Barristers & Solicitors
Decentralised finance: Need for legal framework on taxation
•Onyiuke

Decentralised finance, or DeFi, denotes an alternative financial ecosystem where consumers transfer, trade, borrow and lend cryptocurrency. The system does not rely on centralised institutions to conduct financial transactions and removes the control financial institutions have on money, financial products, and financial services.

How Does DeFi Work?

Decentralised finance runs on blockchain technology. Blockchain technology is a distributed and secured database that is used by DeFi models to eliminate the need for traditional institutions by enabling anyone to use financial services regardless of who or where they are.

In the blockchain, transactions are recorded in “blocks” which are verified by other users through a consensus mechanism used to preserve the integrity of transactions across a decentralized computer network.

If these verifiers agree on a transaction, the block is closed and encrypted; The blocks are “chained” together through the information from the preceding block in each individual block, giving it the name “blockchain”. Information in previous blocks cannot be changed without affecting the following blocks, so a blockchain is secure and can not be altered.

Regulation of DeFi

Despite Nigeria having the largest DeFi market in Africa and one of the fastest growing crypto markets in the world, The Central Bank of Nigeria, issued a ban on Crypto assets on 5th of February, 2021.

The ban prohibits financial institutions operating in Nigeria from dealing in cryptocurrency and directing them to close the accounts of any of their clients who are involved in cryptocurrency transactions.

Per the directives in the letter, Nigerian banks disallowed the use of their issued bank cards on cryptocurrency trading platforms

Individuals and businesses were also barred from receiving funds directly from cryptocurrency exchanges. Thus, there is no definite regulatory framework for Decentralized Finance in Nigeria unlike in the United Kingdom, the United States and Japan.

In the United Kingdom, crypto assets are considered virtual assets and are taxed as assets by Her Royal Majesty’s Revenue and Customs (HMRC). Platforms on which crypto assets are exchanged are called Virtual Assets Service Providers (VASPs).

Transactions of UK-based VASPs are primarily under the regulatory scope of the Financial Conduct Authority (FCA) sector of the Crypto Assets Taskforce which regulates Defi markets in the UK in a way that promotes innovation while maintaining the integrity of the general financial system.

An example of such regulation is the ban on crypto derivatives in the UK, due to the volatility of crypto assets. The VASPs have to register with the FCA unless they have an eMoney license.

VASPs are also mandated to adhere to the UK’s financial regulations and additional regulations around Know Your Customer policies (KYC), Anti-Money Laundering policies (AML) and Combatting the Financing of Terrorism (CFT).

In the United States, due to the legal system practiced there, multiple federal authorities and state authorities have jurisdiction over aspects of DeFi. The federal authorities include the Department of Justice, the Financial Criminal Enforcement Network (FinCen), the Internal Revenue Service (IRS), the Commodity Futures Trading Commission (CFTC), and the Securities and Exchange Commission (SEC).

Crypto assets are generally legal in the US but are still considered a commodity rather than a legal tender, hence it is taxed by the Internal Revenue Service under Capital Gains Tax and Income Tax.

In Japan, The Payment Services Act (PSA), which recognises digital currencies as legal tender, currently offers the most comprehensive regulatory environment for cryptocurrencies in the world. Only companies that have registered with the Finance Bureau are deemed to be cryptocurrency exchanges in accordance with the Act. The Act further regulates bitcoin exchange operations by requiring owners to set up security measures to safeguard the data they possess. According to Article 63-13, cryptocurrency exchanges are required to maintain accounting records of all transactions.

Cryptocurrency exchanges are required to obtain pertinent information about customers’ identities in order to maintain transaction records and alert the authorities when suspicious transactions take place.

Taxation of Crypto Assets

In light of the country’s dwindling oil reserves and the naira crisis, it would be a wise move on the part of the Apex bank to set up a regulatory framework which would allow the government to generate additional revenue. Despite the ban which was placed on crypto assets, Nigerians devised ways to circumvent the need to use bank accounts for crypto asset transactions. In a recent survey of the cryptocurrency space for Q1 2022, there are an estimated 300 million identity-verified cryptocurrency users worldwide; Nigeria set the record for the most significant number of people that used or owned cryptocurrencies at 31.9 per cent. That is an astonishing figure considering the Nigerian Government’s unwelcoming stance toward cryptocurrency.

