto-Asset Reporting Framework 10.2 Crypto-Asset Reporting Framework 10.3 Need for Global Public Digital Infrastructure 10.3 Need for Global Public Digital Infrastructure 10.4 The Challenge of Anonymity Enhancing Crypto Assets 10.4 The Challenge of Anonymity Enhancing Crypto Assets Conclusion and References Conclusion and References Conclusion and References Abstract The Financial system has witnessed rapid technological changes. The rise of Bitcoin and other crypto assets based on Distributed Ledger Technology mark a fundamental change in the way people transact and transmit value over a decentralized network, spread across geographies. This has created regulatory and tax policy blind spots, as governments and tax administrations take time to understand and provide policy responses to this innovative, revolutionary, and fast-paced technology. Due to the breakneck speed of innovation in blockchain technology and advent of Decentralized Finance, Decentralized Autonomous Organizations and the Metaverse, it is unlikely that the policy interventions and guidance by regulatory authorities or tax administrations would be ahead or in sync with the pace of innovation. This paper tries to explain the principles on which crypto assets function, their underlying technology and relates them to the tax issues and taxable events which arise within this ecosystem. It also provides instances of tax and regulatory policy responses already in effect in various jurisdictions, including the recent changes in reporting standards by the FATF and the OECD. This paper tries to explain the rationale behind existing laws and policies and the challenges in their implementation. It also attempts to present a ballpark estimate of tax potential of this asset class and suggests creation of global public digital infrastructure that can address issues related to pseudonymity and extra-territoriality. The paper analyses both direct and indirect taxation issues related to crypto assets and discusses more recent aspects like proof-of-stake and maximal extractable value in greater detail. The overall objective of the paper is to enable a tax policymaker, an auditor, or an investigator to obtain a reasonable understanding of this technologically challenging realm of economic activity, and formulate tax policy and laws according to the specific requirements of their individual jurisdictions. 1. Introduction On 3rd January 2009, Satoshi Nakamoto mined the first block of Bitcoin (the genesis block) and created a revolutionary system of storing and transmitting value in a trustless[1] manner over an open network. The genesis block also insinuated at the philosophy behind the newly created network. The transaction which generated the first 50 Bitcoins contained the phrase “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” which alluded to the problems of the contemporary monetary and financial system. However, Bitcoin was and remains largely a network for storing and transmitting value through the blockchain. Few years later, on 30th July 2015 Vitalik Buterin started Ethereum, which had more features as compared to Bitcoin and worked like a global general purpose computing virtual machine. The ability to run customized code on blockchain started an entire ecosystem of applications which provide innovative financial products from lending and borrowing, to insurance through smart contracts[2]. With blockchain networks like Solana the transaction speeds can outnumber traditional networks like Visa[3]. Entities like Decentralized Autonomous Organizations, Decentralised Applications and the Metaverse challenge the traditional notions of source and residence-based taxation and pose new challenges to taxing this form of digital economy. This has given rise to a new asset class which has unique features like openness, decentralization, pseudonymity, and transparency. This asset class also aims at improving the efficiencies of the current financial and monetary system where transfer of securities can take a couple of days, or sending/receiving huge sums of money across nations can take a few days. It enables creating a financial system where users with lower capital do not get differentially treated than those with huge capital[4]. Although there are studies that indicate that entities with large capital can get certain advantages in the crypto asset ecosystem (Aramonte et. al 2021). This has also created new challenges for tax policy and administration, which is more accustomed to function in a centralized banking ecosystem where identities of the participants are known or possible to be known. The beneficial ownership of entities can be found and the source and origins of transactions can be traced in the centralized system. However, with crypto assets, especially those held and transacted using non-custodial wallets[5] it is difficult, if not impossible, to identify the natural or juridical person behind the transaction. The nature of these assets also blurs regulatory boundaries as they possess the characteristics of money, equity, commodity, financial instruments, and property (Auer, R., & Claessens, S. (2018)). Consequently, many countries have no regulatory or taxation framework for this asset class, and there is wide variety in regulation and taxation of this asset class across jurisdictions which have formulated policies and guidance for crypto assets. The increasing volumes of transactions in crypto assets make it a sizeable tax base, which if not taxed appropriately, can lead to potential revenue loss. Thus, it becomes important for policymakers to have a conceptual understanding of this asset class and its financial ecosystem, to effectively formulate and administer realistic tax policies and laws regarding crypto assets, or to use the existing legal and policy framework to collect due taxes. It is also imperative for investigators and law enforcement agencies to acquaint and train themselves with this technology, as they are likely to have more frequent encounters with it while performing audit and investigating tax fraud cases. There is abundant literature and guidance available to the tax authorities, practitioners, and taxpayers regarding the regulatory and taxation regimes for crypto assets in different jurisdictions. However, it is imperative to have a grasp of the underlying technology and dynamics of these assets and not just the legal provisions, to be able to effectively regulate and tax them. For example, notions like the site of storage of Bitcoins and crypto assets, and the services provided by various members of this ecosystem and their place of supply have a bearing on multiple issues related to direct and indirect taxes. It is important to understand the mining process using proof-of-work and proof-of-stake mechanisms, and the nexus between a miner or validator and crypto asset owner whose transaction is included on the blockchain by the miner or validator (service