INSIGHT: Blockchain’s Relevance for Tax and Transfer Pricing Purposes

Will blockchain revolutionize the world as we know it? As melodramatic as that question sounds, many technology and business experts believe that blockchain’s potential is truly revolutionary. One commentator sees the impact of blockchain technology on the world as being similar to that of the internet (ref1). Another says blockchain is the technology enabling the next generation internet (ref2), and others have predicted that blockchain could transform economic and social foundations (ref3).

Perhaps these claims are hyperbolic and are made because blockchain is the technology behind cryptocurrencies. The most famous cryptocurrency, Bitcoin, and its roller-coaster prices have been heavily covered in the media, as have the rapid emergence of initial coin offerings (ICOs), (ref4) “lost” cryptocurrency (ref5) and illicit activities conducted with cryptocurrency.

However, beyond Bitcoin and other digital currencies, blockchain’s profile has been rising as more and more use cases have emerged that showcase the technology’s potential for businesses and consumers, and this could be just the beginning. Regulatory guidance, including tax regulation, is still light, and nothing currently anticipated would prevent the increased adoption of blockchain by the business community (ref6).

In this article, we provide a general overview of the technology and discuss related tax and transfer pricing considerations, including two key questions:

• How can blockchain technology be used for tax and transfer pricing purposes or in the tax function?
• How and why should taxes and transfer pricing be seriously considered as early as possible by businesses that are using or thinking of using blockchain technology?

Against this landscape, we turn to the features, characteristics and types of blockchains, offering suggestions for when blockchains are warranted.

What is Blockchain?

A blockchain is a distributed database on a peer-to-peer network. It is a decentralized ledger which contains data about all transactions that have taken place in the network since its inception. As new transactions are conducted through a blockchain, their records are added to the database as new “blocks.” The computers of blockchain participants connected to the network are called nodes.

A blockchain is a consensus-based network and therefore has a high level of transparency. In this context, “consensus-based” means that when a transaction is created or edited, it is automatically examined by all participating nodes in the blockchain, and through a consensus mechanism using cryptographic algorithms, the entry is either validated or invalidated. Through the same consensus mechanism, an attempt by any participant to manipulate the records for a malicious purpose would be identified and disallowed (ref7).

This ability of blockchain participants to securely transfer digital assets without the necessity of a trusted central authority is the signal achievement of blockchain technology, and one of the remarkable results of this consensus mechanism is “disintermediation,” i.e., the removal of middle men. There is no need for a central trusted database manager or an authority to approve transactions. No wonder the financial industry in particular is paying such close attention!

Another feature of blockchains that holds great promise for business and government is that they provide a nearly real-time record of transactions taking place through the network, visible to all participants.

Public vs. Private vs. Consortium Blockchains

Blockchains can be designed as public or private databases. Anyone who has access to the internet can participate in public blockchains without permission. Their transactions will be included in the chain if they are validated by the network through the consensus mechanism. For example, the two most renowned cryptocurrencies, Bitcoin and Ethereum, run on public blockchains (ref8).

Private blockchains are usually controlled by a central entity which may invite other parties to join. Commonly, the creator of a private blockchain is a company or group of companies, and the controlling entity may grant various levels of permission: read only, limited transactions, etc., as is common with traditional corporate databases. Even though private blockchains re-introduce the central trusted entity, they retain some of the benefits of being maintained on a blockchain, such as accuracy in record keeping and a technology allowing real-time auditing (ref9). Also, access can be granted to interested authorities and regulators to increase transparency on a real-time basis.

Finally, there is the consortium blockchain, which may grant reading rights to many people or even everyone, but which limits the consensus mechanism to a few trusted nodes. Such blockchains provide a higher degree of privacy and are faster as they have a significantly lower number of participants and transactions to process compared to public blockchains. Consortium blockchains are often used in banking (ref10).

