Emerging Technologies

Key tax considerations when using blockchain for value transfers

Image: Photo by Simone Hutsch on Unsplash

Jarick Poulson
Managing Director, Deloitte Tax LLP
Rob Massey
Partner, Global Blockchain Leader for Tax, Deloitte
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  • New blockchain business applications are enabling digital representations of value that fall outside the definition of property, be it cryptocurrency or other types of digital assets.
  • Considering tax implications during design stages can raise material questions and considerations for further development.
  • Key questions early on can mitigate cost and hassle of tax complications when using blockchain for value transfers.

The world is seeing a proliferation of digital assets – cryptocurrencies used as a means of exchange and a store of value, tokens that allow access to decentralized platforms, and digitized securities offering similar rights to holders of traditional debt or equity. As blockchain transforms traditional business models, there’s still little guidance for businesses, so careful tax consideration is key.

Tax implications exist for blockchain deployments that transfer value without the use of digital assets such as cryptocurrency or tokens. Considering tax planning in the design phases can lead to increased efficiencies and regulatory compliance. Importantly, in some cases, it can help mitigate costly and avoidable problems, such as creating taxable income for the enterprise or user.

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Defining digital representations of value

Digital assets can be complex and asking a range of questions can help provide a full picture of the tax implications, as well as the digital representation of value (DRV), or how the asset functions as a medium of exchange, a unit of account or a store of value. A DRV may or may not be property taxed like cryptocurrency. It could be deemed to be a digital certificate or digital marker. Though it may not be deemed to be property, it may still have tax implications upon transfer.

The simple question ‘What’s the thing?” is a good starting point for these conversations. Understanding an asset’s character, basis tracking, sourcing and expense and revenue recognition will determine how it will be classified for tax purposes. Businesses should apply a tax lens for each of the identified transaction flows for a new blockchain-based business model. This lens can help identify the value that is being transferred and confirm if it’s a “thing” for tax purposes.

"Understanding an asset’s character, basis tracking, sourcing and expense and revenue recognition will determine how it will be classified for tax purposes."

To define a DRV, the first step is to assess how it is used within the intended ecosystem. The way in which the DRV is used is an important factor in defining what it is for tax purposes. If its use falls outside of certain parameters, the way it is used could unintentionally cause it to be treated as property. Crucial considerations in this analysis might include the following (note that not any one factor is determinative in defining the digital representation of value):

  • Is the system a closed loop or open platform (i.e. can the DRV be transferred outside of the ecosystem)? Digital value used in a closed loop environment is less likely to be deemed property, as compared to a cryptocurrency that is transferred openly within a blockchain to any participant on the blockchain.
  • Who are the participants and how are they accepted into the ecosystem? This question can be an essential factor in determining whether a platform is open or closed.
  • What does the digital value represent, and does it have value outside of the ecosystem? Examples of what the digital value represents might include a promotional certificate, a tracking mechanism, or a voting right.
  • What are the legal ramifications? Certain legal ramifications such as “What happens upon bankruptcy?” and “Who is liable for risk of loss?” are issues that can have a significant impact on the tax definition.
  • How is the value stored, managed or audited? Financial and process controls can impact whether the value attributed to the DRV can be relied upon.
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Assessing tax implications

Knowing what the DRV represents for tax purposes lends to assessing potential tax impacts to all participants. Income tax treatment, indirect tax treatment, and information reporting requirements for the DRV can vary depending on the nature of the transfer, the transferor and the transferee.

-Income tax treatment. The income tax treatment of a DRV can vary depending on the relationship between the transferor and transferee even if it is not considered to be property for tax purposes. One example is a promotional certificate used by a business to encourage adoption of certain behaviors and user engagement. This could impact sales revenue of the enterprise depending on their tax accounting methods. If the promotion is geared toward employees or contractors, the enterprise should examine any deemed compensatory transfer.

-Indirect taxes. Indirect taxes are also worth considering through the design and implementation stages. These include state and local sales and use taxes (“SUT”) and value-added taxes (“VAT”) where relevant. The transfer of a DRV may or may not be deemed to be a sale, potentially triggering indirect taxes. Such determination may be dependent on the relationship between the parties and whether anything of value is returned for the transfer (e.g. upon redemption of a promotional certificate). If SUT or VAT do apply, who is responsible for tax withholding and remittances? It is important to consider each jurisdiction’s laws and regulations and apply the analysis early in the design of a DRV.

-Information reporting. These requirements can vary greatly depending on the DRV use and participants involved. A few questions that will help in determining whether information reporting is required include:

  • Is income fixed and determinable at time of transfer?
  • Is there cash value in the DRV?
  • Is the DRV transferrable?
  • Does value transferred exceed minimum thresholds for reporting requirements?

Discussing what the DRV represents for tax purposes, in the design stage, can raise questions and considerations for further development. One tested approach is to depict each transaction in the intended transaction flow lifecycle and the effect upon all key stakeholders (e.g. owners, management, users, operators, issuers, etc.). With the transaction flows identified, tax advisors then analyze the potential impacts to each stakeholder across multiple tax lenses, including income tax, indirect tax, and informational reporting. The results of the analysis can help avoid unexpected surprises or allow for changes to terms or entity structuring that can result in improved tax implications.

The tax analysis might also lead to revising legal agreements and transactions. Some projects, however, go all the way through to operations before bringing tax experts to the table, which can lead to rescinding transactions or revising agreements to existing users.

In summary, bringing tax to the early design stages of a blockchain deployment can mitigate potential complications and create increased efficiencies. It may require a mindset shift to the design and development process, but any effort on the front end may pay for the time and cost of remediation.

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