Preparing for Digital Taxation in a Blockchain World

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Channing Flynn EY

Channing Flynn is Global Technology Sector Leader, Tax Services, at EY

The long-term implications of blockchain technology developments for corporate taxpayers, tax authorities and tax advisory organizations are potentially revolutionary. The changes will require careful preparation and planning by governments and businesses alike.

My colleagues and I in the various tax practices at EY member firms around the world are keeping a very close watch on blockchain technology development. We recommend you do the same.

The long-term implications of this disruptive digital technology for corporate taxpayers, government tax administrations and tax advisory organizations such as EY are potentially revolutionary. Further, in this context “long-term” could mean as soon as five years—which is not much time to prepare for change of the magnitude we are envisioning. Hence, keep a close watch.

I. Blockchain is not Bitcoin

But before diving into our specific thinking on blockchain tax implications, let's make certain we share a common understanding of the technology and the hurdles it faces. Blockchains are large, distributed, multiparty shared databases that have a mechanism for replicating transactional data in real time with unequaled reliability and security. In addition, blockchains are transparent—all parties to a given blockchain see all the transactions recorded therein.

Chief among the hurdles facing widespread blockchain adoption is a perception problem we think of as “bitcoin backlash.” Blockchain and bitcoin are often viewed as synonymous, causing concerns about bitcoin to be associated with blockchain. But the truth is that the bitcoin virtual cryptocurrency simply was the first widespread application of blockchain. Today, there are many others, both live and under development. Let's also clear up the issue of anonymity: blockchains are not anonymous, except in the way it is possible to achieve anonymity in email. Blockchains associate all transactions with users identified by a blockchain address. As with an email address, anonymity is possible but only through separate actions to thwart traceability from the blockchain address to the account owner.

There are a number of other hurdles to widespread adoption of blockchain technology, including concerns about how to quickly scale transaction processing speed and storage. While none of these challenges are trivial, past technologies that generated similar excitement and interest as blockchain has, among as many diverse stakeholders, usually overcome their challenges. Let's assume for the purpose of this discussion that blockchain's hurdles will be overcome.

II. Implications for Corporate Taxpayers

Today, corporations are typically measured annually for income tax purposes based on a retroactive analysis of historical financial information. What are the implications when corporations begin recording all the transactions that generate their revenue and their expenses, their assets and liabilities, in real time in a public blockchain? Tax administrations would have open access to a company's transactions as they happened. Government software programs would calculate the tax owed and automatically deduct it from the company's bank account an instant after the transaction settles. Should blockchain achieve its promise, we expect its use would not be elective; governments would mandate it, certainly for publicly-owned companies.

In such a scenario, corporations would pay their taxes far faster than they do today, and estimated tax payments (an estimate of the future liability) would be eliminated. The function of corporate tax departments would be largely replaced by blockchain's certain, and secure, real-time transaction ledger and related software. Mistakes and fraud could, in theory, be eliminated. Or, so goes the logic.

Of course, jobs would change. Instead of large numbers of tax compliance administrators, blockchain technologists with tax knowledge would be required to build, install and maintain the necessary systems. The opportunity for complete automation here and complete revolution of the corporate tax function is significant.

III. Implications for Government Tax Administrations

The replacement of periodic self-reporting of revenue, expenses and taxes owed by real-time recording of public company transactions means there will be no lag between reporting a transaction and paying the tax. Consequently, governments will benefit from timely and more accurate payments and eliminate the need for manually prepared (even if prepared by software and submitted electronically) tax returns and the entire compliance process. Beyond that, in a world where every transaction is recorded in real time, there is no way to hide illegal businesses and there is no way not to pay the tax that is due. Some governments concerned over tax fraud, such as Russia, Brazil and Mexico, have already begun demanding access to corporate ledgers to review transactions and determine for themselves what taxes are owed. They have moved, or are moving, to digital tax administration, for which blockchain provides further opportunity to create a trustworthy and validated real-time transaction analysis.

