Table of Links
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Bitcoin and the Blockchain
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Decentralized Finance and 8.1 MakerDAO
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Decentralized Autonomous Organizations - DAOs
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International Cooperation and Exchange of Information
10.1 FATF Standards on VAs and VASPs
10.2 Crypto-Asset Reporting Framework
9. Decentralized Autonomous Organizations - DAOs
Both the DeFi applications discussed above rely on smart contracts for their execution without the need for any centralized entity or agency. The parameters like savings rate, token pairs to be exchanged on the platform, collateralization ratio for various tokens etc. are decided by members holding voting rights through governance tokens of the DeFi applications. Such DeFi applications are classic examples of Decentralized Autonomous Organizations, which run on permissionless public blockchains without any centralized institutional structures, usually not having offices or addresses where operations are carried out or decisions are made. The rules that govern such organizations are encoded into and enforced through smart contracts on the blockchain, unlike conventional organizations where board of directors and personnel with clearly defined powers and responsibilities take decisions on behalf of the shareholders or participants
DAOs attempt to address the ‘agency problem’ faced by many traditional organizations by making decision-making more participative. Each member of the DAO’s governance contributes virtual assets to the DAO and obtains rights to vote through governance tokens. Holders of governance tokens can make proposals and vote on proposals through various voting models like Token-Based Quorum Voting, Quadratic Voting etc.138 . The wide variety of activities carried out by participants is based on foundations of Cryptography and properties of the transactions undertaken on the blockchain. This provides pseudonymity to the DAO’s participants who can use the applications to carry out transactions without any KYC requirements or disclosure of tax residency or beneficial ownership information. Also, this renders the DAO technologically unable to gather the required information for filing and compliance purposes, if any. As the application is essentially smart contract code running on a public blockchain, it is possible to create a DAO without any formal registration with a State, any government entity, or a regulator. This makes it possible for a DAO to have an organizational form which does not formally associate with any legal entity with the location of its operations and users not being known with certainty.
The World Economic Forum’s report Decentralized Autonomous Organization Toolkit defines DAOs as organizational structures that use blockchains, digital assets and related technologies to allocate resources, coordinate activities and make decisions. In simple terms, Decentralized Autonomous Organizations (DAOs) are like digital clubs or teams where people work together, but there is no boss or leader. Instead, decisions are made by everyone involved. Imagine a school club where all members vote on what activities to do, what snacks to bring, and how to spend the club’s money. That is analogous to how DAOs work, but they use blockchains and smart contracts instead. DAOs are not just confined to financial applications like decentralized exchanges but can have a wide gamut of forprofit and non-profit objectives. Some examples of different kind of DAOs are:
i. Protocol DAOs: These are like the “rule-makers” for online applications. They decide how the application works, what features to add, and when to update it. example: Uniswap is a popular decentralized exchange (DEX) protocol. Its governance decisions are made by UNI token holders.
ii. Grant DAOs: These are akin to charity clubs. People pool their money to help others, like donating to a cause they care about. example: Gitcoin Grants allows contributors to fund open-source projects and public goods in the crypto space.
iii. Social DAOs: These are like online communities. Members collaborate on projects, share ideas, and organize events, undertaking tasks that require a big team effort. example: Friends With Benefits (FWB) is a social DAO where members participate in events, discussions, and projects.
iv. Collector DAOs: It is like a group of people who collect rare collectibles. They decide which collectibles to buy and how to take care of them. example: Flamingo DAO acquires rare NFTs (non-fungible tokens) and digital art.
v. Investment DAOs: These are like investment clubs. People put their money together to invest stocks, new technologies, startups etc. example: MetaCartel Ventures invests in early-stage blockchain projects.
vi. Media DAOs: Akin to a group of content creators (like YouTubers or bloggers) working together. They decide what videos to make or articles to write. example: Forefront is a media DAO where creators share revenue and collaborate on content.
Many of the different kinds of DAOs listed above have profit as one of their primary motives. Many DAOs may also involve contributions from its members as well as other economic transactions like acquisition of assets by the DAO, changes in value of assets or distribution of profits to the members. The DAO’s governance tokens might also be tradable on secondary markets. All such transactions are likely to involve transfer of economic value and may be taxable events, resulting in tax liability for the DAO at the entity level or for the participant. However, in the absence of a legal entity structure and limited or no information about the location of its operations and users, the DAOs are likely to suffer from uncertainty about their legal structure, tax liability, residency, and jurisdiction as well as the applicable laws, rules, and regulations. It is likely that due to this uncertainty, till date no tax administration has issued any guidance for taxing DAOs.
Despite the uncertainties associated with DAOs, the total value of assets locked in DAO treasuries as of February 2024 is around 33 billion USD with around 10 million governance token holders, out of which around 3 million are active voters and proposal makers[139]. These statistics as shown in Fig. 56 are showing an increasing trend and are difficult for tax administrations across the world to ignore.