Smart Contracts

A smart contract on a blockchain is a computer program that self-executes the terms of an agreement between parties to a transaction when certain pre-defined conditions are met by the transacting parties. Smart contracts are not legal agreements. Rather, they are pieces of software that allow the automation of business processes among various parties to a contract, whether related or independent companies. As part of a blockchain, these pieces of software are stored securely, i.e., they cannot be manipulated or corrupted. Benefits of such self-executing contracts include the reduction of transaction costs for coordination, monitoring, and enforcement (ref11).

When Blockchain Use is Justified

Blockchain technology provides numerous advantages. However, its use is not always justified as it has some limitations (e.g., complexity and increased cost compared to a traditional database, environmental and safety concerns given the immense energy consumptions of cryptocurrency mining). Therefore, when deciding if blockchain is an appropriate technology for a business or if traditional methods of central data management would be better, potential users should consider whether:

• There are multiple parties in the ecosystem where trust between the parties could be an issue.

• It is important to have a permanent, incorruptible record of transactions.

• The ecosystem benefits from increased transparency.

Blockchain Applications for Industries and Government

Blockchain technology has been applied in a wide and interesting variety of areas so far. The most prominent application to date is probably Bitcoin, but that is just one of many hundreds of blockchain applications that are springing up in numerous industries.

Blockchain applications are finding a place in many industries:

• Automotive--Platform for autonomous vehicle fleet management (ref12);

• Banking--Optimization of global internal treasury operations (ref13);

• Finance-- Settlement of securities transactions (ref14);

• Food and beverages--Tracking of ingredients of groceries (ref15), authentication system for wines (ref16);

• Health care-- Digital record keeping (ref17);

• Insurance-- Acceleration and simplification of captive insurance transactions (ref18);

• Life sciences-- Product lifecycle management (ref19);

• Music-- Digital rights management (ref20);

• Real estate-- Decentralized global home rental platform (ref21); and

• Various industries (ref22).

Governments are also taking note of blockchain’s potential. After experiencing cyberattacks in 2007, Estonia has been at the forefront of cybersecurity and blockchain developments. Estonia had the presidency at the European Council in the second half of 2017 (countries take turns for the presidency every six months; the current presidency is with Bulgaria) and worked to raise awareness and to progress toward first solutions regarding the broader challenges of the digital economy and the related tax consequences (ref23).

Estonian blockchain applications include the e-Residency project (ref24) (allowing companies across the globe to register to do business in Estonia) and a project to transfer medical records of Estonian citizens into the blockchain (ref25). Estonia’s e-Law system has stored legislation in a blockchain since 2003, including the legislation’s drafts, changes made through the parliamentary process and its current status (ref26). Once a tax law is enacted, it is published online and no longer printed/published in hard copy.

Luxembourg, (ref27) Singapore (ref28) and India (ref29) are also among the first movers. It is further expected that developing countries will adopt blockchain technology to leapfrog more-developed economies (ref30).

In other words, if you have not seen it yet, blockchain is soon to be on a cloud near you.

Potential Applications for Tax/Transfer pricing

The most immediate impact of blockchain in tax is expected in the areas of VAT, payroll tax, transfer pricing, beneficial ownership, and the taxing of land and buildings.

The groundbreaking tax application that seems to have become accepted first is the administration of VATs. There are currently about 160-170 VAT systems globally. Securing VAT revenue and ensuring fair competition has been a major challenge for tax jurisdictions, especially when it comes to digitalized businesses. Using blockchain technology is expected to improve both effectiveness and efficiency in collecting VAT, possibly relegating the use of thresholds and the problem of leakage to the past and making real-time VAT collection a reality (ref31).

Blockchain also seems promising as a future area of application for transfer pricing. The systematization and automation of processes could provide benefits for applying, documenting and defending transfer prices, especially considering both the increased complexity of intercompany transactions and increased transparency requirements. This has the potential to decrease significantly the effort and time that tax authorities invest in tax audits.