For indirect taxes, blockchain's transparency and real-time validation of transactions could help automate and simplify taxation of trading transactions, particularly in the area of value added taxes (“VAT”) and other sales taxes. This could significantly lower the cost of tax compliance for corporations and governments alike. Of note, a report earlier this year by the U.K. Government Chief Scientific Advisor, Distributed Ledger Technology: beyond block chain, proposes a blockchain-based European VAT system that would increase transparency to “make the black market economy more difficult to conceal” and “include smart contracts designed to outsmart the tax quasi-compliant economy.” “Smart contracts” is blockchain parlance for agent-like software programs that automate transactions when certain conditions are met, such as buying commodities when the price dips below a set point.

Of benefit to both governments and taxpayers is that blockchain drastically reduces the potential for tax controversy, including tax audits, as most tax controversy today comes from arguing over transactions in an historical context. Blockchain's transparent, validated transactions will reduce these areas of controversy. Where tax controversy continues to exist, it will be less time-consuming and expensive as the parties will be making their case with mutually accepted facts and the controversy will be relegated to the interpretations of law. Or, so goes the thinking.

In the blockchain world, government tax-related jobs would change along lines similar to the corporate changes. Governments also will need blockchain experts to build the necessary massive databases and real-time systems—instead of auditors.

IV. Implications for Tax Advisors

So we come to my profession—global tax advisors. We are very aware that we need to pivot and adjust our understanding of blockchain technology, even as it evolves, proactively transforms and disrupts our own businesses as we assist clients in transforming theirs.

It's unlikely that tax advisory professionals will be filling out client tax returns since filing tax returns, paying estimated taxes and perhaps even auditing will no longer be done in the way we know it today. The blockchain removes the requirement for someone to question corporate taxes (or the underlying commercial transactions) because the government and the taxpayer should instantly be on the same verifiable page as to what transactions were just processed a moment ago, and every subsequent moment. It's a just-in-time system. Instead, our Global Compliance and Reporting (“GCR”) teams will likely be staffed with completely different skill sets—tax-knowledgeable blockchain systems and programming specialists.

By way of an example and to understand the possibilities, consider the work our GCR teams do in the mutual fund industry. The legal arrangement of mutual funds is massively complex. Each fund may own hundreds, or even thousands, of individual securities and bonds and other investments, all of which are constantly paying out dividends and interest subject to differing tax rates based on a number of specific characteristics across numerous jurisdictions. The administrative process currently in place to comply with all of the relevant rules and regulations about tax, withholding and reporting is hugely complex, costly and inefficient. That administrative burden could go away in an instant with blockchain, replaced by software that understands and applies the rules and records validated transactions, in real time, shared with governments and account holders in an open ledger.

V. Time to Prepare

While these potentially revolutionary changes seem inevitable, it's important to remember that blockchain technology is in its infancy. How well did we understand the revolutions in business and society to come from the internet during the moments after the first graphical browser emerged in 1993?

That said, from our vantage point today these changes do seem inevitable. Governments have multiple motivations to pursue them, and they're not all bad for taxpayers either in that they will reduce administrative costs and controversies, or improve assurance that the correct tax is being paid. Some observers expect significant change in only three or four years. We believe blockchain adoption will be slower, partly because of the hurdles mentioned above but mostly because changes of this magnitude require careful thought and planning, and time for people's thinking and government and corporate administration to adjust.

By the mid-2020s, however, we may all be living in a blockchain world.

Channing Flynn is Global Technology Sector Leader, Tax Services, at EY

Alex Postma, Global Director, International Tax Services Ernst & Young Tax Co. (Japan); Rod Roman, Tax Leader, Financial Services EMEIA Digital, Analytics and Cyber Solutions, Ernst & Young LLP (U.K.); Mazhar Wani, Global Compliance & Reporting Ernst & Young LLP (US); Gijsbert Bulk, Global Indirect Tax Leader, Ernst & Young Belastingadviseurs LLP (Netherlands), and Paul Brody, EY Americas Strategy Leader, Technology Sector, also contributed thinking to this article.

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