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How to navigate the tax and legal risk associated with DAOs

In this episode of the Tax and Law in Focus podcast, we explore how DAO members can navigate the tax and legal complexity associated with this novel way of conducting business.

Key takeaways:

Decentralized decision-making: DAOs disrupt traditional business models with their transparent, democratic, and agile structure, facilitating global, barrier-free participation.
Financial considerations: Investing in DAOs involves potential gains but also risks, given the market's volatility.
Emerging regulation: Legal and tax frameworks for DAOs are nascent and diverse, with jurisdictions exploring different regulatory approaches.
Tax challenges: Taxable events in DAO operations are multifaceted and require careful examination due to the nuanced and evolving nature of DAOs.
Regulatory collaboration: DAOs must navigate between decentralization and regulatory compliance, urging cooperation between the industry and regulators to foster innovation.

Susannah Streeter

Hello and welcome to the EY Tax and Law in focus podcast – I'm Susannah Streeter and in this edition, we are going to be focusing on a paradigm shift that's developing which could revolutionize how we connect and co-operate in the business world and beyond. The use of decentralized autonomous organizations might be limited for now – but their potential is vast. They present a way of organizing with other people around the world, you might not even know establishing your own rules, and making your own decisions autonomously. Using smart contracts embedded in a blockchain, they offer a new and seamless ways of capitalizing on ideas and collaborating, without hierarchical structures or third parties getting in the way. With rules effectively encoded as a transparent computer program, controlled by members, bureaucracy barriers can be broken down, offering the prospect of greater agility than traditional organizational structures. DAOs seem to bring the possibility of a much rapid exploitation of new markets and emerging trends than conventional corporates, while the shared ownership principle could ensure all participants are financially incentivized. But this novel way of conducting business brings some pretty complex tax and legal complexity. At the moment, the funding of DAOs is mainly based on crowdfunding that issues tokens, and regulation around cryptocurrencies is still a work in progress. The governance of DAOs is based on communities, while traditional companies' governance is mostly based on executives, a board of directors, investors, and other stakeholders. So, there are some big issues at stake for companies looking at exploiting the use of these new ways of organizing and doing business. In this podcast, we are going to navigate the tax and legal risks associated with decentralized autonomous organizations with a panel of world-leading experts in the field.
But before I introduce them – please do remember: Conversations during this podcast should NOT be relied on as accounting, legal, investment nor other professional advice. Listeners must, of course, consult their own advisors.
I'm very pleased to welcome Dennis Post, EY Global Blockchain Tax Leader. Welcome, Dennis. Where are you today?

Dennis Post

Hi, Susannah. Thanks for having me. I am in Amsterdam, The Netherlands, today.

Streeter

Lovely. Great to have you with us. Also, Tom Shea, EY Americas Financial Services Crypto Tax Leader. Tom, where are you talking to us from?

Thomas Shea

Hi, Susannah, and thank you for having me. I am on the island of Manhattan.

Streeter

Great. I hope it's nice and sunny. Darko Stefanoski, Digital Law Leader, focusing on financial services. Hello and welcome, Darko. Where are you based at the moment?

Darko Stefanoski

I'm in sunny Zurich. Hello, Susannah, I'm in Switzerland.

Streeter

Lovely. So truly an international podcast we have. So, let's delve a bit deeper into the workings of DAOs. Dennis, first of all, what would you say makes them so different to the way traditional organizations operate?

Post

Over the last couple of years, we've seen that DAOs are picking up and have become a topic across a wide range of industries. Why? Predominantly because of the opportunity it brings for decentralized decision-making. DAOs are really a new form of business organization that is native to the blockchain ecosystem, and they aim to create a decentralized organization based on a shared vision that really operates automatically based on rules set at the outset by the founding members. In its ideal form, a DAO is like a digital cooperative that operates for specific purposes where transparent rules and algorithms replace a permanent management organization. So, in fact, you may consider them as potentially more democratic, more agile, more transparent, and more automated than the traditional top-down corporations. And in its purest form, essentially anybody may join. And that's really a benefit as opposed to the more traditional organizations that typically have higher barriers to entry.

Streeter

So, on the face of it, lots of potential opportunities and benefits. I mean, Bitcoin is considered to be the first fully functional DAO, but Tom, not all have been as successful. There are plenty of risks, aren't there?

