Bitcoin and Tax

Date: 2020-12-31

Source: https://craigwright.net/blog/law-regulation/bitcoin-and-tax

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There is a common myth that Bitcoin will

allow individuals to avoid paying tax. It could not be further from the truth,

and in today’s post, I will demonstrate how easy it will be for governments and

tax authorities to ensure compliance. In particular, the traceability of all

payments in Bitcoin provides a scenario where any individual that attempts to

falsify tax records, or to underpay tax illegally, could be quickly determined,

and payment of owed taxes can be automated.

Firstly, it is essential to note that the

structure of the keys associated with Bitcoin unspent transaction output (UTXO)

sets can be attributed to an identified individual or corporation. The Bitcoin

white paper talked about the necessity of firewalling identity from the chain.

Doing so does not remove the ability to identify individuals, but it is rather done

in a manner that is not public.

Firstly, any anti-money laundering (AML) rules,

in line with know your customer (KYC) rules, allow for all quantities of money

larger than around US$200 to be associated with an individual. When you put

money in and take money out of an exchange, it must be attributed to an

identified individual. Under the European provisions detailed in the Fifth Money

Laundering Directive (5MLD) [1], custodian wallet providers are required to

engage in anti-money laundering activities for all but small casual amounts of

money that are transferred. Every exchange is a custodian wallet provider.

There are no exceptions to the rule. Exchanges hold your money under a

custodial arrangement. Consequently, when the regulations come into full effect,

in January 2021, it will be necessary for all exchanges and custodial wallets, for

exchanges within the United Kingdom and Europe of more than €150, to report

customer identity information.

Businesses are required to maintain

information concerning their customers. The only businesses that will not

require detailed information on cryptocurrency and digital cash exchanges and

transactions will be ones involving the original use of Bitcoin, as a digital

cash system, and small transactions. From here, there is complete traceability

of all money involved in the Bitcoin ecosystem.

From a tax office perspective, they now

have a powerful tool in ensuring compliance. Where businesses have not

adequately ensured accounting controls around digital currency transactions are

kept in place, they will need to report all of their income or face criminal

sanctions, in the worst case, and, at least, fines for non-compliance. The

reason for such a scenario is that tax authorities can now match all of the

transactions leaving the client. A business will need to transfer the value to

pay bills. When they do so, other clients will also report information. Such

information will be traceable from the customer, across the company, to the

next-hop supplier, and beyond. Here, tax authorities have valuable tools that

will allow the monitoring of business activity.

The assumption that organisations do not

need to pay tax is made in error. The reason is straightforward: some

organisations will always comply and pay their fair amount of tax. They will

not seek to unfairly gain a competitive advantage by cheating. As a result, the

tax authority will always be able to match the incoming transactions and the

outgoing transactions for each of the businesses in a country. Any transactions

that do not match will eventually be caught. In other words, a single compliant

organisation will be able to unravel an entire criminal economy that tries to

avoid its obligations.

It works in such a way: every transaction leading

to a compliant organisation can be instantly matched and checked. If the tax

office finds that there is a mismatch between any incoming and outgoing transactions,

they have a complete record that can be followed.

Alice runs a compliant business. She

reports all of her taxes and obligations. To do so, she records the identity of

all her suppliers and customers. She uses the blockchain such as through the

use of a blockchain-enabled general ledger system. As long as Alice records relevant

information about all of her customers, she can supply a complete hash list of

all of the incoming and outgoing transactions relating to her business, which

have been recorded in the ledger. Alice can publish a list of all transactions,

and transaction identifications (TXIDs), that have either been received by the

organisation as income or equity or gone out as disbursements or payments.

As the tax authority will have been

collecting information from every company, they will now be able to wholly

match all of the incoming and outgoing values. If all of the individual

companies and people in the system are compliant, the tax authority never gains

any information other than the hash [2].

