This article discusses three aspects of the interaction between the emergent technology of blockchain and the international tax system. We will explain some concepts in context in this article but it is not otherwise a technical discussion of the operation of a blockchain. Readers looking for a technical discussion of the technology underlying blockchain itself (or distributed ledger technology as it is sometimes also know) may find our introductory guide, Blockchain 101, helpful.
Taxation of Blockchain transactions
At the outset it is worth noting that bespoke tax regimes for blockchain transactions do not currently exist. Analysing their tax implications is therefore an exercise in applying existing principles to new technology, occasionally in the light of new tax authority guidance. Let us use the simple stock purchase transaction below by way of example.
The first part of the example blockchain transaction is as follows.
- Customer’s inventory management system detects Customer is running out of parts stock;
- Once stock falls below defined threshold, a purchase order is automatically created and sent to Customer’s preferred parts Supplier;
- Supplier captures purchase order and scans its stock management system, confirming it holds requested parts;
- Supplier issues draft invoice to the Customer;
- Customer receives invoice, authenticates Supplier as sender and digitally signs the invoice with a cryptographic signature;
- Smart contract formed between Customer and Supplier with obligation for Customer to pay invoiced sums on 30 days after receipt of parts; and
- Smart contract terms include irrevocable instruction to Customer’s bank to release payment on due date, provided certain conditions met (i.e. parts received, good condition, correct spec etc.).
As noted above, one expects the tax consequences to flow from the actual transaction undertaken; so here a purchase and sale of stock. Where both supplier and customer are in the same country, the use of smart contracts adds little to the tax analysis. We set out the basic consequences below. In a cross-border context, one could imagine that the use of smart contracts could impact the practicalities of what is done where. That could alter the taxing rights of different jurisdictions and that is considered later in this article.
The VAT consequences are as for any other stock purchase. So the supplier of the stock will need to issue a VAT invoice. If the transaction is purely domestic within one EU state, the supplier will charge VAT at the domestic rate and account for it to its home state authorities. If the transaction is cross-border and the customer is an EU resident then the customer will reverse charge the VAT in accordance with its home state rules. So far so straightforward.
Corporate income tax
(a) If the transaction is cross-border, the supplier will need to think about whether to include the net sale proceeds in its corporate income tax computation in the customer state. That is a key point that we will return to in the discussion below. Either way, the supplier will need to consider whether it should include the net sale proceeds in its home jurisdiction corporate income tax computation (and there is a system of rules that mean the supplier should not bear tax in both states on those profits).
(b) The customer will treat the price paid as cost of stock for accounting and tax purposes. Now by way of further example, suppose we overlay invoice factoring as per the diagram on the next page.
Now by way of further example, suppose we overlay invoice factoring as per the diagram below.
The second part of the example transaction is an invoice factoring transaction.
- Supplier’s system programmed to factor receivables due under invoice if Supplier’s working capital is below set threshold and discount rates offered are acceptable commercially;
- Supplier’s system calls out to preferred Invoice Financer to obtain latest discount rates; 10. Customer’s invoice is represented as a digital asset on the blockchain;
- Customer’s invoice is represented as a digital asset on the blockchain;
- Invoice Financer checks Customer’s bank to assess credit risk of Customer paying invoice;
- (Invoice Financer pays 85% of receivables to Supplier and ownership of invoice is transferred to Invoice Financer on the blockchain);
- Various stakeholders in export/import process input on status of sale onto blockchain, enabling Supplier, Customer and Invoice Financer to monitor progress in near real-time;
- Disputes/delays managed between parties and blockchain updated on resolution;
- Customer’s smart contract with Supplier automatically pays invoice when due, payment recorded on blockchain and Invoice Financer notified; and
- Invoice Financer releases remainder of receivables balance due to Supplier, less fee.
The stock supplier and invoice financier will need to consider how to account for this both as a matter of VAT and corporate income tax. Again, fundamentally the mere use of blockchain to facilitate invoice factoring does not generally change the analysis.
Depending on the precise arrangements, the invoice financier will probably make partly standard-rated and partly exempt supplies to the supplier.
Corporate income tax
a) The stock supplier will ultimately show the net sale proceeds net of invoice discount as its net profit for corporate income tax purposes. (And as set out above, the question of which state’s tax returns that should be recognised in may be difficult.)
b) The invoice financier will ultimately include the net profit on the factoring transaction in its P&L.