Shea

Yes, there are. And many of those risks are really financial because as we saw a couple of years back with the big ICO or initial coin offering boom, you saw many investors throwing heaps of money into some of these coins. And unfortunately, a lot of those coins did not really have any true value or tangible value. If you jump into this industry or market without knowing the protocol or the value in the token itself, the volatility of the market you can end up creating, there could be some big winners and big losers.

Streeter

Certainly, that volatility in the crypto Wild West is problematic. But, Tom, there are also plenty of opportunities, as certainly Dennis was pointing out just now. So how can DAOs help big brands tap into, for example, the creator economy?

Shea

We've seen this on a number of other platforms, such as YouTube, TikTok. You have creators that are able to get mass exposure quickly through this type of organizational structure, right? And receive funding. You also see established artists, musicians, other types of content creators that can tap into this market and be compensated where traditional platforms, if I look at musicians, nobody's really selling CDs or some vinyl records, but not nearly as much as we used to. They're able to tap into a market where they can monetize some of their recordings. And so it really provides a nice outlet for creativity to flourish.

Streeter

Let me bring you in, Darko. What are the other benefits of this decentralized organization for companies?

Stefanoski

Yes, there are several which I would like to mention. And let's start with the democracy that Dennis has mentioned. I mean, for democracy, and that's really the society is looking for the democratization of different use cases, and that's where DAOs offer various benefits. They're transparent because DAOs operate on a blockchain. All transactions and decisions are visible for the participants who participate in a given blockchain. With that, you have the greater participation that Dennis mentioned. It's global. Everybody who has internet access can participate. So, there is no geographical border or any financial restrictions. This, of course, for businesses is a huge benefit because you can much better interact with your customers or potential clients. This is an especially important point, in the current macroeconomic environment where I believe we see globalization is under threat and geographies are coming back. DAOs help to keep the globalization on a certain level and get access to individuals. Then the governance Dennis mentioned that as well, DAOs are governed collectively, so everybody who participates has a voting right and it's not just open to shareholders or management members. So this decentralized decision-making process ensures fair participation, minimizes the concentration of the power at the individual level.

Stefanoski

And then going over to the different layers in a traditional company, it eliminates intermediaries. As you mentioned, Susannah, in your intro, DAOs focus on communities rather than on corporate executives, shareholders, or traditional set-ups. Hence, DAOs eliminate the need for these decision-making organs because the decision-making is automated and executed through smart contracts. This reduces the bureaucracy, avoids single points of failure, and minimizes corruption. With the help of technology, we can increase the efficiency. DAOs leverage blockchain technology, and blockchain technology allows for quicker and more efficient decision-making and execution and smart contracts and automated processes. Then you also have the security and resilience element as a further benefit. DAOs are built on decentralized networks. They provide robust security and censorship against attacks. The distributed ownership and decision-making prevent a single point of failure here, again, which, in my eyes, makes DAOs highly resilient. And last but not least, there are also the economic incentives that Tom mentioned because DAOs typically incentivize participation and the contribution through tokenized systems. The members are rewarded with tokens for their efforts and the participation. So, as you can see, I would say all these benefits that I just mentioned offer a more inclusive, more transparent, and efficient way of organizing and governing entities with the potential to disrupt the traditional hierarchical structure as we know it in usual corporates. And that's the change from top-down to bottom-up or how I love to say it, we're changing the internet from a platform-based Internet into a user-based Internet. Then, we're closing the circle with the democratization.

Streeter

And you certainly can see there, Darko, and you lay out why there has been so much interest and excitement about the advent of DAOs. Let me bring Dennis back in. Among other things, DAO smart contracts are being used to automate transactions. Here, Darko talked about the disruption. So, what sectors could we see the most significant upheavals in both in terms of challenges and opportunities through the adoption of DAOs in the coming years?

Post

I think it's fair to say that most of the DAOs have a clear link with blockchain-native activities such as decentralized finance, where parties can enter into smart contracts in a peer-to-peer manner without needing an intermediary. So I could enter into a financial contract with Tom or Darko through a DeFi platform that is typically organized as a DAO. But there are clearly other DAOs as well. And generally, I'd like to make three groups that we see out there. The first group is really the people pooling money. Individuals join DAOs to really have the opportunity to participate in the creation, incubation of ventures, invest in innovative projects, or to donate to a certain cost, so DeFi, grants, and other ventures. Then there's the second group. It's really people spending time. It's individuals that join the DAOs to really have the opportunity to participate in creating and building decentralized protocols and decide on governance and strategy of this project. So Impact DAOs. But what I'm most bullish about is gaming commercial DAOs, for example, in sports and software development. And then there's the last group, which I call the People Sharing Interest group, where individuals really join DAOs to have the opportunity to participate in a community of really like-minded people, share common interests, work toward the same goal. This could be media, social, decentralized science, and research. And this is also where we see traditional companies, for example, investing in scientific projects that are organized as a DAO.

