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Addressing Tax Evasion from Cryptocurrency Transactions

About the author: Ankit Kapoor is a fourth-year BA-LLB (Hons.) student at National Law School of India University, Bangalore. He is acutely interested in the intersection between technology and the law. Presently, he has worked with renowned litigators, law-firms, and policy-makers in India on data protection/governance as well as legal and policy challenges from the internet, blockchain, and artificial intelligence.

Photo by Marco Verch available here.


Introduction


There are at least 2,247 different cryptocurrencies worldwide, with a total market capitalization of $171 billion and valuation around $2 trillion. While this constitutes a fraction of the aggregate financial market, trends indicate that crypto-transactions will rise exponentially in the next decade. However, it is well-recognized that the unique characteristics of cryptocurrencies facilitate tax evasion, with over $1.4 billion illicitly funneled. The increasing global crackdown on offshore tax havens also renders crypto-transactions more lucrative.


Blockchain is an open and distributed ledger that records transactions amongst parties permanently, verifiably, and efficiently. The architecture of blockchain imbues it with key characteristics: decentralization, pseudonymity, immutability, and transparency. Cryptocurrencies are a type of virtual currency that operates on blockchains. Therefore, they use blockchain protocols and demonstrate its characteristics. The European Commission has defined cryptocurrency as a digital representation of value that is neither issued by a public authority nor attached to a fiat currency, but is accepted by persons as an electronic medium of exchange, store of value, and/or unit of account.


Outlining Tax Evasion Concerns from Crypto-Transactions


There are two kinds of tax evasion: evasion of assessment and evasion of payment. The most common is evasion of assessment, where the evader wilfully attempts to omit the levy of taxes on income either by underreporting their income or overstating their deductions. The other is evasion of payment, where the evader escapes tax liability by concealing funds or assets. Both forms of tax evasion create economic distortions because the resources invested in evading liability create no social benefit.


I. Features enabling evasion

Crypto-transactions facilitate tax evasion because they are anonymous and decentralized.Additionally, structural problems like global non-uniformity and inadequate disclosure and reporting make regulation and enforcement difficult.


Anonymity prevents government authorities from tracing the identity of the evader. This restricts transactions from being monitored and sanctioned by tax authorities, enabling evaders to operate outside of the regulatory perimeter. As explained earlier, the anonymity of crypto-transactions can range from pseudonymity to complete anonymity. While the former allows for some traceability, it is far too expensive, complex, and inaccurate to yield consistent results. Decentralization means the absence of a centralized authority. This hinders regulatory efforts because there are no issuers or payment processors to use as focal points of regulatory action. Moreover, there are little to no intermediaries, which reduces vulnerabilities for the evader.


Cross-border transactions further enhance decentralization because countries lack a uniform approach to recognizing and classifying crypto-transactions for tax purposes. Therefore, cross-border transactions facilitate evasion. Moreover, some countries have lax rules and enforcement, which frustrates domestic information gathering and enforcement. There is also inadequate disclosure and reporting because anonymity reduces the type of information crypto-intermediaries may themselves have. Further, there are no mandatory disclosure and reporting requirements for reporting income from crypto-transactions. Since tax evasion investigations depend on “following the paper trail,” this lack of information handicaps tax authorities.

II. Mechanisms Enabling Evasion


Peer-to-Peer Transfers

Peer-to-peer transfers are crypto-transactions undertaken between two users through their wallets, outside exchanges, and platforms. Strategically, this is the best option for evaders because it does not involve any intermediaries, creating almost no traceability.


Conversion into Fiat Currency

All convertible non-centralized virtual currencies are tradeable or purchasable with fiat currency, represented by traditional options like cash. This is facilitated through confidential transactions with online vendors, or through cryptocurrency ATMs.


Using Third-Party Agents

Under these confidential schemes, an investor subscribes to the stock of a company by paying the buying agent through cryptocurrency. Thereafter, the agent remits any dividends on stock of the company to the investor.


Fork and Merge

Crypto investors use the “fork and merge” pattern to hide the source and destination of funds. This involves either splitting large volumes of the cryptocurrency into multiple small accounts owned by the same investor or purchasing the cryptocurrency in smaller lots using multiple wallets.


Anonymizers

Anonymizers involve the use of third-party tools like “mixers” or “tumblers.” Mixers obfuscate the source of certain units of cryptocurrency by mixing the cryptocurrency of multiple investors before the concerned units are delivered to their desired destination. Tumblers sever the link between the buyer and seller entirely.


Privacy Coins

While typical cryptocurrencies only provide pseudonymity, “privacy coins” like Monero and Verge are effectively invisible because they leave no trace.


Proposing a Multi-Stage and Multi-Levered Toolkit


The anonymity, decentralization, non-uniformity, and inadequate information concerns must be addressed at all three stages of the tax regulation process: information gathering, investigation, and enforcement.