Some pertinent questions related to DAOs which regulators in general and tax administrations in particular would want to seek answers to are:
a) How do DAOs classify under existing laws? Are existing legal structures and frameworks sufficient to provide legal personhood to DAOs or new legal technology is required for DAOs which pose challenges to any known classification?
b) How does the place of operation of DAO get determined and which laws, rules and regulations apply to it?
c) How do the organizational structure and nature of the tokens/crypto assets determine the regulatory framework of the DAO?
d) Is the DAO required to identify or collect information about its members? If yes, then how it does so to fulfil its legal and regulatory obligations?
e) Who has the power to act legally on behalf of the DAO and how does the DAO confer such powers?
f) How does a DAO carry out its legal affairs like filing of taxes and other compliances like social security contributions, withholding taxes etc.?
g) How the profits of DAOs from their multiple revenue streams are determined and who is obligated to pay the corresponding taxes?
h) How do investors/participants and the DAO are prevented from No Taxation as well as Double Taxation?
i) Do DAO participants have an unlimited or limited liability for debts, judgements, obligations, and liabilities of the DAO?
Though this is not an exhaustive list of issues being faced by stakeholders in the DAO ecosystem, but the issues highlight the unique challenges posed by DAOs. Most of these questions arise because of Blockchain based operations of DAOs and the pseudonymity of their members/users. These questions might be difficult or impossible to answer due to the technological bottom-lines of crypto assets. To answer these questions standardized technological solutions which address these issues on a global scale would be required. It would also require global policy action to formulate bespoke laws, rules and regulations that address the technological framework of DAOs, the blockchains on which they operate and their underlying crypto assets.
Due to such uncertainties, there have been multiple instances where DAOs have faced actions from regulators and other stakeholders, some of which are given below:
a) CFTC action on Ooki DAO[40:] Ooki DAO faced regulatory action by the U.S. Commodity Futures Trading Commission (CFTC) for allegedly operating an illegal trading platform without proper registration as a futures commission merchant. The CFTC filed a legal action against Ooki DAO, alleging violations of the Commodity Exchange Act. Ooki DAO failed to respond, leading to a default judgment. The court held that ‘Ooki DAO is a ‘person’ under the Commodity Exchange Act and thus can be held liable for violations of the law.’ The court also ordered Ooki DAO to pay a penalty and permanently cease operations.
b) SEC action on The DAO[141]: In 2017, the SEC investigated digital assets associated with The DAO, a virtual organization which was created in 2016 with more than 11,000[142] anonymous investors who collectively raised more than 150 million USD[143]. The SEC applied the Howey test, which is a legal framework used to determine whether an arrangement constitutes an investment contract (and thus a security) and found that The DAO tokens met the criteria for investment contracts. The SEC concluded that these tokens were securities, subject to federal securities laws as The DAO did not meet the criteria for Regulation Crowdfunding exemption. It issued a warning in the report that the digital assets offered by virtual organizations like The DAO could be subject to federal securities laws.
c) MakerDAO arbitration[144]: On 12th March 2020, the crypto assets market witnessed a crash and the event later came to be known as Black Thursday. On the Black Thursday, the value of Ether plummeted dramatically. As explained earlier, this led to under-collateralization of the DAI loans in the Collateralized Debt Position vaults, triggering liquidations. Due to multiple issues related to the crash in price of Ether, several CDP vaults could be liquidated at a bid price of $ 0 resulting in heavy losses to the borrowers. Subsequently, a class-action lawsuit was filed against the Maker Foundation which governed the Maker protocol and DAI, claiming loss and damages for misleading investors about the risks associated with MakerDAO. The suit culminated in an arbitration and subsequent dissolution of the Maker Foundation.
There is a general lack of certainty about the tax and regulatory treatment of DAOs which results in instances of actions as given above. Many legal experts are of the opinion that DAOs would be classified as general partnerships (Shenk, Van Kerckhoven, & Weinberger, 2023). Some experts also argue that DAOs have certain characteristics of corporations and they should be given the ability to choose their legal entity status for tax and other regulatory purposes (Brunson, 2022). However, the truly Decentralized Autonomous Organization is an entity which lives and operates on the blockchain and suffers from real impediments in its interaction with the physical world. Such interaction requires agents who are natural persons acting on behalf of the entity for important tasks like regulatory compliances, filing and payment of taxes and compliance and cooperation with law enforcement.
Thus, it would be important for a DAO to have a real-world legal identity to avail benefits of legal personhood like access to banking, more certain tax and regulatory treatment and limited liability. This would have to be augmented by technological solutions which help to ameliorate issues related to pseudonymity on the blockchain.
Author:
(1) Arindam Misra.
This paper is
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DAO Voting Mechanisms Explained - LimeChain
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https://deepdao.io/organizations
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https://www.cftc.gov/media/8736/enfookidaoorder060923/download
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https://www.sec.gov/news/press-release/2017-131
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The DAO Attack: Understanding What Happened – CoinDesk
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https://www.bitstamp.net/learn/crypto-101/ethereum-dao-hack/
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https://www.coindesk.com/policy/2020/09/29/28m-makerdao-black-thursday-lawsuit-moves-toarbitration/