Streeter

With the advent of a new technology like this, it brings a certain level of complexity. So, Tom, if DAO participants are to make the best possible assessment of their tax and legal exposure, they first need to identify taxable events. So, what kinds of taxable events occur within the DAO value cycle? Is it easy to decipher?

Shea

So you have potential taxable events all throughout the lifecycle, some of which there is clearer guidance, some of which many of it is still very much facts and circumstances based. So if you talk about entering a DAO, right? How are you entering the DAO? Are you assisting to build the architecture of the DAO itself, and then you're receiving tokens in exchange for that service? Are you simply contributing cash in exchange for a set number of tokens? Are you contributing other types of digital assets to engage in the DAO? All three of those can have very different answers. When we talk about the day-to-day normal operations, right? Darko talked about how the participants are incentivized for their involvement. That seems to be fairly cut and dry, at least in the US. The IRS has really taken a firm position that any type of rewards or yield with this type of participation is currently taxable. What they really look to is this concept of dominion and control. And that doesn't necessarily mean that you have it in your own personal wallet or you sell it. It just means you have the ability to sell those tokens. And at least the IRS has again stated pretty clearly that position that income is ordinary and taxable basically as soon as you can sell the crypto. Now, we are seeing a proposal in the Lummis-Gillibrand to defer these type of rewards until those tokens are actually monetized. But that's still a big what-if. And quite frankly, it could be highly unlikely that we reverse existing guidance. So that's during the lifecycle. And then you also have to look at how you're going to exit the DAO, and whether that trigger is a taxable event as well. Above all of this, there needs to be consideration of how the DAO is actually being treated for tax purposes. Is it being treated as a partnership or an LLC, some type of flow-through? Or is it being treated as a cooperative, which could also have very different consequences? There's really not a hard and fast framework yet, and so at least what we're seeing in our clients that are coming to us with these types of ventures is it is very facts and circumstances-based.

Streeter

Each case has got to be taken individually. There's certainly a lot to consider. Darko, what's your take on this?

Stefanoski

It's the same as Tom. We are at a very early stage. DAOs are pretty new concepts. If you look at Bitcoin was invented in 2009 and we're still talking about it, and financial institutions try to get their head around that. So the same will happen with DAOs, and it's going to take time. We will definitely see in the future. As we learn, as we educate ourselves, as the regulators and policymakers try to get their head around this and educate themselves, we will see that there will be regulation around DAOs which will be helpful. But if you look at the current circumstances, a lot of open questions, and hence you need to look at it on an individual case.

Streeter

So, Dennis, regulators are still trying to get their heads around all of this. Dennis, how would you describe the legislative landscape around the world surrounding DAOs? How diverse are regulators' approaches, and which countries would you say are leading the way in regulation?

Post

This is where it gets really interesting as we see countries taking really various approaches on this. Some countries and also some US states have really set up specific legislation for DAOs to boost innovation, but also because they have the view that the DAO in its purest form doesn't necessarily fit in existing legal and tax framework. Because, at the end of the day, we are talking about borderless organizations in a sense. The Marshall Islands, some US states such as Wyoming and Utah, but also Cayman and BVI. Then on the other side of the spectrum, we see countries mainly in Europe like Switzerland, Norway, UK and Netherlands that are trying to fit DAOs into existing legal frameworks because as Tom mentioned, to some extent they can be viewed or are comparable to general partnerships or a cooperative. And also foundations are being used in some instances. But you could really argue whether they are really fit for purpose in all situations.

Streeter

So what do you think? Are they fit for purpose?

Post

I would say traditional legal frameworks don't necessarily work in all situations due to formalistic procedures that need to be worked through, and that is obviously not per se, the best way of dealing with these borderless corporations. So my personal view, I would definitely welcome a specific framework for DAOs that really addresses some of these challenges and also, let's say, to have DAOs act in a more seamless way.

