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Bitcoin and Tax

By Craig Wright | 31 Dec 2020 | Bitcoin & Blockchain Tech

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