provider) for the purpose of indirect taxation. Also, questions like tax treatment of Non-Fungible Tokens (NFTs) and what exactly the owner of an NFT gets legally, are central to their taxation. This paper tries to relate the technological underpinnings of this asset class to the tax events they trigger and the source of economic value creation in this ecosystem, which can enable the tax administrations to tax them intuitively based on the existing tax provisions or any other specific provisions or guidance for crypto assets. It also tries to quantify their tax potential from publicly available data on crypto asset transactions. This paper first explains the basic concepts of blockchain technology using Bitcoin as a classic example. It also explains the vulnerabilities of the Bitcoin Blockchain to emerging technologies like quantum computing. The later sections deal with Ethereum and its recent change to the proof-of-stake consensus mechanism. The discussion tries to link the underlying technology to the regulatory and tax implications. It also tries to make the reader understand why a specific regulatory or enforcement action which is effective in the current centralized system, may not be practical in case of crypto assets. The paper also includes the regulatory and tax policy responses by multiple jurisdictions to specific areas in crypto assets to enable the tax practitioners to understand the various approaches used to tax this asset class. For example, a law enforcement agency’s request to a Decentralized Application to identify the beneficial owner of a particular crypto asset address might be impossible for the application to process for purely technological reasons. The understanding of underlying technology is also important to formulate practical and realistic policies to ring fence this technology from its potential misuse for tax evasion, money laundering, terror financing, proliferation financing and other illegal activities and at the same time, not to stifle the innovative spirits of the torch bearers of this technology, which also has huge potential benefits (Marian, 2013), (Kapsis, 2023), (Shin & Rice, 2022). This paper is available on arxiv under CC BY 4.0 DEED license. This paper is available on arxiv under CC BY 4.0 DEED license. available on arxiv available on arxiv A trustless system is one in which the participants do not need to trust a third party or each other for the system to function as intended. *The author belongs to the Indian Revenue Service and is currently working as a Joint Commissioner at the Tax Policy Research Unit, Department of Revenue, Government of India. Email: misra.arindam@gov.in **This paper is not a legal or investment guide or advice and is purely academic in nature. Readers should draw their own legal conclusions and investment decisions regarding Crypto Assets and their Taxation. *** The findings, interpretations, and conclusions expressed herein are those of the author and do not necessarily reflect the views of the Government of India. This paper represents the personal views of the author only, not the views of the Government of India. The author accepts sole responsibility for any errors. **** Readers are advised not to send any Crypto Assets to any public addresses given in the paper, the author is not responsible for loss of any Crypto Assets due to any such actions. Smart Contracts are analogous to automated agreements stored on the Blockchain which can accept or release crypto assets or perform certain actions when certain conditions specified in the form of code are met Solana: Better Than Your Credit Card? https://hbr.org/2022/05/how-digital-currencies-can-help-small-businesses Non-Custodial wallets allow users to have full ownership of their crypto assets without relying on any central custodian of the secret keys corresponding to the crypto assets A trustless system is one in which the participants do not need to trust a third party or each other for the system to function as intended. *The author belongs to the Indian Revenue Service and is currently working as a Joint Commissioner at the Tax Policy Research Unit, Department of Revenue, Government of India. Email: misra.arindam@gov.in **This paper is not a legal or investment guide or advice and is purely academic in nature. Readers should draw their own legal conclusions and investment decisions regarding Crypto Assets and their Taxation. *** The findings, interpretations, and conclusions expressed herein are those of the author and do not necessarily reflect the views of the Government of India. This paper represents the personal views of the author only, not the views of the Government of India. The author accepts sole responsibility for any errors. **** Readers are advised not to send any Crypto Assets to any public addresses given in the paper, the author is not responsible for loss of any Crypto Assets due to any such actions. A trustless system is one in which the participants do not need to trust a third party or each other for the system to function as intended. *The author belongs to the Indian Revenue Service and is currently working as a Joint Commissioner at the Tax Policy Research Unit, Department of Revenue, Government of India. Email: misra.arindam@gov.in **This paper is not a legal or investment guide or advice and is purely academic in nature. Readers should draw their own legal conclusions and investment decisions regarding Crypto Assets and their Taxation. *** The findings, interpretations, and conclusions expressed herein are those of the author and do not necessarily reflect the views of the Government of India. This paper represents the personal views of the author only, not the views of the Government of India. The author accepts sole responsibility for any errors. **** Readers are advised not to send any Crypto Assets to any public addresses given in the paper, the author is not responsible for loss of any Crypto Assets due to any such actions. Smart Contracts are analogous to automated agreements stored on the Blockchain which can accept or release crypto assets or perform certain actions when certain conditions specified in the form of code are met Smart Contracts are analogous to automated agreements stored on the Blockchain which can accept or release crypto assets or perform certain actions when certain conditions specified in the form of code are met Solana: Better Than Your Credit Card? Solana: Better Than Your Credit Card? https://hbr.org/2022/05/how-digital-currencies-can-help-small-businesses https://hbr.org/2022/05/how-digital-currencies-can-help-small-businesses Non-Custodial wallets allow users to have full ownership of their crypto assets without relying on any central custodian of the secret keys corresponding to the crypto assets Non-Custodial wallets allow users to have full ownership of their crypto assets without relying on any central custodian of the secret keys corresponding to the crypto assets