Blockchain Technology and The Inherent Impact On Taxes

With the emerging, potentially disruptive nature of blockchain technology, it is critical to understand its function and fundamentals. This article seeks to highlight the basics of blockchain technology, and more specifically, how blockchain’s inherent characteristics pose a problem to the existing tax infrastructure.

The Rise of Blockchain Technology: Bitcoin

Bitcoin is a P2P electronic cash system known as Bitcoin developed in 2008 and using an infrastructure for electronic payments known as blockchain technology. Blockchain is a decentralized ledger that records ownership and value transfers with no need for an intermediary. As such, blockchain provides a novel framework for independently executed transactions that traditionally required a trusted third party, such as a bank or a credit card company.

Contractual arrangements can be programmed onto the blockchain and automatically executed once a triggering event occurs. These contracts have earned the moniker “smart contracts”, despite making plenty of imprudent mistakes since inception. Since the contractual execution is decentralized, neither a party to the contract nor a third party, like a government, can prevent execution. For example, inheritance funds can be programmed to be transferred to an heir when that heir reaches a certain age, or business profits can be programmed to be distributed once certain financial targets are met.

While such a system may offer societal benefits, it also presents significant challenges to the tax system. In order to understand the challenges to tax enforcement, it is helpful to consider some of the unique characteristics of blockchain-based applications.

Business without an intermediary

Blockchain technology offers the ability to document value transfers without using an intermediary. This presents a unique challenge to any tax system because modern tax enforcement relies heavily on reporting by financial intermediaries. Intuitively, tax-compliance rates are significantly increased when third-party reporting is involved.

There are multiple mechanisms by which financial intermediaries strengthen tax compliance. They issue to taxpayers’ returns (e.g., Form 1099s) pertaining to interest, dividends, and capital gains that assist taxpayers in reporting their taxes. At the same time, they submit the same information to the IRS, which enables the agency to match information it receives from financial intermediaries to the information received from taxpayers. These same financial intermediaries often serve as tax collection agents and are required to withhold taxes on payments that they clear. If the fail to meet their reporting and withholding requirements, the financial intermediaries may be subject to tax-enforcement actions, liable for their customers’ unpaid tax liabilities. However, if they are removed from the picture by blockchain technology, tax authorities lose a powerful enforcement mechanism. As long as the two parties to a blockchain transaction agree not to voluntarily disclose the transaction to the tax authority, there is nothing that the government can do to collect information on the transaction. Since the system is fairly anonymous, it is possible that taxable events cannot be pinpointed to an individual, hindering the IRS and other tax authorities in the fulfillment of their oversight mission.

Further, even if both parties to a blockchain transaction are compliant taxpayers who voluntarily share information with the tax authorities, enforcement still suffers. It is easy and economical to verify transaction information by using centralized databases held by large financial intermediaries, and to use the intermediary as a central point of enforcement. The alternative, since…