Crypto Tax Clarity on Bitcoin DeFi: Babylon, BOB, and the Tax Treatment in Different Jurisdictions

I. With Babylon and Bob, True Bitcoin DeFi Emerges

For years, Bitcoin has been the digital asset with the deepest liquidity and strongest network security, yet largely absent from DeFi.

This landscape has fundamentally changed with Babylon and BOB (Build on Bitcoin).

• Babylon Labs is developing a trustless Bitcoin vault architecture that enables native BTC (not wrapped) to serve as collateral on smart contract platforms such as Ethereum.

• BOB extends this innovation through a hybrid Layer-2 architecture that combines Bitcoin security with Ethereum’s DeFi composability, creating a seamless cross-chain environment for yield and collateralized products.

Together, Babylon and BOB establish a trustless Bitcoin DeFi ecosystem.

II. How Babylon’s Trustless Vaults Work

According to the Babylon Whitepaper, the system will operate as follows:

1. The Bitcoin holder locks native BTC into a vault, which is a UTXO governed by a pre-signed transaction tree.

2. The vault’s spending conditions are verified by BitVM3, which allows Bitcoin to read external smart contract states on other blockchains such as Ethereum.

3. The holder retains exclusive control over their BTC through cryptographic proofs with no third party has access or custody.

4. The user interacts with an Ethereum-based smart contract to borrow assets, use BTC as collateral, or issue synthetic representations of BTC value.

5. Withdrawals are only possible after providing valid proofs that the external state (e.g., repayment) meets the conditions stored in the vault.

This structure is trustless, non-custodial, and fully reversible by the original depositor under protocol-defined rules. The user remains the beneficial owner of the BTC at all times.

III. The Tax-Relevant Core: Is There a Realized Gain When Using a Vault?

The essential tax question in DeFi is whether locking an asset in a protocol constitutes a disposal that triggers capital gains taxation. Under Babylon’s system, no disposal occurs.

When BTC is locked in a Babylon Vault:

• Ownership remains with the depositor.

• The depositor does not transfer control or economic benefit to a third party.

• There is no exchange of BTC for another asset.

Accordingly, no capital gain is realized at the time of vault creation or redemption, and the original retention period or regulation of existing stock (Haltefrist and Altbestand) continues uninterrupted.

If the user borrows stablecoins or tokens against the BTC, this represents a loan transaction, not a taxable sale. Only if the collateral is liquidated by the protocol would a disposal occur, and the gain would then be recognized.

This treatment is consistent across many jurisdictions when properly documented and substantiated.

IV. U.S. Tax Perspective

Under U.S. tax law, the Internal Revenue Service (IRS) classifies cryptocurrencies as property. Taxable events occur upon sale, exchange, or other disposition of property.

• Transferring BTC to a Babylon Vault does not qualify as a disposition.

• The depositor retains beneficial ownership and does not exchange the BTC for another asset.

• The holding period for long-term capital gains (12 months) continues uninterrupted while the BTC is locked.

• Borrowing against BTC collateral is non-taxable, as it represents a debt transaction.

• If collateral is liquidated, the gain is realized and must be reported based on the fair market value at the time of liquidation.

Taxpayers are required to maintain precise documentation showing the deposit, collateralization, and redemption process. Under current IRS principles, Babylon Vault interactions constitute non-dispositional self-custody transactions, preserving long-term capital gains treatment.

V. German Tax Perspective

Germany regulates crypto taxation under § 23 EStG private sales transactions (Private Veräußerungsgeschäfte). Crypto assets are treated as private assets. A sale or exchange within one year of acquisition triggers income taxation; holding for more than one year renders the gain completely tax-exempt.

• Depositing BTC into a Babylon Vault does not constitute a disposal (Veräußerung). The depositor retains both legal and economic ownership.

• The one-year holding period continues during the vault period.

• A later sale of BTC after more than one year remains fully tax-exempt.

• If the protocol pays yield, interest, or other rewards in return for the collateral, those rewards qualify as taxable income under § 22 Nr. 3 EStG (income from other services).

• Liquidation events represent a taxable disposal, calculated as the difference between acquisition cost and liquidation proceeds.

Accordingly, for private individuals in Germany, using Babylon Vaults preserves the retention period or regulation of existing stock (Altbestand and Haltefrist), ensuring that tax-free treatment after one year remains intact.

VI. Austrian Tax Perspective

Austria currently operates under the most advanced crypto tax framework for DeFi globally. The Austrian Ministry of Finance (BMF) fully integrated crypto assets into the capital income tax regime through the 2022 Crypto Tax Reform.

Under Austrian law:

• Crypto assets are classified as income from capital assets (Einkünfte aus Kapitalvermögen) under § 27b Abs. 4 EStG.

• Disposals are taxed at a flat 27.5 % Capital Income Tax (KESt) rate.

• Lending rewards are treated as taxable capital income at the same rate.

• Transferring BTC to a non-custodial vault is not a disposal, as ownership and economic control remain unchanged.

• The acquisition date and cost basis remain constant throughout the vault lifecycle.

• Only when the collateral is sold or liquidated by the protocol does a taxable disposal arise.

Austrian law provides full clarity for DeFi use cases:

• Vault usage is non-dispositional.

• Lending and yield income are capital income.

• Disposals are taxable at 27.5 %, regardless of holding period.

This framework shows that Austria is the most legally and fiscally advanced jurisdiction for DeFi, as it treats blockchain-native lending and vault transactions with complete regulatory certainty.