So far we have just applied existing principles; nothing is new.
However there are areas where there may be differences, whether on this blockchain transaction or generally for e-commerce transactions.
Cross-border business and the changing tax landscape
As with other forms of e-commerce, blockchain potentially offers new ways of doing business. Those new business models in turn alter the requirements for people and assets in particular jurisdictions. That change in the activities actually undertaken in each jurisdiction can radically alter the tax take of particular jurisdictions as compared to more traditional business models.
To understand how this has become an issue, it is useful to appreciate that, with some notable exceptions (such as the US), and as a very broad generalisation, most countries (“source states”) have similar nexus tests to decide whether foreign companies should be subject to tax on those profits that in some sense derive from the source state. That nexus test requirement involves a concept known as a “permanent establishment”. At a first level of approximation a permanent establishment might be thought of as a place where a foreign company has “its own people on the ground” in the source state. Turning then to the nexus test, a source state will generally tax those profits of foreign companies that arise in the source state if and only if there is a “permanent establishment” in the source state to which the profits are attributable.
In source states where those are the rules, there are then two commonly seen approaches to minimising corporate income tax in the source state arising from business customers in that source state:
(1) avoiding creating a permanent establishment in that source state in the first place; or
(2) if there is such a permanent establishment, limiting the profits that are attributable to that permanent establishment; usually by demonstrating that the real profit generating activities do not occur in that source state. Rather it will only be low risk (and thus low profit margin) activities that occur in the source state.
The definition of a permanent establishment is still (in the main) driven by physical attributes like buildings and employees. Generally renting a local computer server, without more, is not a permanent establishment.
Given that background, one can imagine that, if smart contracts reduce the need for the presence of individuals in a particular country, that that could impact the jurisdictions in which a company has to pay corporate income tax.
In a UK context you may be aware of the controversy about the level of corporation tax paid in the UK by non-UK headed multi national groups. This ultimately drove a number of changes to certain aspects of UK tax – in particular the introduction of the UK diverted profits tax (publicly and somewhat unfairly labelled the “Google tax” by many).
Whatever the economic arguments, from a public policy perspective, we are increasingly seeing states taking the position that companies that derive revenue from within their respective markets have a filing obligation or ‘nexus’ despite a lack of physical presence in the state or arguments that the value in the transaction with the customer in that state properly sits in another jurisdiction.
The last few months have seen a number of differing proposals to address the (non) taxation of digital businesses, in part driven by the Estonian Presidency of the Council of the European Union. The ‘Issues Note‘ issued by the Estonian Presidency, discussing the corporation tax challenges of the digital economy gave an indication of the divergence in preferred approaches. By the time you read this that will have been overtaken by the December 2017 ECOFIN meeting which is also due to seek a consensus on a way forward.
Absent some level of EU or international agreement, the danger is that there will be a plethora of local measures. For example, in September the finance ministers of France, Germany, Italy and Spain and presented a proposal for a turnover based “equalisation tax” for tech companies of between 2 and 5 per cent of turnover at the ECOFIN meeting in Tallinn. The result of the December 2017 ECOFIN meeting is therefore awaited with interest. Though given the divergence of interests between EU states with different types of economy, we suspect that any EU-wide proposals will ultimately be incremental rather than transformational. By way of further example the UK government also announced in November a further consultation on the taxation of digital businesses.
Changes on the VAT side are more straightforward since VAT is an EU-wide tax; though still one that requires unanimity to develop. ECOFIN have announced that they are looking to revamp the application of VAT rules to e-commerce and online transactions.
Taxation of virtual currency
What if one pays for goods or services in bitcoin or other cryptocurrencies?
In the UK, bitcoin and other similar cryptocurrencies are treated as foreign currency. That is a practical view and was taken by HMRC in Business Brief 9 in 2014. The UK says that a cryptocurrency is just like cash (albeit foreign cash). There may be some valuation issues (particularly for more volatile cryptocurrencies) but, ultimately, the rules are clear since the tax system has developed over time to deal with foreign exchange issues.
