Increased transparency of tax information on digital assets
A global tax transparency framework is in the works to allow for automatic exchange of tax information on crypto-assets transactions.
The Common Reporting Standard (CRS) has been in place since 2016. CRS enables tax authorities to audit and review tax matters relating to assets parked overseas. The Organisation for Economic Co-operation and Development (OECD) is reviewing the CRS to expand the information exchange framework to other asset classes including crypto-assets.
The role of crypto-assets in the financial services sector has expanded rapidly. One of the reasons for their popularity is the use of blockchain technology, which allows them to be recorded, issued, transferred and stored in a decentralised manner without reliance on traditional centralised financial intermediaries.
Given the many benefits of the CRS framework, tax authorities are interested in receiving information beyond financial assets, more specifically information about crypto-assets traded or held outside the home jurisdiction.
Background
Traditional financial intermediaries such as banks, funds and brokers are subject to the CRS rules under which holdings of clients’ cash and financial assets are reported to the tax authority and exchanged with the tax authority of the jurisdiction where the relevant client is resident. The CRS regime has empowered many country tax authorities to administer compliance within their local jurisdiction using the information received through CRS.
Currently, the CRS rules are not designed to fully allow the exchange of information about crypto-asset. The OECD has been in discussions with various tax authorities as well as crypto-asset industry representatives on the design of the reporting framework governing crypto-assets.
On 22 March 2022, these discussions culminated in the OECD releasing a public consultation document Crypto-Asset Reporting Framework (CARF) and Amendments to the Common Reporting Standard. The proposed CARF is a standardised global tax transparency framework to allow for the automatic exchange of tax information on transactions in crypto-assets. Once transposed into domestic law, CARF will allow collection and reporting of information by crypto-asset intermediaries on crypto-asset transactions. Similar to CRS, this information is expected to be shared with other jurisdictions.
This new regime is expected to empower tax authorities with the information needed to appropriately tax crypto-asset transactions. The industry is also supportive of this regime given the comfort that comes with plugging the gaps in tax avoidance in this area.
In-scope crypto-assets
The proposed definition of crypto-assets under the CARF focuses on the use of cryptographically secured distributed ledger technology. “Crypto-asset” under the CARF is defined as “a digital representation of value that relies on a cryptographically secured distributed ledger or a similar technology to validate and secure transactions”.
The reference to “similar technology” is to ensure it can include new asset classes that emerge in the future and those that operate in a functionally similar manner to crypto-assets. This design feature means that each time a new type of crypto-asset is introduced, the industry would have to evaluate whether it falls within the realm of the CARF rules.
Two types of crypto-assets pose limited compliance risks and are specifically excluded from the definition. These are closed loop crypto-assets, which can only be used within a fixed network for specific goods and services such as restaurant vouchers, and central bank digital currencies, which is expected to be include in CRS.
Various representatives from the industry as well as governments have recognised the challenges in arriving at a complete definition of CARF that will meet the expectations of tax authorities and at the same time, ensure that the growth in this sector is not stifled due to unreasonable or restrictive compliance obligations. It appears that the definition of crypto-assets will evolve over time with the evolution of and familiarity with this asset class.
Reporting crypto-asset service providers
Similar to CRS, intermediaries are expected to have due diligence and reporting obligations under CARF. Reporting crypto-asset service providers (RCASP), are individuals or entities that facilitate exchange between crypto-assets or between crypto-assets and fiat currencies. Examples of CASP would include exchanges, brokers and dealers in crypto-assets, and operators of crypto-asset ATMs.
To capture the majority of the transactions in this space, there has been feedback to allow for phased implementation of the CARF rules. In relation to intermediaries, if implemented, this means that the first phase would include the intermediaries of centralised exchanges and those that are covered by Financial Action Task Force (FATF), with the rest of the RCASPs being covered in subsequent phases.
Given the broad definition of RCASPs, intermediaries involved in the chain of exchanges involving crypto-assets are advised to periodically evaluate whether they fall under the definition of RCASP.
Due diligence and reporting obligations of RCASPs under CARF
RCASPs will be required to perform due diligence on their customers who transact in crypto-assets, and to report certain information to the tax authority on an annual basis. The reported information will then be shared with the tax authority where the customer is resident.
The CARF due diligence procedures are built on existing CRS due diligence processes and existing anti-money laundering and know your customers obligations. Customers will have to certify their tax status and RCASPs will be required to confirm reasonableness of this information in light of other available information. RCASPs will also be required to monitor any changes in circumstances that may make the customer’s certification invalid.
Unlike CRS, customers are required to reconfirm the information provided once every three years and RCASP must refuse to effectuate relevant transactions until a valid self-certification is obtained.
There are four types of reportable crypto-asset transactions that RCASPs will be required to report under the CARF:
- Crypto-to-fiat currency transactions
- Crypto-to-crypto transactions
- Reportable retail payment transactions
- Other transfers
Similar to the CRS rules, RCASPs will report to the local tax authority on an annual basis in respect of reportable clients.
Tax authorities and the OECD appear to be approaching this new area with caution, imposing additional safeguards and obligations to scale up the transparency in this space. On the other hand, industry participants have consistently asked for a level-playing field with traditional financial institutions i.e., that the due diligence obligations be aligned to CRS.
Until the governments are comfortable with this new asset class, RCASPs are advised to prepare for additional systems and processes to ensure compliance with the proposed CARF rules.
Amendments to the existing CRS rules related to crypto-assets
The OECD also proposes to amend the current CRS rules to allow for effective integration of CRS and the CARF rules. These proposals include:
- Extending the scope of the CRS to cover electronic money products and central bank digital currencies
- Expanding the definition of an investment entity (e.g., funds) to include entities that invest in crypto-assets
- Expanding the definition of financial assets to include derivatives referencing crypto-assets
- New provisions to limit instances of duplicative reporting
Despite the above, duplicative reporting exists under the current proposal, especially for entities that qualify as a reporting financial institution under CRS, and as RCASP under CARF.
What’s next
The OECD is working on the finalisation of the model CARF rules and commentaries to the CARF, taking into consideration the various feedback received. Once this is completed, the country tax authorities will be expected to implement this in their rules. Similar to CRS, we would expect that the core rules will remain substantially the same as the OECD proposal.
While it may take 6 to 12 months to see the country-specific rules, at this moment, we would recommend the following:
- If you are a crypto-asset market participant, take into consideration the current CARF while building and enhancing systems and stay close to the development.
- If you invest or trade in crypto-assets, review your existing investment structure and build on the documentation needed to face potential questions from tax authorities.
While new regulations may increase cost and raise the entry bar for participants, overall, regulation and transparency in the digital asset space is a welcome move because of the potential to make this asset class and its ecosystem safer.
The co-authors of this article are Mercy Joseph, Partner, Business Tax Consulting, Customer Tax Operations and Reporting Services and Tom Toryanik, Partner, Financial Services Tax from Ernst & Young Solutions LLP.
