How stablecoins and central bank digital currencies will affect tax

In brief

• Jurisdictions across the globe are currently exploring the use of digital currencies, such as stablecoins and central bank digital currencies.
• Tax is a key aspect of financial systems likely to benefit from disintermediated transactions that are faster, easier, more secure and more transparent.
• Tax teams should prepare now and form partnerships to get the most from the fast-evolving future of money.

There is a growing consensus that in the near future, individuals and organizations will increasingly use digital currencies to exchange value directly, saving time and money by bypassing conventional financial systems.

Stablecoins and central bank digital currencies (CBDCs) harness many of the benefits of cryptocurrency while mitigating much of the volatility associated with the medium, making them look particularly well-placed to lead disruption in the digital currency space. But what does this important change towards digital currencies mean for the future of tax and how should tax teams prepare?

For a start, stablecoins and CBDCS both promise a host of tax benefits, including improved tax transparency, increased transaction security and reliability, improved tax administration and simplified cross-border payments. There are also unanswered questions around whether digital currencies themselves should be subject to tax.

To fully understand the potential impact of digital currencies on tax, however, it is first necessary to understand the difference between CBDCs and stablecoins and how their underlying technology and purpose vary from non-pegged cryptocurrencies, such as Bitcoin and Ethereum. 

CBDC development is now a global phenomenon

As of mid-2023, 130 countries (representing 98% of global GDP) found the benefits of CBDCs compelling enough to start developing their own central digital currency. Of these countries, 64 were in an advance state of exploration (development, pilot or launch).²

The Chinese digital yuan and the Bahamian sand dollar, which are among the most advanced CBDCs in general circulation, give a good idea of how this fast-moving space is likely to evolve and impact tax.

The sand dollar became one of the first CBDCs to progress beyond pilot phase when it launched in October 2020. More than 1 million sand dollars were in circulation in July 2023.³

The digital yuan is part of China’s long-running efforts to centralize digital payment systems, which have been increasingly dominated by tech companies. China is testing its CBDC in a range of scenarios, including e-commerce, stimulus payments and payment on public transport.⁴ The country is now considering the use of the digital yuan for cross-border payments⁵.

Elsewhere, the European Central Bank has set up industry working groups to help lay the foundations for the EU’s digital euro. Like many jurisdictions, the trading block’s CBDC program was in response to the launch of Facebook’s Libra (later renamed Diem) cryptocurrency in 2019, which has since been wound down. In the US, the Federal Reserve Bank of Boston and the New York Reserve are researching the potential benefits of digital currencies for general commercial use facilitating wholesale bank-to-bank transactions.

Stablecoins: mitigating volatility but generally taxable

Stablecoins harness the same blockchain technology as other forms of cryptocurrency; however, they are pegged to a stable asset, such as a fiat currency or a commodity like gold, to avoid the volatility associated with other forms of crypto.

This makes correctly regulated stablecoins a useful store of value, unit of account and means of exchange. Investors often use stablecoins to protect their money from sudden price swings associated with other cryptocurrencies.

Like CBDCs, stablecoins can boost tax transparency, transaction security and reliability, and simplified cross-border payments. This has led some of the world’s biggest banks to develop their own stablecoins to capitalize on these tax and finance benefits.

Unlike CBDCs, however, stablecoins are generally taxable. As with any other cryptocurrencies, the majority of jurisdictions treat stablecoins as property for tax purposes and therefore any gains or losses from buying, selling or exchanging stablecoins are reportable and may be subject to income and capital gains tax.

Programming digital currencies to automate tax processes

Smart contracts are another potentially huge facet of tax innovation for digital currencies. Like conventional cryptocurrencies, CBDCs and stablecoins can feature software which can be programmed to take specific actions once certain conditions are met.

No central bank has successfully embedded a smart contract into a CBDC yet, but they could theoretically enable central banks to control how digital currencies are spent and what kinds of transactions can and cannot be made. They could, for example, be used to prevent money laundering and financial activity linked to crime and terrorism.

In theory, smart contracts could also be used to automatically calculate and trigger real-time tax remittances and tax withholding. This functionality would be particularly useful in cross-border transactions, with smart contracts withholding payment until a product or service has been successfully delivered, or any other conditional element necessary for payment has been satisfied. Organizations could also harness CBDC programmability to enable real-time tax planning.

Meanwhile, at a public policy level, smart contracts could in theory enable countries to develop flexible and targeted tax policies, such as dynamic tax rates and conditional tax incentives.

Overcoming the challenges associated with programmable digital currencies

No central bank has yet overcome the technical barriers to embedding smart contracts into CBDCs, but there are potentially at least three approaches jurisdictions are investigating.

Intrinsic functionality involves embedding a smart contract directly into a digital currency’s blockchain layer. One of the biggest challenges with this approach is that tax is rarely simple. Using current technology, the level of energy and computing power needed to calculate tax remittance and withholding across the full, complex range of scenarios may not be possible.

An alternative approach, known as integrated functionality, involves building and operating a smart contract alongside a digital currency, without embedding the software within a blockchain layer. As the name suggests, the third option, known as external functionality, features a completely separate system which monitors individual transactions and calculates the tax consequences. This could be carried out by a tax engine, for example.

External integration is likely to be the least problematic way for CBDCs to harness smart functionality, but it is unlikely to achieve the same levels of tax efficiency and effectiveness as intrinsic or integrated smart contracts.

How tax teams can prepare for digital currencies

The potential offered by digital currencies is great, so it is imperative that corporate tax teams are well-prepared for this new era by taking steps such as:

Understanding underlying technology and how it interacts with existing systems

The advent of digital currencies will require tax teams to engage with new technologies. For example, understanding how secure digital wallets operate will be essential for receiving, holding and transacting in CBDCs and stablecoins as well as remitting taxes.

Achieving regulatory compliance

Digital currencies will likely be accompanied by new regulation that directly impacts tax. Staying informed of the latest developments will be essential.

Strategic planning

Digital currencies are likely to bring new opportunities to innovate tax models, systems and processes. Tax teams need to take a holistic approach, working with partners to improve the value they derive from this new and exciting landscape.

Summary

Digital currencies have the potential to simplify payments and generate significant efficiencies within the global financial system. Advocates suggest innovation in this area could make tax administration more efficient by enabling practitioners to track and trace payments and achieve higher levels of tax reporting and regulatory compliance in a more cost-effective way. There is also an opportunity to embed smart contracts within digital currencies, so actions are automatically triggered once conditions are met. Tax teams should monitor the rapid evolution of digital currencies and develop a partnership ecosystem in preparation.