Streeter

So, Darko, what kind of frameworks do you think are needed? And are regulators ready to do this?

Stefanoski

Not sure whether I want to answer this question, but I will try. I mean, overall, I would say regulators are not ready yet because the approach of legislation and regulation follows a concept of centralization, right? There needs somebody to be accountable. Now we have, in essence, two options, right? We mentioned them already. We either do it, the current easy way and build wrappers around it. So we use an association, a foundation, or go to states where DAOs are recognized as a company, or we try to come up with a new way of regulating these things. So the regulator needs to work on that, and we need to help them educate them to come up with our concerns because you cannot regulate the DAO just like that because it's decentralized and autonomous, so it's just flowing. And all these questions today the majority of are unanswered, and this even on a supranational level, right? There are no borders when we're talking about blockchain technology and DAOs, and therefore we need to come together and come up with solutions. But this will take some time and a lot of discussions in order to also shift the mindset from centralization to the acceptance of decentralization.

Streeter

Where jurisdictions are starting to recognize DAOs as legal entities and say, give them an opportunity to register as a limited liability company. What's the rationale here? What are the benefits? And do you worry that perhaps they're rushing too quickly, having not set up those legal frameworks that you were talking about?

Stefanoski

Look, the lawyer part of me says, no, we're not rushing into it because we try with the wrappers to give legal certainty and apply a known or established concepts on a DAO because we put a wrapper on that. And that's definitely a short-term benefit. But in the long term, yes, we need to ask ourselves, is this wrapper fit for purpose? And the most interesting or key question, as Thomas mentioned, is how can I get out of such a structure or wrapper if need be? So we need to come up and evolve rapidly this way. If we look at the various jurisdictions, we have Switzerland, Norway, the Netherlands, as mentioned by Dennis. And let's look at Switzerland. Switzerland has demonstrated a very proactive and favorable approach. Of course, it's easy for a jurisdiction in Switzerland because we have a principle-based and technology-neutral approach. So it's easier than in other jurisdictions, especially the Anglo-Saxon jurisdictions, to squeeze in new concepts into known concepts. But also if we look at the Asian market, Singapore has positioned themselves also as a leading hub for blockchain innovation. So, they are also a very pragmatic and technology-friendly regulator and legislator. Germany has taken also advancements in enabling blockchain-based financial instruments through their legislation, which at the end also fueled the MiCA regulation, which is the Markets in Crypto Assets Regulation, which shall give us a consistent framework in the European Union. Wyoming and Tennessee have also enacted expressly to recognize DAOs as a legal entity. So all these examples show us that there are movements and jurisdictions are trying to get their head around this topic.

Streeter

Tom, as they try and get their heads around this topic, tax is certainly part of it. So what are the major tax elements being thrown up here are, particularly when it comes to LLCs, for example?

Shea

So, the default classification for tax purposes of an LLC is that being treated as a passthrough. You could elect to be treated as a corporation, but then the income earned is then subject to separate layers, right? So let's go down the path of just the flow through, which means each participant is effectively treated and is taxed currently on the earnings of the DAO. And that might seem straightforward from a tax technical perspective, although potentially an undesirable answer from the individual participant. But we really haven't talked about this yet, but this can create significant operational hurdles given the frequency at which participants can enter and exit DAOs. If you think about they can leave multiple times and enter multiple times within the same hour, within the same day, and trying to capture all of that activity from a tax reporting perspective could be an incredibly significant burden. So the question is, is there some way that the regulators, the taxing authorities, can simplify this reporting into a way that's more manageable for these types of operations?

Streeter

Dennis we talked about this operational hurdle. So while identifying taxable events might be relatively straightforward. Is this continued lack of DAO-specific regulation creating more uncertainty and complexity?

Post

Yes, the combination with those taxable events makes it complex at the end of the day because Tom mentioned some of the qualification issues if you are an unregistered DAO. But if you are setting up a legal wrapper, then I think on the one hand, it could really help because tax authorities and also the DAO in itself would have a starting point of this is where we are starting to have presence, physical or taxable presence in a country. And at the same time, it also raises some questions. And this is more than just a semantic discussion, but it ultimately really boils down to what do we actually mean with a legal wrapper? Is it an entity that is actually safeguarding that we're issuing tokens? And on the one hand and on the other side we have a separate legal structure that is, for example, developing a platform or is really, let's say, busy with the entrepreneurial activities. And how do those activities really interplay at the end of the day? And there could be questions around value creation, if there's IP being developed and is that relevant and then attributable to all token holders. There's the DAO treasury, which needs to be allocated to some countries, obviously in order to assess the taxing rights. So, lots of international tax-related questions all come together when you start thinking about it. But I believe that the benefit of considering a legal wrapper in any case provides a tangible touchpoint.

