Blockchain, most commonly associated with bitcoin, may present new global tax challenge for governments. (AP)
Governments have regulated havens by enforcing rules against intermediaries that might use them. But blockchain, by design, avoids intermediaries.
"The technology itself is a haven; it doesn't need a haven to operate," said Omri Marian, a tax professor at the University of California, Irvine School of Law. "But it needs one to start."
Blockchain is most commonly associated with bitcoin, and both were created by the mysterious online figure Satoshi Nakamoto, who still has yet to be identified. Blockchain uses encryption to record transactions in a decentralized, peer-to-peer format, which gives bitcoin users confidence in the system without a financial intermediary or regulator.
Once the technology caught on, the use of cryptocurrencies beyond bitcoin exploded. Online ventures began to use "initial coin offerings" — the creation of a new cryptocurrency — for funding, in lieu of an initial public offering of stock. By using blockchain to create transactions that self-execute, cryptos created a new type of currency used not only for barter but as an investment that can generate its own income or be used for control of an entity — whatever the programmer inputs into the code.
Experts say that blockchain will have uses well beyond cryptocurrencies, and could become a ubiquitous part of online commerce, with far-reaching implications that are difficult to fathom today.
One of those could be that it will facilitate commerce that is beyond the reach of governments to control — both legally and practically. This could make controlling the entry point, or jurisdictions where investors put down their cash to gain access to the system, all the more important.
"They can only provide a safe haven at the point of centralization, when you're getting started," said Stuart Levi, partner at Skadden Arps Slate Meagher & Flom LLP and co-head of the firm's technology and intellectual property group. "Once it's launched, and fully decentralized, and you've disintermediated everybody. It's not clear where the blockchain is in any legal, meaningful way."
Blockchain transactions are designed to be impossible to change, once it has been recorded. Aside from the two participants in the transactions, there's no one with authority to alter it — that's the whole idea.
"For certain public permission-less blockchain, it's not quite clear who a regulator could approach if they had concerns or issues," Levi said.
Marian authored a draft paper entitled "Blockchain Havens and the Need for Their Internationally-Coordinated Regulation" on March 21, arguing that countries need to work together to regulate the use of blockchain havens, similar to how they dealt with international tax avoidance through the Organization for Economic Cooperation and Development's 2015 Action Plan on Base Erosion and Profit Shifting.
But Marian also argued that action needs to come soon, rather than waiting for the problem to fester for decades as tax avoidance did. If blockchain havens become better-established, the world may have missed its chance to control them at all, without more heavy-handed approaches that could stifle the otherwise promising technology.
According to the paper, Switzerland, Malta and the Cayman Islands — all criticized in the past for lax enforcement of tax rules — have begun to develop initiatives to attract blockchain activity, including a tax-free "Cayman Enterprise City."
Marian said the rise of blockchain havens is, in part, a reaction to increased enforcement of new taxation and financial secrecy rules, which have made tax havens less attractive.
"In recent years, developed economies have instituted a multitude of laws, and engaged in multiple international initiatives to undo the perceived damages caused by tax havens," he said.
Those initiatives include the BEPS project, which created new reporting requirements for multinational companies as well as new transfer pricing standards, and the U.S. Foreign Account Tax Compliance Act, which creates new reporting requirements on individual financial information for banks that hold U.S. debt. The OECD also incorporated similar rules for a common reporting standard, a system of information exchange between nations.
The next logical step, Marian says, was for havens to turn to blockchain.
"As developed economies act against haven governments, it seems that haven jurisdictions are responding by becoming hosts to technologies that offer traditional haven-like benefits," he said.
Marian calls the jurisdictions potential "meta-tax-havens," providing the benefits of financial secrecy and low taxation not through a light tax regime, but through light regulation of blockchain that would allow users access to a world with barely any tax regulation at all.
Many of these jurisdictions rose in prominence during a wave of initial coin offerings in the past few years, which has since subsided as investors have found them to be an unstable refuge for their cash. An analysis from EY found that 86 percent of initial coin offerings in 2017 dropped in price after they were listed, and that 30 percent lost "substantially all of their value."
But during the boom, investors found foreign jurisdictions to be attractive for a variety of reasons. Those include not only more favorable conditions than the U.S., but more certainty as well.
"When we're dealing with clients who want to comply with U.S. regulations, we're seeing a lot of them set up shop in these countries," said Lisa Zarlenga, a partner with Steptoe & Johnson LLP in Washington, D.C. "There's certainty and there's favorability."
The Internal Revenue Service and the U.S. Securities and Exchange Commission are still struggling to deal with cryptocurrencies and blockchain, most often categorizing them under pre-existing legal regimes. The IRS, for instance, has said that its rules on assets apply to cryptocurrencies, but has yet to expound on how those rules work, beyond a 2014 notice.
"It's not a hands-off approach, and it's not, 'here's some certainty,'" Zarlenga said. "It's somewhere in between and that's not always the best place to be."
Blockchain could be used for funding illegal activities, or for financial scams in which the victim would have no recourse. But Marian also claimed it could become a highway for tax evasion, much as Swiss banks were notorious as a place to hide funds before FATCA and other new financial disclosure regimes.
He noted that the IRS successfully enforced a John Doe summons against Coinbase Inc., for information about accounts worth more than $20,000, due to suspicions of nonpayment of federal income tax.
But Coinbase is a currency exchange registered in San Francisco.
"If I'm the next Coinbase, I'm just going to put Coinbase in the Caymans," Marian said. "What is the IRS going to do now?"
Efforts to bring international blockchain under coordinated regulation are still in the embryonic stage, as countries themselves are just barely beginning to understand the technology. The OECD hosted a Paris policy forum in September 2018, and has announced plans to investigate the issue further, possibly as part of its larger effort on taxation in the digital economy. But there is not yet momentum for a coordinated project similar to the BEPS initiative — or a consensus that the OECD would be the ideal forum for one.
Marian said the process needs to be much faster than that for building an international response to tax avoidance and evasion, which took decades to fully crystalize. And it must also include some consensus with the havens themselves.
"Since any one blockchain haven can independently offer unregulated entry point for malicious blockchain applications, there is a need for a coordinated international effort to prevent a regulatory race to the bottom," he said.
--Editing by Tim Ruel and Neil Cohen.
"Blockchain Havens and the Need for Their Internationally-Coordinated Regulation" was published by SSRN, which is owned by Elsevier Inc., a division of RELX Group, which owns Law360.
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