DeFi Broker Rule

January 3 - Newsletter

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Good morning and Happy New Year! As Congress readies to kick off the 119th Congress, this year’s first edition covers Treasury’s DeFi broker rule and two bipartisan crypto bills.

Top Points

  • Treasury and the IRS finalized a rule to require certain providers of front end services that enable users to interact with DeFi trading protocols to comply with broker tax reporting requirements.

  • The House will vote for a Speaker later today.

  • Two bipartisan crypto bills were introduced in late December:

    • Reps. William Timmons (R-SC) and Ritchie Torres (D-NY) introduced a bill to clarify that certain NFTs (like artworks, collectibles, and video game assets) are not securities.

    • Reps. Gabe Amo (D-RI) and Young Kim (R-CA) introduced a resolution emphasizing the importance of distributed ledger technology in “democratic governance, human rights, internet freedom, and transparency.”

DeFi Broker Rule

Background

On Friday, December 27, Treasury and the IRS released a final rule detailing which DeFi participants will be subject to new tax reporting requirements (the “DeFi Broker Rule”).

Treasury and the IRS issued the DeFi Broker Rule pursuant to Section 80603 of the Infrastructure Investment and Jobs Act (“IIJA”). See Final Rule at 1-2 (citing § 80603 of the IIJA and § 7805 of the Tax Code, which authorizes Treasury to write rules “as may be necessary” to carry out the code, as the basis for the rule’s authority).

Specifically, Section 80603 amended the definition of broker for tax reporting purposes to include:

  • “any person who (for consideration) is responsible for regularly providing any service effectuating transfers of digital assets on behalf of another person.”

The DeFi Broker Rule

In short, the DeFi Broker Rule details which DeFi actors fall under § 80603’s definition of broker—and, in turn, which DeFi actors will be required to collect and report user transaction information to customers and the IRS via a yet-to-be finalized Form 1099-DA.

Who Is a Broker?

Through a weave of definitions and sub-definitions, the DeFi Broker Rule defines broker to include front-end service providers who enable customers to interact with DeFi trading applications. See § 1.6045-1(a)(21)(defining “digital asset middleman” and “effectuating service”); See also Final Rule at 55-56.

More specifically, a broker would include someone who provides a “trading front-end service” where, by the nature of the service arrangement, the provider ordinarily would know or be in a “position to know” the nature of the digital asset transaction potentially giving rise to gross proceeds. See § 1.6045-1(a)(21)(i)(A).

A “trading front-end service” is a service that receives a person’s order to sell digital assets and processes that order for execution by providing user interface services, including graphic and voice services designed to:

  • Enable a customer to input order details for digital asset sales to be carried out on a cryptographically secured ledger (or similar technology); and

  • Transmit those order details so they can be carried out or settled on a cryptographically secured ledger (or similar technology). See §1.6045-1 (a)(21)(iii)(A)(1); See also Final Rule at 55-56.

Treasury and IRS intended this definition to be broad enough to include “any front-end service that enables customers to interact with aggregation protocols as well as digital asset trading protocols.” Final Rule at 56.

A person is in a “position to know” if they “maintain control or sufficient influence” over the trading front-end service such that they are able to determine if, and the extent to which, the transfer of digital assets involved in a transaction gives rise to gross proceeds. See § 1.6045-1(a)(21)(B)(ii).

A person maintains control or sufficient influence if they have the ability to:

  • Amend, update, or otherwise substantively affect the terms under which the front-end services are provided or the manner in which orders are processed;

  • Collect fees for providing front-end services (regardless of whether they actually collect those fees); or

  • Add to the order a sequence of instructions to query the ledger or otherwise determine if a processed digital asset transaction has, in fact, been executed. See id.; See also Final Rule at 71-72 (noting this is a non-exhaustive list of examples).

Who Is Not a Broker?

The broker definition excludes persons who are engaged in the following services:

  • Distributed ledger transaction validation services (whether through proof-of-work, proof-of-stake, or any other similar consensus mechanism), including those services necessary to complete the validation. See §1.6045-1(b)(2)(ix).

  • Licensing of software or selling hardware, if the sole function is to permit a person to control private keys which are used for accessing digital assets on a distributed ledger. See §1.6045-1(b)(2)(x).

However, if someone providing these services also provides trading-front end services, they would still be subject to the broker reporting requirements, but only to the extent of those activities that satisfy the trading-front end service criteria outlined above. See Final Rule at 113-115 (note §1.6045-1(b) Examples 24, 25).

Why Did Treasury Include Front-End Service Providers?

The thrust of Treasury and the IRS’s rationale is that Congress authorized the agencies to define broker to capture a broad range of persons who provide any service effectuating transfers of digital assets—not just those who effectuate transfers. Final Rule (Summary & Explanations Part II.B at 24-25).

