Fundamentally Incompatible: How the Proposed Crypto Tax Rules Miss the Mark

In a potentially hugely disruptive move, a last-minute provision of a major bipartisan infrastructure bill moving through the U.S. Congress would impose stricter reporting requirements on cryptocurrency transfers, which the bill estimates would raise an additional $28 billion in tax revenue.

But the legislation, according to at least two crypto-regulatory experts, is so badly flawed it might be unenforceable. Specifically, the rule as written appears to define any actor who participates in a transfer of cryptocurrency as a “broker.” That could impose transaction reporting requirements on a strange array of players, including miners and decentralized exchanges.

This article is excerpted from The Node, CoinDesk's daily roundup of the most pivotal stories in blockchain and crypto news. You can subscribe to get the full newsletter here.

The creators of software wallets could even be required to track and report user transactions, according to both crypto lobbyist Jerry Brito of Coin Center and Blockchain Association head Kristin Smith. Software and hardware crypto wallets, of course, do not record user information, which would make the law impossible to comply with.

The disconnect highlights the shaky foundations of U.S. attempts to tax or regulate crypto. There are at least two separate bills in the House of Representatives attempting to establish basic definitions, jurisdictions and standards for crypto regulation. Having those in place before trying to rush through a poorly conceived tax might have been a good idea.

The case of software wallets is illustrative. They’re fundamentally tools for interacting with a database, not tremendously different from a web browser. They are not services, any more than your leather wallet is a “service” for holding dollar bills. There is in fact no “service” managing bitcoin or any other legitimate cryptocurrency, a fact that fundamentally clashes with the regulatory framework legislators are trying to shove it into.

These flaws are particularly worrisome because the measure has been introduced as a revenue-generating element of the much larger bipartisan infrastructure bill, creating a rushed environment with little margin for subtlety or revision. On Twitter, Brito described the bill as “must-pass,” and said that Coin Center staff “worked all day [Wednesday] trying to fix” the measure, and continued into Thursday. The good news is the bill is still in process, so there’s at least the possibility for things to change.

Aside from their technical shortcomings, the new tax rules lean on near-universal monitoring and automated reporting, rather than on a privacy-protecting system of voluntary reporting, with investigation and enforcement for those who break the law. This potential law, much like the new European money laundering rules introduced this month, would likely create huge honeypots of personal and financial data to be targeted by hackers – including your data, whether you sought to evade taxes or not.

Read more: Compliance Exec: Crypto Too Slow to Adopt Anti-Laundering Rules Ahead of FATF Review

The sins of this poorly designed tax, though, shouldn’t be laid at the feet of taxation as a whole: Strange as it may seem, cryptocurrency development has been advanced to a huge degree by investments funded by past tax revenue. SHA-256 cryptography was developed by the National Security Administration. The internet itself was created largely by the Defense Department’s DARPA (Defense Advanced Research Projects Agency) program. David Chaum, one of the 10 or so most important pioneers of digital cash, earned a PhD at University of California, Berkeley in the 1970s, when public funding kept tuition costs to about $800 a year.

Most world-transforming innovations rely on a similar level of collective support, because basic or speculative research is usually not profitable fast enough for the private sector to invest in. So there’s nothing inherently objectionable about crypto being expected to give back to support the next generation of innovators. But the current rushed and technically flawed approach could significantly harm the very innovation that took so many years and resources to bring to life in the first place.