Streeter

Okay, we're talking about regulations and changes. Tom, what are the data requirements that are coming in that could also be a game-changer?

Shea

This is part of what we're seeing not just in the US, but with releases by the EU and the OECD is this customer-reported, right? Because we've been talking, I've been talking or focusing on the participants that are investing in the DAO. But if I look at decentralized finance, right? A DAO can facilitate exchanges, lending transactions, buys and sells for digital assets. And what we're seeing between the US is that these decentralized organizations are, at least in the proposed form, getting pulled into this reporting as a digital asset broker. So put aside the tax reporting of the entity itself and any token holders or investors, now you have the entity that is being required to report out to participants that are simply transacting on the exchange. And again, with the frequency and the volume that we see with so many of these, it can create just an additional massive compliance burden. And on top of that, outside of the transactional information, it requires you to report customer information, which would be, I think... Well, I think it would be a seismic shift from how DAOs operate. Right now, if you enter into a DAO, you don't have to provide your tax ID or anything like that. You just hook your wallet and you start participating. And so we're seeing a lot of these reporting regulations that could cause a real seismic shift in just how these entities have to report out all their operations.

Streeter

It certainly does seem that way. Darko, what's your take on this? A seismic shift?

Stefanoski

Yes, given the decentralized nature of DAOs and the global scope of their operations, I think supranational bodies could potentially play a significant role in fostering cooperation, standardization, cross-border recognition, also what kind of data would be required, what type of data fields for DAOs. That's going to be a key thing here.

Streeter

And Dennis, what implications do you think all of this regulation will ultimately have?

Post

That is a great question. And at the end of the day, the industry is luckily realizing that there needs to be regulation in order for this industry to really mature and to be sustainable in the long run. So it's ultimately regulation is a big step forward. The question is then how fast are you going to do this regulation and how fierce are the regulations going to be? That is a balancing act between what do you actually want to regulate. Of course, consumer protection here is really important, and tax avoidance and tax evasion are obviously also things that need to be combatted. And at the end of the day, but it's also a question because in this industry we're dealing with a lot of startup and scale-up companies. And the question that I would have is, are they ready for all this compliance burden coming their way? Because that will be a heavy lift for them to comply with.

Streeter

Darko, would you agree? Just how heavy will this be for companies large and small?

Stefanoski

Yes, I think it will be heavy. Will it be easier for smaller companies, or will it be easier for corporates? I think we need to look at the individual case at the end of the day. If you look at the large organizations, they are used to the top-down approach, governance models, et cetera, that's a total shift for them, right? They will need to turn the organization upside down if they want to fit into a DAO-like manner. So huge stress in the system for the big players. On the other side, you have startups which are used to short ways, direct communication. Everybody has a say, right? Which is more like DAO-like. However, they have less consciousness for governance things and to comply with regulation because mostly they're coming with an idea and not having been active in a regulated environment, it's not easy to get used to regulation that you need to talk with the regulator and read laws and regulations and comply with it. So I think different challenges for both categories, I would say.

Streeter

Now, Thomas, you mentioned DAOs being seen as digital asset brokers. And back in 2017, the SEC ruled in the US that DAO governance tokens should be treated as securities and would be subject, therefore, to securities law. So, does this mean that members risk being held liable for the actions of the wider DAO? And what implications will this have?

Shea

Yes, from a tax perspective, the conclusion of how a certain asset is treated doesn't always align with how the regulatory authorities view it. The IRS made it clear back in 2014, and has reiterated that position rather recently that the default classification are property. But obviously, how regulatory authorities view can certainly influence a carve-out or a particular treatment of an asset. And more broadly, the proposals are showing that the application of specific rules are being applied to digital assets. So there are some rules out there that were traditionally applied to securities that they're now proposing we apply to digital assets such as mark-to-market, wash sales. But then there's also other proposals out there that are akin to treating it similar to a currency. So it's one of those things where it almost seems like they're trying to piecemeal all the rules that make the most sense given the product. And in effect, they're creating this new framework for digital assets.