If Nigeria decides to regulate and tax crypto assets it would fall under the regulatory scope of the Personal Income Tax Act (PITA). Section 108 of PITA defines a taxable person as an individual or body of individuals having any income which is chargeable with tax under the provisions of the Act. This means that “income” is a necessary component for the charge for tax purposes under the Act; and since an individual may earn income from crypto by engaging in crypto trading, mining, transaction confirmations, or airdrops, he comes under the scope of s. 108.

However, due to the volatility of the crypto market and the flexibility of crypto income, there’s an obvious challenge in defining the assessable income of people dealing in crypto assets and at the time of this study work, there is no law governing the taxes of crypto transactions in Nigeria. This gives rise to the need for a regulatory framework for Decentralized Finance which makes taxation of crypto assets easy to implement. We would briefly examine the cryptocurrency tax regulations in other jurisdictions.

In the United States of America, the US Internal Revenue Service (IRS) released a guideline document on taxes in March 2014 which declares that for federal tax reasons, cryptocurrency will be treated as property and stipulates the two types of taxes to be paid on cryptocurrencies. The types of taxes are, Capital Gains Tax (CGT) and Income Tax.

Capital Gains Tax is similar to the tax on bonds and stocks. In the case of CGT, the rates depend on the holding period and are classified as Short-term CGT where assets are held for less than a year and the rates range from 10 per cent to 37 per cent. Long-term CGT, where assets are held for longer than a year and the rates range from zero per cent to 20 per cent. Transactions which qualify for Capital Gains Tax include trading cryptocurrency for fiat currency or another cryptocurrency and paying for goods and services using cryptocurrencies.

Income Tax is paid on crypto-related activities that one can earn from; these include mining, staking, airdrops, etc. The document further states that “A person who ‘mines’ virtual currency as a trade or business is subject to self-employment tax”. This implies that people and tax companies who accept cryptocurrencies as payment for goods and services are required to pay income tax on the money they receive.

In the United Kingdom, Her Royal Majesty Revenue and Customs (HMRC) taxes crypto assets depending on whether the individual chooses to report it as a personal investment or business activity. Ordinarily, the HMRC treats tax on cryptocurrency like stocks, and so any gain on the assets is subject to Capital Gains Tax. The CGT tax rate on cryptocurrencies is 10% for basic ratepayers or 20% for higher ratepayers.

However, if you trade cryptocurrency as a business, such as mining Bitcoin, receiving airdrops or accepting cryptocurrency as a non-cash payment, then the interest on this is treated as income and subject to income tax and national insurance.

In Japan, The Japanese National Tax Agency classifies proceeds from cryptocurrency sales as miscellaneous income rather than capital gains. The tax rates for this category depend on your annual profit. Generally, taxes start at five per cent and increases to a maximum of 45 per cent as your income increases; a municipal tax of 10 per cent has to be added at any rate of taxation, thus, there is a total minimum of 15 per cent and a total maximum of 55 per cent.

The Japanese tax authorities do not tax for holding cryptocurrencies but there is a tax on trading cryptocurrencies and purchasing items using cryptocurrencies.

Conclusion

According to experts, Nigeria is not earning enough revenue to bolster its spending and economy.

As oil revenues dry up, experts in the cryptocurrency space have pointed out that government regulation of crypto assets will ensure that the industry is correctly taxed and levied, thus increasing government income.

Therefore, there is a need to make provision for a regulatory framework for Decentralised Finance which would protect investors and consumers; reduce fraud in DeFi spaces and also impose tax on the users of this technology as a means of generating revenue for the government in Nigeria.

  • Mr. Onyiuke, (MCIArb UK), is a Partner in Accendolaw Barristers & Solicitors, a commercial law firm in Lagos.
  • PUNCH