Given the complexity of the discussed evasion mechanisms, regulators must use architectural and market tools in addition to legal tools. So far, most regulators have restricted their action to merely legal tools. Architectural tools are the instructions embedded in software and hardware, as well as the institutional design of the blockchain. Market tools are the forces of demand, supply, and quality, as well as the acceptable market practices and institutions.


I. Information Gathering


Disclosure and Reporting Requirements

As a legal solution, regulators must mandate disclosure and reporting of crypto-transactions when they exceed a predetermined de minimis threshold. The threshold should be determined based on each jurisdiction’s unique circumstances, but the US’ $10,000 threshold is a good starting point. The requirement must extend to all crypto-exchanges, payment settlement entities, and custodian wallet providers. As per reports, such third-party disclosures can improve taxpayer compliance rates by 95%.


The Financial Action Task Force proposed the travel rule, which requires all crypto firms to securely transmit originator and beneficiary information between themselves while transacting. Regulators must mandate this domestically. Importantly, there is a need for architectural intervention because, unlike SWIFT, there is no communication network to reliably transfer identification data along with crypto-transactions. There are emerging market solutions to this, such as the OpenVASP Association or the Sygna Bridge. However, it is imperative that countries reach global consensus on one of these networks to avoid fragmentation and ensure interoperability.


At the investor level, regulators can design voluntary self-disclosure forms for person-to-person transactions. However, the complexity of the present system has enabled the emergence of market players, like Koinly or CoinTracker, that charge exorbitantly. Regulators can decrease the leverage of these players by simplifying the compliance process or by imposing ceilings on their fees.


By providing appropriate incentives and adequate safeguards, regulators can establish effective whistleblower programs. This will provide exposure to reports from those inside the business, who are best placed to expose any wrongdoing.


Through these interventions, regulators can establish an effective feedback loop within each market participant.


John Doe Summons

While disclosure and reporting requirements are useful, they are limited when the entities are recalcitrant or when their adoption is delayed due to structural issues. Here, regulators can enact provisions allowing “John Doe summons.” In the US, tax authorities use them as legal tools to obtain information (names and documents) about unnamed taxpayers from a third-party. This information can then be combined with data from publicly available databases to examine compliance.


International Cooperation

Global consensus on crypto-asset taxation is vital. While jurisdictions may adopt different classifications, they can at least functionally and reciprocally enforce each other’s regulations.


More importantly, there is a need for timely and comprehensive exchange of information across borders, which would enable regulators to perform risk analysis. The ineffectiveness of bilateral taxation treaties, due to complexity, time, and opportunity cost, necessitates the adoption of multilateral treaties to ensure an extensive network of tax information. Given concerns of ceding sovereignty, this solution can be administered through an international body like OECD.


Traceability Requirements

Traceability of taxpayer information is required for both individuals and entities.


To collect information about individual investors, regulators must legally mandate that all crypto-exchanges adopt Know Your Customer (KYC) procedures. KYC is the initial stage in customer due diligence by the service-provider to verify that customers are who they claim to be. This requires the collection of personal data like full name, date of birth, and address. This information is then verified against official government databases. KYC enables the service provider to also assign a risk value to the customer based on their propensity and background. Presently, KYC implementation is abysmal with 69% crypto-exchanges lacking adoption.


There is also a need to recognize that the architecture of certain technologies precludes or obfuscates any traceability. Regulators must consider banning privacy coins since they provide an excessive degree of anonymity. Otherwise, mandatory registration past a materiality threshold must be imposed. Additionally, regulators must forbid crypto-platforms from allowing the usage of anonymizers and even proactively block access to such software on the internet.


II. Investigation Analysis


Data Analytics

Regulators should engage in architectural solutions like tracking crypto-transactions, scraping data, and using analytics to derive insights. The insights gathered from each of these tools when combined will provide regulators with a 360-degree view of the taxpayer.


Inducting Experts

The data collected and insight deduced are only as good as the people interpreting them. Therefore, tax authorities must consciously expand their membership to subject matter experts in data science, cryptocurrency, and behavioral science.


Red Flags

Regulators can use indicators of suspicious market activity to focus their efforts for further monitoring and examination. These red flags extend to inter alia the size and frequency of transaction, suspicious transaction patterns, excessive usage of anonymity, and the source of wealth.


III. Enforcement

Borrowing from South Korea, countries can implement laws to empower regulators to seize cryptocurrencies from the digital wallets of offenders. To enforce this, crypto-exchanges and wallet providers will have to implement necessary architectural changes.


Conclusion

Cryptocurrencies have emerged as the new tax havens due to their anonymity and decentralization, alongside structural problems of non-uniformity and inadequate information. Tax evasion through crypto-transactions is mechanized through various disparate means. The complexity of this problem requires an intervention at each stage of tax policy: information gathering, investigation analysis, and enforcement. At each stage, there must be a multi-level response using architectural and market tools alongside the law.


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