Streeter

So are we going to see this approach continue, this piecemeal approach to create the framework bit by bit? Or do you think we will see DAO-specific regulation coming forward?

Shea

The focus is going to be more on the digital assets, and it is going to continue to be piecemeal. We saw a couple of things come across this year around look through rule on NFTs, the IRS firm, their position on the treatment of staking rewards. I know there's a huge focus now on finalizing those broker reporting regs. I think we'll just continue to see those piecemeal publications come through. And there's a lot out there in the Lomis Gillibrand proposal, that incorporated a lot of the other things we had been seeing in the Green Book. So, I think there's an attempt out there to put together a comprehensive framework, but I guess we'll just have to wait and see.

Streeter

Dennis, let me bring you in. Darko, a bit earlier, talked about the need for supranational regulation. Is the OECD likely to take a position on DAO regulation?

Post

I don't think specifically on DAO regulation because as Tom also mentioned, I think governments and multilaterals really have their hands full currently about qualification issues around crypto assets in general. The DAO is, I think, an extension of that complexity in a lot of ways. And obviously, the first step that we're going to see in terms of regulation from a tax perspective is the information reporting piece. I think that we can expect that in future iterations of the Crypto Asset Reporting Framework and also of the EU's Doc 8, which is based on the Crypto Asset Reporting Framework, that we will see hopefully a little bit more guidance on how these organizations are aiming to capture DAOs for information reporting purposes as a starting point. But I don't think these organizations are ready yet to actually qualify DAOs from a tax perspective per se. There is a separate initiative that is ongoing that is really worthwhile mentioning here as well, and that is an initiative from a couple of academic scholars called the Koala Initiative. They've actually tried to develop a legal framework for DAOs that are really unregistered. They're not using a legal wrapper and they've actually tried to articulate qualifications on how to deal with these unregistered DAOs if they're not using legal wrappers and if they meet certain qualifications. There's also a text paragraph in there, which, in my view, does require a little bit further work. That work needs to mature over time, and then we need to see how these organizations like the OECD, but I also envision that the World Bank ultimately needs to have a view on this. So we need to see how they will take that forward.

Streeter

So, given all of this uncertainty, Darko, would you say there's a one size fits risk mitigation strategy that DAO participants can adopt? Or do you think every DAO should be considered individually, depending on underlying assets, for example, and associated legal and tax considerations?

Stefanoski

It's the latter, Susannah. Each DAO will have unique characteristics like underlying assets, associated legal and tax issues or considerations, and they will necessitate individual assessment. And the same is true for the respective risk mitigation strategy toward such approaches. However, I think what every DAO should do, and here may be an attempt from my end to generalize a bit or try to come up with a one size fits all strategy, is DAOs need to continue to advance the technology. Technology is new and needs to get better, needs to work. They need to be involved in creating a clear regulatory framework. For that, they need to participate in education, so educate different stakeholders and not just the government and the regulators, because if this gets bigger, it could get into a cultural shift of this decentralization element and collaboration element and away from the centralization.

Streeter

Certainly does seem as though that cultural shift is underway. And, Tom, what specific barriers do DAO members face when trying to say integrate their blockchain activity with the bricks-and-mortar world, for example, opening bank accounts and reporting taxable income.

Shea

Just working off the two examples you just mentioned, you need some unique identifier and information about your organization in order to engage in those activities. And we've talked about partnerships and all of these and cooperatives and all these other types of potential entity types. But right now, the reality is a lot of these DAOs are none of the above. And so, in order to push toward this move to be compliant, and maybe it's a matter of some centralized back-office function that does not disrupt the decentralized spirit of the operation of the DAO. Maybe it's some hybrid like that that will enable DAOs to advance, to evolve, to become compliant, to become more widely adopted and widely used. I know that's probably viewed as a compromise, but I see it as a worthy one.

Streeter

So Dennis, do you agree? Does there have to be a compromise?

Post

My answer to that, Susannah, would be a phrase I borrowed from a DAO that we work with: centralize what you must and decentralize what you can. I think that is ultimately the compromise. And it really resonates well because, as Tom mentioned, there's a balancing act between the brick-and-mortar world that we need to deal with. We cannot circumvent, we need to pay taxes, we need to be compliant with some of the legal rules that are out there. And at the same time, we want to be more flexible when we talk about these blockchain-native companies. So that's the balancing act that these DAOs and the community members of these DAOs need to take into consideration. And then ultimately raise the question, is a DAO then really fit for purpose if we combine these elements? And do we really need a DAO then? That's going to be the key question that needs to be addressed in order for those DAOs to be sustainable in the long run.

