The continuing reluctance of national tax authorities around the globe to issue detailed guidance on the treatment of digital currencies has been an increasing concern for businesses over the past five years. The situation is arguably more confused today than it has ever been. Virtual currencies and other crypto assets have increased greatly in number, but tax jurisdictions including the US and the UK have yet to develop systematic approaches to their treatment. Meanwhile, China, India, Japan and South Korea have all imposed rules to make trading in cryptocurrencies difficult, costly or even illegal.1
About 1,500 digital currencies exist, along with an ever-expanding range of other crypto assets, such as utility and securities tokens. As Michael Meisler, our Tax Blockchain Leader, says: “We’re seeing an increase in consensus among the asset management community that crypto assets are a viable asset class from an investment standpoint.”
Buying a cryptocurrency is not taxable in most countries, but holders are likely to become liable when they profit by selling or even spending it. The sum owed will depend on how long they have held the currency, the size of profit and whether the jurisdiction concerned taxes capital gains. Most countries also treat earnings in cryptocurrencies as barter transactions or payments in kind.
Although the US Internal Revenue Service (IRS) recently won a case that forced a large cryptocurrency exchange to turn over the account records of more than 13,000 customers, the IRS and other US authorities have maintained a relatively hands-off approach in other respects.
The IRS still falls back on guidance on crypto assets that accompanied regulations published in 2014. This states that a taxpayer will experience a capital loss or gain upon concluding an exchange or sale of a cryptocurrency serving as a capital asset. The implication is that the IRS views cryptocurrencies as similar in nature to traditional assets.
Asked to describe the current state of cryptocurrency regulation in the US, Perianne Boring, Founder and President of the Chamber of Digital Commerce, told The New York Times: “It’s unorganized and incredibly complicated — and it’s really putting the US at risk of falling behind from an innovation and technology perspective. There are turf wars between the different regulatory agencies, and none of this is in the best interest of the US or the blockchain technology industry.”
In the UK, the most recent specific pronouncement by HM Revenue & Customs (HMRC) on the tax treatment of cryptocurrencies was published in March 2014. Rather than giving definitive guidance, it continues to insist that tax liabilities on crypto assets will be decided on a case-by-case basis.
A particularly thorny issue arises when developers modify the blockchain ledger code underlying a cryptocurrency to such an extent that it causes a “hard fork” — in simple terms, the creation of a separate parallel currency. For instance, bitcoin underwent this process in August 2017 to spawn bitcoin cash.
This raises a number of tricky questions that tax administrations worldwide have yet to answer definitively: on the day of a fork, does an owner of the original asset recognize income for the new asset? What if there is no market for the new asset because, say, digital wallets do not support it? And at what value should the adjusted basis be calculated? If it’s the fair market value, at what date: that of the fork or the date on which it can be transacted?
It’s clear that authorities are reluctant to commit themselves at a time when new products are emerging almost daily, points out Chirag Patel, who heads our EY Americas Tax Innovation Foundry. It could be that they don’t want to stifle innovation but, whatever the reason, the continued lack of definitive tax guidance is a real worry for holders of crypto assets seeking clarity about their compliance responsibilities.
“The bottom line is that people who are dealing with cryptocurrencies should keep meticulous records on when they bought and sold these assets, so that they can calculate the correct costs for tax purposes,” Patel adds.
With such considerations in mind, we are working to have the Crypto-Asset Accounting and Tax (CAAT) tool available for use in connection with the 2018 tax compliance season starting in 2019. The tool methodically connects with multiple cryptocurrency exchanges and wallets, giving users a broad view of transactions and inventory.
“CAAT will allow EY teams to help clients investing in crypto assets in the fund space and beyond,” Meisler says. “The uncertainty in applying existing guidance relating to the timing, character and source of income generated in connection with trading and investing in crypto assets necessitates the use of flexible solutions. CAAT facilitates taxpayers to model different potential outcomes so they are better able to assess their risk relating to reporting taxable income for this new asset class.”
We favor a holistic approach. When companies review their tax profiles in the digital space, their discussions should cut across all traditional disciplines, including income tax, value-added tax (VAT) and transfer pricing.
Digital currencies have expanded considerably in type and scope in recent years. One of the biggest, Ethereum, supports a wide range of sophisticated apps that cover areas ranging from smart contracts to financial instruments, for instance. So-called stablecoins form another emerging cryptocurrency class. Designed to combine the strengths of both digital and traditional investments, they are pegged to a stable asset such as gold or a fiat currency such as the dollar.