One potential application that immediately comes to mind is for a multinational enterprise (MNE) to use a blockchain for automated and reliable application of its transfer pricing policy, whereby payments are made according to pre-established, arm’s length rules and conditions via smart contracts. Intangible assets can be tokenized, with a token representing the entire intangible asset or a defined fraction of it. This could prove especially valuable for transactions involving shared asset ownership, cost contribution arrangements and the application of profit split methods.

Implementing real-time license payments could also be feasible, automating the appropriate payments when sales are recorded. Monthly or quarterly data reporting and invoicing administration would no longer be necessary, and eliminating the time gap between invoicing and payment would greatly reduce or eliminate the need for bridge financing and associated interest expenses.

In multinational companies, blockchains could also be used to optimize intra-group treasury transactions including intra-group current accounts, cash pooling, other types of lending transactions, and guarantees, among others.

Further, blockchain has the potential to revamp supply chain management (ref32). If all transactions in a supply chain are conducted using a blockchain, including transactions among unrelated parties and members of a multinational company, the multinational would automatically ensure the application of its transfer pricing policies through smart contracts, as mentioned above. This should greatly facilitate the documentation of transfer prices. Additional benefits could be that the multinational would have real-time visibility of all its interactions with subsidiaries, various suppliers and customers along and across the supply chain in different jurisdictions.

At this stage, we can only speculate whether greater data availability will impact the ability to benchmark third-party pricing. For example, it’s possible that access to new sources of bigger and better data could be used to apply the comparable uncontrolled price (CUP) method (ref33).

Relevant Questions from Tax and Transfer Pricing Perspectives

While blockchain application is still in its early stages, with the most enthusiasm still in technology circles, the tax function needs to be an early participant. Which tax-relevant data will be included in the blockchain? Will it come from an MNE’s enterprise resource planning (ERP) system? If so, how can we be sure that data captured in the blockchain are relevant and accurate? Who will be the members to the blockchain, and which type of information will they be allowed to see? How will the scope of work with accountants and auditors change? Will tax authorities have access to the blockchain in the future? It is also of the utmost importance that blockchain solutions – which are likely cloud-based – be compatible with the respective bookkeeping requirements and regulations of an MNE’s jurisdictions.

While the technology is deemed to be secure, or at least more secure than others, questions around the correctness of the content remain. If inaccurate or erroneous data (e.g., in a supply chain management context, from an inconsistent ERP system) are entered into a blockchain without first making it fit for final use, the data will be accepted and validated throughout the chain and lead to inappropriate results. This is often referred to as “garbage in, garbage out” in a computing context (ref34). Which parties should therefore be responsible for providing appropriate data entries and approvals of data correctness?

How will the tax authorities adapt? Some countries are more eager than others to work with blockchains. On one hand, tax authorities with access to MNEs’ blockchains could potentially perform tax audits in real time. However, all of the potential users of this technology have a stake in determining what type of information tax authorities will have access to from both a technical and a legal perspective. On the other hand, tax authorities could use the technology to optimize their own processes and data management. This is a delicate issue due to the required secrecy in tax matters (e.g., potential use of “secret comparables” by tax authorities for assessing the appropriateness of transfer prices or even harmful public leak of stored information), and so decisions will depend on the security of the technology, both today and in the future.

Further, there are legal issues that must be resolved. For example, government and industry will need to reconcile the “right for personal data to be forgotten” (ref35) with the fact that public blockchains are intended to be difficult to edit. In fact, even when erroneous, outdated or embarrassing data is deleted from a blockchain, the correction is stored in an accessible log so that the transaction record is always complete.

Outlook

So far, blockchain technology has received a lot of attention, including sensible praise and skepticism as well as the hype accompanying many innovations. The fact that its brief history is so intertwined with Bitcoin has played a role in the hype and skepticism. However, recent developments show that the technology has legitimate, promising applications and it cannot be ignored.

As difficult as it is to predict what blockchain will mean to business and the tax world, the potential use cases we’ve described above lead us to believe that blockchain will have a tremendous impact on tax authorities and taxpayers. We encourage MNEs’ tax functions to familiarize themselves with the general concepts and implications of blockchain and to get involved in discussions early. Tax data will be affected, as will tax regulations. Waiting too long to give these developments proper attention may prove costly on many fronts.