Streeter

Darko, let me get your view on this. To what extent do you think DAOs must inevitably relinquish a level of decentralization to overcome risk to evolve and ultimately grow?

Stefanoski

I fully agree with Tom and Dennis, and I love the word, which is not a bad one. I use 'fake DAO' pretty often because for me, a fake DAO is an organization which has, to a big extent, centralized elements, but has the mindset and the goal to become a decentral organization. And that's what Dennis mentioned. I believe that a company or a DAO, an organisation can go through different stages, right? And if you look at the beginning, it might be important to have a governance in place which is shorter, meaning centralized. So the governance or the decision-making is controlled by a few, the founders, who have an idea, but then they have a clear path to open up the governance at a later point in time. The same is with security. If you keep the circle smaller and decentralization smaller, that can help mitigate vulnerabilities and difficulties also in the decision-making process. But it helps also in centralizing certain elements. It helps also in legal and regulatory view, as some jurisdictions would want you to do a KYC and comply with anti-money laundering rules. So, it's easier to identify 10 stakeholders rather than 1,000 or 100,000. Therefore, I believe it's an evolution, and it's important that everybody is aware that this is an evolution, which is starting more with centralized elements. But never forget about the North Star, the fully decentralized organization as a nirvana which we hope will be achieved someday.

Streeter

But certainly, a level of compromise may be needed. Well, to finish, I'd really like to get a key takeaway from each of you. What would you say should be at the forefront of mind as companies look at how they should approach DAOs? Dennis?

Post

I want to focus, Susannah, on the traditional companies we see out there and potentially see DAOs as a great opportunity. I would really encourage them to embrace the great elements that DAOs have and not really look at this in a puristic way in a sense that everything needs to be fully decentralized or everything needs to be fully autonomous, but really start experimenting with some of these key features of DAOs and pick and choose these elements that really work well at the end of the day. I'm really bullish about how sports and entertainment industry are already embracing what I like to call Web3 operating models. So using some of these features from DAOs to their best efforts to ultimately make the best out of these new organizations.

Streeter

Thomas, what would you say? What can you build on what Dennis has put forward?

Shea

I would say that the industry is willing not only to evolve, but to be a little flexible and engage in discussions with the taxing authorities and the regulators. If I take the IRS, we've had since the reporting regs were released, we've engaged on behalf of a couple of clients in discussions around the application of those regs to the decentralized world. The IRS is eager to hear and to learn more about this industry. I know they cast this wide net, but they're only proposed, right? If the industry could be a little more open and transparent about a discussion and engage in these discussions, they could work to a better solution or a compromise that fits the needs of the IRS and of the industry.

Streeter

That word compromise again. And finally, Darko, a final thought from you.

Stefanoski

I would use the previous statements I made. Everybody involved needs to continue this cultural shift toward decentralization and collaboration. Of course, playing around, which is the continuance of the technology, also means educating. So get involved, look at use cases, and have this discussion, which means help to clarify the regulatory frameworks. I would turn it around from what Tom said. Look, the regulators are busy, and not every project can talk to them. That might be a bit overwhelming for the regulators. Here, I would ask the regulators to be more active and enable innovation with sandboxes and environments which allow failure. Because innovation means you need to fall on your nose and learn from such failure and improve the technology, the idea, et cetera. I think continuing this cultural shift will help and support the further flourish of DAOs.

Streeter

Well, thank you very much. And thank you very much to all three of you. It really has been a fascinating discussion.

Post

Thanks for having us.

Stefanoski

Thank you, Susannah.

Streeter

These are really super useful insights on why DAOs are said to be such a game-changer and how to navigate the complexity ahead. A quick note from the legal team. The views of third parties set out in this podcast are not necessarily the views of the global EY organization nor its member firms. Moreover, they should be seen in the context of the time in which they were made. I am Susannah Streeter. I hope you'll join me again for the next edition of EY Tax and Law in Focus. EY, building a better working world.

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Susannah Streeter

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Episode 15

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0h 46m 13s

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EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.

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How to navigate the tax and legal risk associated with DAOs

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Susannah Streeter

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