According to the final rule, trading front-end services fall within this definition because they provide services that enable their customers to trade their digital assets through other DeFi participants, similar to services provided by securities brokers. See, e.g., Final Rule (Summary & Explanations Part II.B).

Treasury and the IRS rejected arguments that the definition of broker should be limited to persons who act as the customer’s agent or who take custody of their customers’ digital assets. See id. 24-29 (citing Treasury’s existing authority prior to the IIJA, Section 80603’s plain text and legislative history, and analogizing to functions of securities brokers).

As to why the rule focuses reporting requirements on trading front-end service providers and not other DeFi participants, Treasury and the IRS explain:

  • (1) Front-end service providers have the closest relationship to customers and thus are in the best position to obtain customer identification information;

  • (2) Concerns stemming from the immutability of software and around identifying application operators are not as salient in the case of front-end service providers, because front-end service providers are typically legal entities or individuals, and the software used to provide trading front-end services is not immutable; and

  • (3) Front-ends provide services that are most analogous to the functions performed by brokers in the securities industry. See Final Rule at 44.

When Does The DeFi Broker Rule Kick In?

Reporting requirements for DeFi brokers will apply to sales of digital assets occurring on or after January 1, 2027. Final Rule at 90-94.

What’s Next?

Challenges may come from Congress, the White House, and in the courts.

Congress

Congress has a couple of options. First, Congress could attempt to rescind the rule by passing a Congressional Review Act joint resolution of disapproval. This only requires a simple majority vote in the House and Senate, but must be done within 60 legislative days of the rule being submitted to Congress. If passed and signed by President Trump in time, Treasury and the IRS would also be prohibited from issuing a substantially similar rule in the future, absent clear congressional authorization.

Second, Congress could send a bill to President Trump’s desk that narrows and clarifies the definition of broker and the scope of reporting requirements. For example, someone could reintroduce a bill similar to Rep. Patrick McHenry (retired) and Rep. Ritchie Torres’s (D-NY) bipartisan Keep Innovation in America Act. However, a legislative fix like this would likely require 60 votes in the Senate (unless it could somehow get rolled into a reconciliation package).

Incoming House Financial Services Chair Rep. French Hill (R-AR) already made clear his opposition to the DeFi Broker Rule, but it’s unclear what path Congress will take

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White House

The Trump Administration could repeal the rule, but the Administrative Procedures Act (“APA”) generally requires a public notice and comment process to repeal a final legislative rule. See 5 U.S.C. § 551(5) (defining “rule making” to include “agency process for formulating, amending, or repealing a rule”).

Courts

Industry will likely challenge the rule in court on several grounds, many of which were previewed in public comments (e.g., scope of rule exceeds Treasury’s statutory authority, rule violates Major Questions Doctrine, First & Fourth Amendment concerns, etc.).

Indeed, the DeFi Education Fund, the Blockchain Association, and Texas Blockchain Council have already filed suit in the Northern District of Texas challenging the rule under the APA. Specifically, the filing argues the DeFi Broker Rule violates the APA because Treasury exceeded its statutory authority and failed to adequately consider substantive comments.

Looking for More on the Rule?

Here’s a few more break downs of the DeFi Broker Rule, potential implications, and likely arguments and counter arguments in court:

Look Ahead

Today (Friday, January 3)

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Monday, January 20th - 11AM

  • ​President Trump’s Inauguration

  • Until then, still keeping eyes out for any last minute rule makings or enforcement actions in the waning days of the Biden Administration.

Quick Hits

Legislation

A couple of bipartisan crypto-related provisions were introduced in late December. While they will need to be reintroduced in the 119th, they offer a preview of how some Members of Congress are thinking about NFTs and blockchain.

NFTs

  • Rep. William Timmons (R-SC) & Rep. Ritchie Torres (D-NY) introduced a bill that would:

    • (1) Clarify that certain types of NFTs (e.g., works of art, collectibles, digital identifiers, rewards, etc.) are not securities, and

    • (2) Direct the GAO to study NFTs and other digital assets, including issues like interoperability, market risks, use cases, and more.

    • More detailed summary from The Digital Chamber here.

DLT Resolution

  • Rep. Gabe Amo (D-RI) and Rep. Young Kim (R-CA) introduced a resolution “emphasizing the importance and power of distributed ledger technologies (DLT) to support democratic governance, human rights, internet freedom, and transparency.”

Articles

Trivia

Last Week's A: Though some dispute the claim, the first “White House Christmas Tree” was a Foxtail hemlock. Bonus: This trivia was inspired by the opening scene of Christmas Vacation.

This Week's Q: Who was the first president to host a New Years Reception in the White House?

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-GSL

Warpcast: @caphillcrypto