With the emerging, potentially disruptive nature of blockchain technology, it is critical to understand its function and fundamentals. This article seeks to highlight the basics of blockchain technology, and more specifically, how blockchain’s inherent characteristics pose a problem to the existing tax infrastructure.
The Rise of Blockchain Technology: Bitcoin
Bitcoin is a P2P electronic cash system known as Bitcoin developed in 2008 and using an infrastructure for electronic payments known as blockchain technology. Blockchain is a decentralized ledger that records ownership and value transfers with no need for an intermediary. As such, blockchain provides a novel framework for independently executed transactions that traditionally required a trusted third party, such as a bank or a credit card company.
Contractual arrangements can be programmed onto the blockchain and automatically executed once a triggering event occurs. These contracts have earned the moniker “smart contracts”, despite making plenty of imprudent mistakes since inception. Since the contractual execution is decentralized, neither a party to the contract nor a third party, like a government, can prevent execution. For example, inheritance funds can be programmed to be transferred to an heir when that heir reaches a certain age, or business profits can be programmed to be distributed once certain financial targets are met.
While such a system may offer societal benefits, it also presents significant challenges to the tax system. In order to understand the challenges to tax enforcement, it is helpful to consider some of the unique characteristics of blockchain-based applications.
Business without an intermediary
Blockchain technology offers the ability to document value transfers without using an intermediary. This presents a unique challenge to any tax system because modern tax enforcement relies heavily on reporting by financial intermediaries. Intuitively, tax-compliance rates are significantly increased when third-party reporting is involved.
There are multiple mechanisms by which financial intermediaries strengthen tax compliance. They issue to taxpayers’ returns (e.g., Form 1099s) pertaining to interest, dividends, and capital gains that assist taxpayers in reporting their taxes. At the same time, they submit the same information to the IRS, which enables the agency to match information it receives from financial intermediaries to the information received from taxpayers. These same financial intermediaries often serve as tax collection agents and are required to withhold taxes on payments that they clear. If the fail to meet their reporting and withholding requirements, the financial intermediaries may be subject to tax-enforcement actions, liable for their customers’ unpaid tax liabilities. However, if they are removed from the picture by blockchain technology, tax authorities lose a powerful enforcement mechanism. As long as the two parties to a blockchain transaction agree not to voluntarily disclose the transaction to the tax authority, there is nothing that the government can do to collect information on the transaction. Since the system is fairly anonymous, it is possible that taxable events cannot be pinpointed to an individual, hindering the IRS and other tax authorities in the fulfillment of their oversight mission.
Further, even if both parties to a blockchain transaction are compliant taxpayers who voluntarily share information with the tax authorities, enforcement still suffers. It is easy and economical to verify transaction information by using centralized databases held by large financial intermediaries, and to use the intermediary as a central point of enforcement. The alternative, since enforcement is solely dependent on the cooperation of dispersed end-users, is much more complex, and it is also likely to be much more expensive.
Blockchain applications can operate without identifying participants. Anyone can start a blockchain “wallet” at virtually no cost, without providing any identifying information. Parties do not even need to know one another for a transaction to be consummated. This anonymity makes it hard for tax authorities to detect the identity of tax evaders who use blockchain to facilitate their illicit activity. Blockchain is thus a particularly powerful instrument in the hands of evaders, even in the face of recent advances in international tax enforcement.
In 2010 the U.S. adopted the Foreign Account Tax Compliance Act (FATCA) requiring foreign financial institutions to disclose the identities of U.S. investors or endure a punishing withholding tax on their U.S. investments. Congress enacted this law to target tax evaders who use offshore bank accounts located in secretive tax haven jurisdictions. FATCA requires foreign financial institutions to deliver the account information of U.S. taxpayers to the IRS or face burdensome U.S. taxes on their U.S.-sourced income. In the context of FATCA, multiple countries have agreed to share information with the United States, and the Organization for Economic Co-operation and Development (OECD) has developed a “Common Reporting Standards” (CRS) framework based in large part on the FATCA model. Under the CRS framework, financial institutions share information with tax authorities, and the latter share information with one another. More than 110 jurisdictions have adopted binding CRS instruments.
However, blockchain provides a medium to navigate around this elaborate statutory framework. As noted earlier, as part of the blockchain process, value exchanges do not have to rely on intermediaries, and parties to a transaction need not identify themselves. Even for jurisdictions in which blockchain agents wish to identify themselves, it is not clear that they could do so. The combination of disintermediation and anonymity has led to the characterization of blockchain applications as “super tax havens.”
Another unique aspect of blockchain technology is its tamper resistance. “Once information has been recorded to a blockchain, it becomes exceptionally hard to change or delete.” Undoing a transaction requires a majority of the dispersed network participants to agree to undo the transaction, a near-impossible task. When tax evasion is involved, once such a transaction is executed, no financial institution or government can unwind the transaction. This means that even if fraud is identified, no one can remedy it. Thus, this makes the recovery of lost tax payments especially challenging even if the illicit activity is discovered.
Blockchain facilitates the autonomous execution of smart contracts. This means that once a malicious code is released using blockchain, there is no stopping it, even if one becomes aware of the code’s existence. The execution is based on a dispersed confirmation process, and governments cannot simply ask what may amount to millions of users to stop using a particular blockchain application. The existence of legal standards aimed at preventing such transactions becomes irrelevant. “Autonomous systems do not need to abide by existing rules and jurisdictional constraints; they can be designed to bypass or simply ignore the laws of a particular jurisdiction. Once deployed on a blockchain, these systems will continue to operate.” Thus, even when tax authorities identify a blockchain-based application aimed at tax evasion, there is nothing that a government can do short of shutting down the internet.
These blockchain technology traits have led some experts to note the potential of blockchain technology to be used as an instrument of tax evasion, and there is at least some anecdotal evidence that the technology is being used as such. For example, in United States v. Coinbase, Inc., the IRS successfully forced Coinbase (a cryptocurrency exchange soon to be offering public stock) to turn over information about its account holders. During the period applicable for the request, Coinbase served millions of customers each year, but fewer than 1,000 U.S. taxpayers reported any transactions in cryptocurrencies on their tax returns during the same period. Since, the company has adopted a Know Your Customer (“KYC”) strategy that requires validation of U.S. residence, driver’s license and social security number. This KYC strategy is becoming popular amongst other centralized exchanges, such as Binance.
Since our nation’s tax laws were drafted before the advent of blockchain technology, Blockchain presents a continuing tax-enforcement challenge. The application of existing legal standards to blockchain-based transactions is uncertain. To date, the IRS has issued only two pieces of administrative guidance on the tax consequences of transactions involving cryptocurrencies. While the guidance offers some clarity on a few basic issues, it falls short of answering important questions on timing, amount, and character of income inclusion. The IRS has justifiably been harshly criticized for not issuing additional guidance. Currently, it seems the main concern is with those who have traded larger sums of money.
This lack of guidance has resulted in three negative outcomes. First, even the best-intentioned taxpayers may find it hard to comply with the law. There are legitimate questions about how to report certain blockchain transactions, and the lack of guidance may cause taxpayers to take legal positions on their tax returns that seem reasonable, but that may eventually turn out to be wrong. Second, a lack of guidance creates legal uncertainty, which may discourage entrepreneurs from engaging in this new technology in ways that may be beneficial to society. Third, the regulatory vacuum allows aggressive taxpayers to use the ambiguity for their benefit, and there is some evidence that this indeed is happening.