If Bob is not a compliant company, by reporting

only some of his income and outgoings or inflating results, when he deals with

Alice, Alice will report all of the transactions with Bob. If Bob doesn’t

report all of his transactions with Alice, in an attempt to underpay tax, the

tax authorities now have a list of hashes from Bob and Alice, where the

difference can quickly be analysed. The tax authority will now go to Alice and

ask for additional information. They will do so because Alice has provided them

with a hash payment she has received or made that has not been recorded twice.

All entries should be recorded twice. There should be an entry in the hash for

Alice and Bob. If Alice provides such information, while Bob doesn’t, there is

a disparity that can quickly be found.

Because the tax authority has received an

unmatched set, they will now go to Alice and ask her to provide her company

records for any respective, non-compliant hash set. The assumed scenario could

be proven with an extract of information demonstrating that a particular input

hash has never made it to the tax authority. The same extract of information

could become evidential and allow the issuing of court orders. The information

of the input hash can be stored on-chain, giving details of the customer and

the sales, without leaking any information so long as the company or individual

is compliant.

The tax authority will only be able to

access information concerning the non-compliant entity. Here, they will prove

that they have not received information on a particular transaction and ask

Alice for the details of the transaction. When Alice provides such information,

it will link to evidence of Bob’s non-compliance. That is, Bob will have signed

a transaction proving the details of his company and the transfer, whether it’s

receiving money or goods or anything else that has not been reported to the tax

authority. Remember, if the transaction is correctly reported, the information

concerning the companies and the goods and payment will be included in the

transaction. It will be completely private, as only the individuals involved

will hold such information.

The logging of information relating to tax

returns and lodgements can be automated [3].

The scenario can extend to the

incorporation of classification information. For instance, the nature of a meal

can be recorded. Both parties can automatically record the type of capital

goods and the use. In the future, automated accounting systems can be built.

Alice and Bob would benefit from using such a system, because both financial

accounting reports and managerial accounting reports can be created using such

information. It is not only paying the required amount of tax.

In the exchange process of simplified payment

verification (SPV), when invoices and purchase orders are created and exchanged

between individuals or companies, Bob and Alice exchange information that

allows each party to determine the identity of the other. It mirrors the

initial IP-to-IP process developed within Bitcoin when it was first launched.

At the same time, there is no leaking of private information to the public.

So, with the mismatch between values, when

the tax authorities ask Alice for information, they will have definitive proof

of the exchange between Alice and Bob. As the recording of all such exchanges

is an automated process, the only way Bob will be able not to meet his tax

obligations is to try to defraud the tax authorities intentionally. But, in

doing so, he will be caught. Notably, the information that Alice provides could

even be linked to whistleblower rewards, to speed up the process. If Alice does

not hand over the information, it would be an indication that she is not compliant.

So, the options are to either be compliant or be caught.

References

[1] *Directive (EU) 2018/843 of the

European Parliament and of the Council of 30 May 2018 amending Directive (EU)

2015/849 on the prevention of the use of the financial system for the purposes

of money laundering or terrorist financing, and amending Directives 2009/138/EC

and 2013/36/EU (Text with EEA relevance)*; PE/72/2017/REV/1; OJ L 156, 19.6.2018, p. 43–74; ELI: http://data.europa.eu/eli/dir/2018/843/oj

[2] Wright, C. S. Savanah, S. (2017). *A Method

and System for Verifying Integrity of a Digital Asset Using a Distributed Hash Table

and a Peer-to-Peer Distributed Ledger*. International Patent Application No. PCT/IB20 17/052800. Geneva: WIPO. https://patentimages.storage.googleapis.com/e6/2e/cd/056daf91dbdd04/WO2017195160A1.pdf

[3] Wright, C. S. (2017). *Cryptographic Method

and System for Secure Extraction of Data from a Blockchain*. International Patent Application No. PCT/IB20

17/050979. Geneva: WIPO. https://patentimages.storage.googleapis.com/a0/59/46/11cc97e7f31c22/WO2017145048A1.pdf

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