DAO : Estonian Tax And Legal 101

DAO : Estonian Tax And Legal 101
Photo by Kelly / Unsplash

Kaido Künnapas, tax and legal expert in Estonia, shed lights on the legal and tax implications of DAOs in Estonia and answers some of the common questions in this post. Please note that the information in this post is for informational purposes only. It should not be construed as legal, tax, investment or other advice.

Kaido, what is your definition of DAO?

A decentralized autonomous organization (DAO) is an emerging form of online human cooperation that builds on direct democracy and aims to provide a flexible alternative to rigid corporate rules. By automating the execution of its decisions as much as possible via smart contracting, the risks of malicious management and high compliance are addressed. Use cases can vary from crowdfunding investment pooling to political assembly supervision over government activities.

DAOs do not exist in a legal vacuum. Without any dedicated rules, the work of lawyers is about squeezing DAOs into existing legal categories. The same applies to tax people. This is something DAO participants, DAO builders, and governments must be aware of.

As I had a great opportunity to share my ideas about that at the DAO Day that was held in Tallinn, I have put down some thoughts to give some color to the discussion. Please bear in mind that these are some general thoughts and should not be taken as legal advice applicable in all jurisdictions – each is different. It is up to each legal jurisdiction to say how they treat DAOs from legal and tax perspectives and what type of “connectors” trigger such laws.

The most common view is that a pure DAO qualifies as a partnership. A partnership is generally a form of cooperation where the participants are acting together as a group of people having no uniting and legally regulated fiction called a corporate body. It is transparent from a legal point of view.

As the lack of a corporate body has caused some pushback – such as the unlimited liability it brings to its partners, or it is extremely difficult to engage external partners and suppliers – we often see DAOs as corporate governance tools on top of some corporate entities. In Estonia, a non-profit organization seems to be the most appropriate form for that. This might be a sign that it is time to update the law for non-profit organizations as causing issues with its rigidness for a long time already.

We should first distinguish internal and external legal relationships. It is true that the freedom of contract is generally applicable within partnerships and DAOs. Well, the contractual freedom perception is only a half-truth. There is much common between Harley riders and DAO participants. Both follow the “ride free” principle, but only until the cop pulls them over for speeding or lane splitting.

The internal  - the contractual - part of the partnership DAO microflora can usually be designed quite freely. You can agree on how the list of partnership members is kept (token holder list), how the partners can be changed (transfer of token rights), what are the voting thresholds (whether 50% majority voting or something else), and how inactive members are punished or motivated (repeating meeting with no participation threshold, extra votes for the next meetings).

However, in relation to the external participants have much more triggers for protective rules. Many of those hit as a surprise, often for the protection of some weaker party (e.g. consumer, a minority contributor, recipients of advertisements, or even yourself).

Does it make sense to abandon the limited liability shield the pure DAO does not provide for its participants?

DAO rebels against a corporate form of LLC. Limited liability emerged back in the time of the Dutch East India Company (that would be around the 17th century) to encourage investors to take risks by limiting such risks only to the assets put into the LLC. This is the corporate limited liability shield that some people call the greatest invention by humankind after the wheel and sliced bread.

DAO not having a such shield makes it a risky format for its participants. There are actually two levels of additional risk – extended liability and shared liability. First, the liability is not limited to the assets of the DAO but it extends to the personal assets of all DAO members. Secondly, each DAO participant is liable for the actions of other members of the DAO.

One of the main challenges for legislators who want to design a DAO participant-friendly legal environment is to invent a corporate model that would limit the liability of DAO members. Or should it go only along the LLC format? The U.S. DAO LLC concept may be a step toward the solution. However, it makes DAO more of a tool for community management, voting, and management supervision than a totally new form of cooperation. But maybe this is the angle of corporate governance where the revolution is actually needed.

How to manifest reliability towards third-party service providers as corporates do with their share capital?

Another issue is about how to manifest the trustworthiness of DAO towards external players. Suppliers and copartners need to trust its debtors and customers to take whatever risks against them. In the corporate world, such trust is shown via published annual reports and equity of a company that represents the risk shareholders have taken.

How to avoid past examples of failed direct democracy in the DAO governance model?

DAO is about democratizing corporate governance. More specifically, it builds on direct democracy where all the decisions are made bottom-up and there is no delegation of powers to some central body of management.

I believe one of the central topics for making this democratic system work is community management, and how the interest of minorities will be protected. To draw a parallel from the corporate world, minority shareholders face similar issues as the DAO participants.

While the laws usually foresee a possibility to require third-party audits by a certain critical amount of minority shareholders (in Estonia the threshold is 10% of shareholding), there is no equivalent for partnerships. To address all the fears and needs of all DAO members, community management becomes critical and most probably determines the failure or prosperity of a DAO.

Who pays taxes? Can the transparency of DAO lead to DAO members paying dry taxes on DAO profits sitting in its treasury?

Even DAO must contribute its fair share back to society. From an income tax perspective, DAO is usually tax transparent, meaning DAO members pay tax on DAOs profits as their own profits. This can lead to dry tax, meaning while the income sits in DAO treasury, DAO members must pay tax out of their own pockets.

In Estonia, corporate bodies enjoy a better tax position. Our LLC format (OÜ) enables a better tax position by deferring the tax liability until the actual distribution of profits. OÜ enables reinvesting before taxes, meaning OÜ has 20% more to reinvest. Tax kicks in only upon distributing profits from OÜ. Meaning it usually makes sense to have an operating company for profit-earning DAO. But what is the point of DAO then?

DAO is about remunerating people investing their time in a common goal. What about share options to employees?

It was commented that one of the purposes of DAO can be incentivizing people who contribute to the organization. It can lead to a risk that the contributor is seen as an employee for DAO or for all DAO members, meaning everything that is gotten in is hit by income tax plus social security contributions. The same purpose we can see for employee share options we already have in many countries.

In Estonia, it provides a great tax incentive by remunerating the employee’s active contribution with passive income. It means the elimination of social tax which is 33% in Estonia. Should the government make share option rules more tech-oriented?

This post was contributed by Kaido Künnapas — a partner at Sorainen Law Firm and Senior lecturer (law of business and economics) at Tallinn University of Technology.