By Harrison Dell & Patrick Simon, Cadena Legal
Applications that offer users passive rewards for locking up assets in the application are bread and butter products of the DeFi space, as well as being a fundamental element of proof-of-stake mechanisms. However, not all passive yield-bearing activities operate the same way or cause the same tax outcomes. The Terra network’s dramatic fall from grace has cost investors billions, and in more ways than one highlights the critical importance of fully understanding how a network, protocol, or product really works before buying in.
There appears to be a misconception among many tax advisors, commentators, and the ATO that passive-yield bearing activities always operate as ‘staking’ mechanisms. In reality however, DeFi protocols are becoming more complex, and many protocols now offer a variety of different passive-yield functions that operate with fundamentally different mechanisms.
A proper understanding of the mechanical operation of any particular passive-yield function is essential to correctly diagnosing the tax implications for investors. Many advisors and commentators are only familiar with the most common ‘staking’ style mechanisms, which result in the user receiving periodic ordinary income and can create tax headaches when accumulated rewards drop in value – often resulting in capital losses on disposal which cannot be offset against the staking income.
However, an analysis of Terra’s most popular DeFi application “Anchor Protocol” reveals that there can be much more to passive yield functions than immediately meets the eye.
The main source of this confusion appears to stem from the fact that Anchor Protocol offered a variety of complex functions that each operate slightly differently, none of which are particularly well explained in the Anchor whitepaper. The result is that the practical mechanics of the protocol can be particularly opaque, and a good look under the hood is necessary to determine the ultimate tax implications of participating in any particular function of the protocol.
This article contains our opinions on how Australian tax law applies to certain activities. This is not advice and you should seek advice from your tax advisor.
Background on Anchor
Anchor Protocol was one of the most popular layer-2 projects that drove Terra’s pre-crash popularity, with yields reaching up to 20% on various functions offered by the protocol. The core function of the protocol is a “lending protocol” that essentially allows users to lend and borrow the Terra network stablecoin $UST, essentially positioning Anchor as the primary “money market” of the Terra network.
During the UST depeg, pandemonium ensued as investors scrambled to salvage positions and reckoned with substantial losses on their investments. Although the dust has settled in the months following the depeg, we have continued to see speculation and confusion from both investors and advisors around the tax implications of these events.
Anchor Protocol offered a variety of complex functions that each operate slightly differently, none of which are particularly well explained in the Anchor whitepaper. The result is that the practical mechanics of the protocol can be particularly opaque, and a good look under the hood is necessary to determine the ultimate tax implications of participating in any particular function of the protocol.
A high-level breakdown of staking in general, and the two main Anchor reward mechanisms are as follows.
The most common type of passive-yield arrangement involves the user locking up or otherwise committing tokens to the application. Periodically, rewards are provided in the form of further tokens that are either deposited into the user’s wallet/account directly, or otherwise can be claimed by the user at a later stage by interacting with a smart contract. Where the rewards are received by the user directly, or can be claimed without the need to exchange any other assets as consideration, it is widely accepted that:
- the market value of the rewards are ordinary income for the recipient user at the time the rewards are received or first available for claim; and
- the first element of the recipient’s cost base in the rewarded tokens is the market value of the tokens at that time, pursuant to the ‘market value substitution rule’ under section 112-20 of the ITAA97.
Examples of this kind of arrangement include:
- rewards paid in respect of staking $SOL to a Solana validator node;
- for a more niche DeFi example, a node on the Pirate Nodes platform accrues daily rewards of the native $DOUB token for the node owner, which can be claimed whenever desirable; and
- staking the Anchor protocol governance token $ANC to governance polls, in exchange for periodic rewards of further ANC.
Claiming functions for staked crypto assets and the point of income derivation have not been considered by the ATO in significant detail to date and are outside the scope of this article.