The picture is becoming even more complex with the development of crypto assets such as utility tokens. In July, Martin Etheridge, Head of Division at the Bank of England with responsibility for FinTech, told the Commons Treasury Committee, “The challenge comes when you see that the bulk of activity seems to be in the unregulated space, around things like utility tokens, where you are buying, for example, future rights to access a theme park or something that does not yet exist. It is certainly not the sort of thing we regulate at the moment and that seems to be the approach being taken internationally as well.”
Globally, national views are diverse. At one end of the scale is Ilan Goldfajn, President of the Central Bank of Brazil, who has declared that cryptocurrencies will not be regulated on his watch. At the other is China, which last year banned direct trading between renminbi and virtual currencies. As a result, the yuan is now involved in less than 1% of Bitcoin trades worldwide. That said, China does take a much more positive view of blockchain, with its central bank seriously thinking about creating its own digital currency, doubtlessly tightly controlled.
Digitalizing tax collection
Blockchain, the technology invented to make bitcoin work, is revealing its transformative potential in several other fields, from logistics to medicine. It even promises to revolutionize taxation. Authorities are attracted by the transparency and security it offers; in particular, the traceability afforded by blockchain could aid in the prevention of financial crimes such as money laundering.
HMRC is working toward a paperless system under the Making Tax Digital banner and is taking blockchain seriously as a potential administrative tool. But its Chief Technology Officer, Steve Walters, said in March that the agency’s progress was cautious at best.
Many authorities are piloting new digital approaches in VAT/goods and services tax (GST) administration, which involves a lot of transactional data, as a test for their use in other areas. The improved availability of data has prompted several to consider how to evaluate and collect the VAT/GST payable on transactions at the instant they’re completed.
Data-matching techniques are also transforming VAT/GST audits, helping the authorities detect suspicious activities. One promising application concerns the prevention of crimes such as missing-trader fraud — whereby a company in the EU imports goods from another Member State free of VAT, charges customers VAT on their sale and then fails to pass this on to the tax authority — and more sophisticated cross-border scams such as carousel fraud and contra-trading.
In a 2016 report on distributed ledger technology, Sir Mark Walport, the then-UK Government Chief Scientific Advisor, proposed the establishment of a pan-EU blockchain system incorporating artificial intelligence with the ab¬¬ility to detect cases of VAT fraud in real time. Walport said that distributed ledger technology such as blockchain “provides the framework for government to reduce fraud, corruption, error and the cost of paper-intensive processes. It has the potential to redefine the relationship between government and the citizen in terms of data sharing, transparency and trust.”
Broad-based taxes on consumption, such as VAT/GST, and customs duties, energy taxes and environmental levies often follow chains of transactions. Tax liabilities are usually triggered by key events that need to be documented — for instance, a ship’s arrival in port.
Much of the processing work could be done by blockchain, preventing problems such as human error and fraud. Consider the example of a container-load of goods, the legal ownership of which is transferred while they are being shipped from New York to Singapore. The rate of sales tax that applies, which authority levies it and who accounts for it may depend on the time when the transfer of ownership occurs and the location of the shipment at that moment.
A GPS system can pinpoint when the freighter arrives at Singapore using smart devices that communicate with each other to report their status. This would enable all parties to confirm when contractual conditions have been met, thereby satisfying everyone that the goods have been delivered and triggering an irrevocable payment.
VAT and customs authorities could also create blockchains for the transmission of data and payments between taxpayers and government portals. Participation in a blockchain regime could eventually be made compulsory for all companies.
The invoice remains the most crucial VAT document. In a blockchain-based system, it’s likely that an invoice will require a digital fingerprint, derived through the VAT blockchain consensus process, to prove its validity. Authorities could scrutinize the history of the whole commercial chain extending both ways from a given transaction. It’s often hard to provide enough documentary proof to benefit from any potential tax breaks, such as those available through a free-trade deal, for example. However, if the items were traded in a blockchain and the authorities had access to the chain, they could verify with complete accuracy the origin and nature of goods at each stage.
The digitalization of taxation is inevitable. It’s simply a question of when it happens — nearly three-quarters of respondents to a World Economic Forum poll of more than 800 IT experts in 2015 predicted that blockchain would be used in tax collection before 2025. The onus is on companies to be ready for that transformation.
Key action points
- Assess the impact. Hold regular meetings to update teams on tech changes and plan on how to integrate those changes into your organization’s digital strategy.
- Beware of the risks. Consider a risk or capability assessment to determine whether your organization has the ability to track this as a viable investment and integrate cryptocurrency investment into your enterprise-wide risk management strategy.
- Take a “one for all” approach. Integrate the ever-changing cryptocurrency landscape into your companies’ other functional areas to create a holistic and resilient enterprise strategy.
To find out how our professionals can help, visit www.ey.com/gl/en/services/tax/digital-tax---why-digital-tax.