Because we see blockchain technology as having such great potential, we are thrilled by the challenge of understanding its implications for the tax world, and we urge our colleagues in the tax function to join in shaping this exciting future.

References

1. E.g., Joichi Ito, Neha Narula, and Robleh Ali, “The Blockchain Will Do to the Financial System What the Internet Did to Media”, Harvard Business Review, March 9, 2017. https://hbr.org/2017/03/the-blockchain-will-do-to-banks-and-law-firms-what-the-internet-did-to-media

2. Shermin Voshmgir and Valentin Kalinov, “Blockchain, a beginner’s guide”, BlockchainHub, September 30, 2017. https://s3.eu-west-2.amazonaws.com/blockchainhub.media/Blockchain+Technology+Intro.pdf

3. See Marco Iansiti and Karim R. Lakhani, “The Truth About Blockchain,” in Harvard Business Review, from January-February 2017 Issue. https://hbr.org/2017/01/the-truth-about-blockchain

4. Channing Flynn, EY, “Preparing for Digital Taxation in a Blockchain World,” in Tax Planning International Review, Bloomberg BNA, October 2016.

5. According to a recent EY study, around 10% of the funds raised through ICOs (amounting to around US$4 billion at the beginning of 2018) have been stolen by hackers. http://www.ey.com/Publication/vwLUAssets/ey-research-initial-coin-offerings-icos/$File/ey-research-initial-coin-offerings-icos.pdf

6. A significant legal ruling on cryptocurrencies was issued by the EU’s Court of Justice in 2015, saying the services of a cryptocurrency exchange for exchanging bitcoins for a traditional currency are exempt from VAT. Court of Justice of the European Union, Judgment in Case C-264/14 (Skatteverket v David Hedqvist). https://curia.europa.eu/jcms/upload/docs/application/pdf/2015-10/cp150128en.pdf

7. Garrick Hileman and Michael Rauchs, “Global Blockchain Benchmarking Study,” Cambridge Centre of Alternative Finance, University of Cambridge, 2017. https://fsinsights.ey.com/big-issues/Digital-and-connectivity/Global-blockchain-benchmarking-study-2017

8. Shermin Voshmgir and Valentin Kalinov, “Blockchain, a beginner’s guide,” BlockchainHub, September 30, 2017, https://s3.eu-west-2.amazonaws.com/blockchainhub.media/Blockchain+Technology+Intro.pdf

9. See reference 8.

10. See reference 8.

11. See reference 7 and reference 8.

12. Joshua Althauser, “EY Launches Blockchain-based Platform for Autonomous Vehicle Fleet Management”, Cointelegraph, 31 August 2017, https://cointelegraph.com/news/ey-launches-blockchain-based-platform-for-autonomous-vehicle-fleet-management

13. BNP Paribas press release, “BNP Paribas and EY explore private blockchain to optimize the bank’s global internal treasury operations”, 17 October 2017, https://group.bnpparibas/en/press-release/bnp-paribas-ey-explore-private-blockchain-optimize-bank-s-global-internal-treasury-operations

14. Deutsche Börse Group, Business areas, “Blockchain - A game changer for the financial markets“, accessed on 27 April 2018, http://deutsche-boerse.com/blockchain/

15. CB Insights, Research brief, “How Blockchain Could Transform Food Safety”, 13 December 2017, https://www.cbinsights.com/research/blockchain-grocery-supply-chain/

16. Phil Taylor, “EY partners with EZLab on blockchain wine security project”, Securing Industry, 18 April 2017, https://www.securingindustry.com/food-and-beverage/ey-partners-with-ezlab-on-blockchain-wine-security-project/s104/a4014/#.WpUWCmbrs2w