Staking arrangements can cause additional tax headaches for investors when the market value of the received rewards plumets during a downturn in the market. In most cases, the investor has ordinary income equal to the market value of the rewards at the time of receipt, however when they attempt to mitigate the damage by selling tokens, the losses for entities not in business are on capital account and cannot be applied to offset the income generated by receiving the rewards. This is a lesson on risk that isn’t just confined to staking rewards but due to the extreme volatility and lack of education in the market, is a common unaddressed risk.
Much of the discussion around the depeg by Australian tax advisors appears to have focused on the above situation, under the misconception that all of the Anchor protocol passive-yield functions operate with this ‘accumulation model’ – the rewards are income and the losses are capital which is unfortunate for investors.
Some of the Anchor passive yield functions operate via this accumulation mechanism, such as $ANC governance staking and holding $bLUNA (i.e. ‘bonded’ Luna), however other Anchor functions operated in a completely different way.
Anchor’s algorithmic appreciation mechanism
Two other core functions of Anchor are:
- the “EARN” function, marketed as a ‘savings account interface to earn Anchor yield on Terra stablecoin, $UST, and
- the ‘lending’ function of the core “money-market”, which allows users to deposit stablecoins into the pool of assets available to be ‘lent’ out to borrowers.
Both of these functions offer passive-yield returns, however in this case the incentives are not provided in the form of additional tokens allocated to participants, which would usually be treated as ordinary income at the time of accumulation. Rather, participants in these applications swap tokens in exchange for newly minted tokens issued by the Anchor protocol smart contracts:
- $UST is swapped for $aUST in EARN; and
- and a variety of stablecoins are swapped for $aTerra in the general lending pool.
These $aUST and $aTerra tokens were intended to appreciate against the value of the deposited UST or other stablecoin tokens at a rate determined by a complex algorithm designed by Anchor. The ostensible intention was that the $aUST/$UST or $aTerra/stablecoin exchange rate would change at a fixed rate, with the result that the amount of UST that the protocol would pay out when a user ‘cashed in’ their $aUST would increase over time – generating a predictable gain. Likewise, over time the user would receive a relatively smaller amount of $aUST for depositing the same amount of UST. The precise tokenomics of the arrangement are well beyond the scope of this article as they are particularly complex, and we note that flaws in the algorithms and broader Terra ecosystem ultimately caused the $UST depeg.
In light of the above, it is our opinion that tax is generally triggered when the $aUST or $aTerra is ultimately traded via Anchor Protocol or for some other token outside Anchor Protocol, and not upon the accumulation of the rewards. This is because the accumulation of $aUST of $aTerra is algorithmic capital growth despite how the protocol is explained.
Importantly, this means that it may be possible for losses from investments in this type of passive yield function to be offset against the investor’s other capital gains as:
- if the investor is carrying on a trading business the losses will be on revenue account and can be offset against trading stock gains, and
- if the investor is not carrying on a business the losses will be on capital account and can be offset against the investors other capital gains.
There is also a possibility of a profitmaking undertaking or scheme existing to bring gains and/or losses from Anchor onto revenue account, though this should be assessed on the facts of each investor. If this position is taken and heavy revenue losses were sustained, expect the ATO to scrutinise the position.
The above examples barely scratch the surface of the arrangements that are available through the Anchor protocol and DeFi. However, this analysis highlights the critical importance a detailed analysis of the functions of any DeFi applications that clients have actually engaged with for the purpose of determining ultimate tax positions.
The cryptocurrency space is showing no signs of ‘calming down’ from a volatility perspective, and catastrophic failure of a network is not necessary for the issues highlighted in this article to be relevant – even ‘standard’ fluctuations in the market can lead to investors dumping tokens and exiting ‘passive yield’ positions.
The key takeaway is that advisors should take steps to ensure that they are fully informed on the details of clients’ investment activities and the mechanical operation of the relevant protocols, or seek specialist advice, to ensure that clients are not incorrectly exposed to additional tax liabilities on top of investment losses.