It is important to note at this point that the HMRC guidance refers to other cryptocurrencies that are “similar” to Bitcoin. Those that follow the financial news will have noticed there has been increased media coverage of what have been termed “initial coin offerings” (ICOs) over the course of this year. ICOs come in a variety of forms and one should not assume that simply because something is described as a coin it is equivalent to currency – as the interest of the SEC in the US and FCA in the UK indicates, in many cases what investors acquire in these offerings may in fact be some form of security or other chose in action which would not be treated as foreign exchange for the purposes of UK taxation.
In 2015, in Skatteverket -v- David Hedqvist (C-264/14), the CJEU followed the approach of HMRC in relation to VAT at least. Mr Hedqvist intended to carry out the purchase and sale of Bitcoin in exchange for traditional currencies, such as the Swedish crown. He intended to make a spread. The CJEU held this was akin to any other currency exchange service and thus exempt from VAT. The judgment should mean that from a VAT perspective the tax treatment of Bitcoin transactions is the same throughout the EU.
Treatment otherwise than as a currency
In cases where the relevant cryptocurrency is treated as some other form of property (as is we understand the case in the US) that can quickly give rise to awkward compliance points.
First on the practical side, if taxpayers automate transactions using smart contracts, it should be relatively straightforward to feed the outputs into their internal accounting systems and their VAT and other tax compliance software packages. So for those that want to be compliant, that may simplify things. But that is not really the prize here. Let’s look further afield. First, compare and contrast:
The Estonian government has been experimenting with blockchain for a number of years using a form of distributed ledger technology known as Keyless Signature Infrastructure (KSI), developed by an Estonian company, Guardtime. That system allows taxpayers to access their account, change details and pay online. According to the former President of Estonia, Toomas Hendrik Ilves, writing for the World Bank in 2016, nearly 95 per cent of Estonians now declare their income to the tax authority online (Mr Ilves claims that it “takes less than five minutes and no accountants”, although this may be as much a function of the efficiency of Estonian tax law as the technology for filing returns), reducing the cost of collecting tax and saving citizens time – reportedly 5.4 workdays a year.
The UK is (slowly) moving towards a paperless digital tax system under the banner of “making tax digital”. The process of ‘making tax digital’ is ongoing and has had numerous teething issues. For example the implementation for businesses have been put on hold until April 2019 for VAT (although this is a rather low-hanging fruit as 98 per cent of businesses already file electronic returns) and April 2020 at the earliest for taxes other than VAT. It is also a traditional system where all information is provided to HMRC who keep an internal record rather than a distributed ledger.
So what is the UK attitude to blockchain?
The UK government Chief Scientific Adviser (GCSA) in the 2016 report “Distributed ledger technology: beyond block chain” wrote that ‘”distributed ledger technologies have the potential to help governments to collect taxes, deliver benefits, issue passports, record land registries, assure the supply chain of goods and generally ensure the integrity of government records and services”.
Steve Walters, HMRC’s CTO in March 2017 said the UK is taking blockchain seriously as a technology for tax administration but described HMRC as adopting a “a slow-and-go approach”. He cited regulatory oversight, security concerns and reputational risk as factors causing HMRC to proceed with caution.
So what should one do? There are some lower-hanging fruit that people are talking about. For example, many people are focused on preventing one particular type of VAT fraud, known as MTIC or carousel fraud. The 2016 GCSA report proposed a pan-EU blockchain-based VAT system to facilitate the use of artificial intelligence (machine-learning) to identify VAT fraud in real time. The report viewed this as already technologically possible but also acknowledged that government agencies “need to be able to handle [distributed ledger technology] for tax” – it may be harder to tell when that requirement is met.
According to a World Economic Forum survey of technology company executives, most respondents expected that tax would be collected for the first time by a government using blockchain technology before 2025.
In theory tax collection generally could be revolutionised. For example, a blockchain-based transaction using “smart contracts” (a computer protocol to facilitate self-executing contracts) could be used to automatically pay transaction-based taxes such as VAT to HMRC on a real-time basis.
Ultimately, the use of blockchain technology for the collection of tax may reduce or remove the need for tax advisers to help produce tax returns. Rather their input would be much more important in ensuring that the rules had been encoded correctly within the relevant software.
Our current expectation is that blockchain is more likely to facilitate revolution in administration than fundamentally change the taxation of transactions.