17. “Healthcare companies start to see the potential of the emerging technology, envisioning a wide set of possible applications targeting a large set of stakeholders such as biotech companies, pharmaceutical distributors, patients, hospitals and care service providers.” Reply, accessed on 27 April 2018, http://www.reply.com/en/content/healthcare

18. Allianz, Press release, “Allianz pioneers blockchain prototype for the captive insurance market”, 7 November 2017, http://www.agcs.allianz.com/about-us/news/blockchain-prototype-captive-insurance-press-release/

19. EY, Life Sciences industry insights, “Product life cycle management using blockchain”, accessed on 27 April 2018, http://www.ey.com/gl/en/industries/life-sciences/ey-product-life-cycle-management-using-blockchain

20. BlockApps, “Use Cases & dApps: Blockchain & The Evolution of The Music Industry”, accessed on 27 April 2018, https://blockapps.net/blockchain-music-industry/

21. For example, https://rentberry.com/ and Daniel Frumkin ,“ICO Review: Rentberry”, Invest In Blockchain, 14 February 2018, https://www.investinblockchain.com/rentberry-ico-review/

22. Paul Brody, EY, “How blockchain is revolutionizing supply chain management,” http://www.ey.com/Publication/vwLUAssets/ey-blockchain-and-the-supply-chain-three/$FILE/ey-blockchain-and-the-supply-chain-three.pdf.

23. Estonian Presidency of the Council of the European Union, Insights, “Digital Europe and the Free Movement of Data,” 7 October 2017, https://www.eu2017.ee/news/insights/digital-europe-and-the-free-movement-of-data

24. Website of the government of Estonia, accessed on 27 April 2018, https://e-resident.gov.ee/

25. Website of the government of Estonia, accessed on 27 April 2018, https://e-estonia.com/solutions/healthcare/e-health-record/

26. Website of the government of Estonia, accessed on 27 April 2018, https://e-estonia.com/solutions/security-and-safety/e-law

27. Colm Hebblethwaite, “Government-backed Luxembourg firm and Cambridge Blockchain launch identity solution”, Blockchain Technology News, 15 May, 2017, https://www.blockchaintechnology-news.com/2017/05/15/government-backed-luxembourg-firm-cambridge-blockchain-launch-identity-solution/

28. Neha Gupta, “This is how Singapore is supporting blockchain technology development”, MSN Money, 29 December 2017, https://www.msn.com/en-sg/money/topstories/this-is-how-singapore-is-supporting-blockchain-technology-development/ar-BBHsZK6

29. Bipin Preet Singh, “Blockchain: India is headed for a fintech revolution this year”, The Economic Times, 13 January 2018, https://economictimes.indiatimes.com/news/economy/policy/blockchain-india-is-headed-for-a-fintech-revolution-this-year/articleshow/62478932.cms

30. Vinay Gupta and Rob Knight, “How Blockchain Could Help Emerging Markets Leap Ahead”, Harvard Business Review, 17 May 2017, https://hbr.org/2017/05/how-blockchain-could-help-emerging-markets-leap-ahead

31. Kid Misso, “How blockchain could shape tax automation”, Avalara VAT News, 11 October 2016, https://www.vatlive.com/vat-news/how-blockchain-could-shape-tax-automation/

32. See reference 22.

33. The CUP method compares the price charged for property or services transferred in a transaction between group companies (controlled transaction) to the price charged for property or services transferred in a comparable uncontrolled transaction, i.e., transaction between independent companies, in comparable circumstances. See OECD Transfer Pricing Guidelines 2017, section B.1.

34. See reference 22.

35. Reference is made to a 2014 decision of the European Court of Justice on the matter of personal information used by internet search engines, and in particular to the user’s right to have such information removed; https://curia.europa.eu/jcms/upload/docs/application/pdf/2014-05/cp140070en.pdf

Author Information

Laurette von Grambusch is an executive director in the International Tax practice of Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft in Frankfurt, Germany; Ariana Kosyan is a senior manager in the Tax, Technology and Transformation practice of Ernst & Young LLP in London, UK. The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global EY organization or its member firms.