Smart Contracts & Their Potential Tax Implications

What are the possible tax reporting issues that crop up with Smart Contracts? Below, Jimmy Royer, Principal and Alan G. White, Managing Principal, at Analysis Group, Inc., conclude that the SEC and IRS will need to develop different monitoring approaches, frameworks and guidance for private blockchain systems that will most likely be used.

As new transaction payment methods enabled by digital technology – such as smart contracts – become more pervasive, they raise complex taxation issues. These include considerations of what type of tax is relevant, and in what tax jurisdiction any given tax must be paid.

What are smart contracts?

Smart contracts are decentralized, anonymized, blockchain-coded agreements that facilitate the exchange of cryptocurrencies (e.g., Bitcoins) or tokens (e.g., Ethers) for goods or services. When the preprogrammed terms and conditions of an agreement are met, the smart contract executes automatically, enabling the exchange of the payment for a given good or service. A single smart contract could have thousands of anonymous transactions associated with it.[i] As a result, smart contracts can be difficult and costly for tax authorities to trace and follow.

Smart contracts raise some complex taxation issues. The underlying transaction in which the cryptocurrency is exchanged for goods or services may result in taxation at different levels: 1) Profits (or losses) made on the cryptocurrencies’ change in value; 2) income generated by fees associated with the transaction; and 3) sales tax on the goods or services sold.

Issue 1: Taxing changes in the value of the underlying cryptocurrencies

Smart contracts can be connected to various decentralized exchanges (DEXs) to automatically perform preprogrammed trades of cryptocurrencies or tokens. This could include arbitrage of cryptocurrency-pairs across DEXs. If there are gains made on the cryptocurrencies’ change in value, it could be considered a profit (or loss) by tax authorities and subject to tax. This tax could be at the state or federal level, or may also involve a number of international tax authorities.

Issue 2: Taxing smart contract administrative fees

Each time a smart contract triggers a transaction, a fee is associated with that transaction. Since the administrative fees for smart contracts are paid in cryptocurrencies, there may be income tax implications. The recipient of the fee associated with the transaction, oftentimes cryptocurrency miners, may need to report this income. Once again, there may be state or federal tax implications. To the extent that the transactions may span international markets, they may raise transfer pricing considerations and the possibility of income-reporting requirements to multiple international tax authorities.

Issue 3: Taxing the sale of products or services

Companies and individuals can use smart contracts to exchange goods and services, which may be subject to sales tax. For instance, two parties could enter into a smart contract where the buyer agrees to pay X Ethers in exchange for Good Y from the seller. Once Good Y is delivered (and verified by the network), X Ethers are automatically sent to the seller.

In a more traditional business setting, a bank or credit card company would likely be involved in the transaction, making it more straightforward for tax authorities to monitor. However, because the blockchain exchange happens automatically and anonymously, tax authorities may have to rely solely on the seller to collect and report sales tax on the transaction.

Regulation of smart contracts: weighing the costs and benefits

Currently, there appears to be no easy way for tax authorities, such as the IRS, to monitor and tax these blockchain transactions. Developing an overly burdensome framework to appropriately document and collect taxes on transactions related to smart contracts could potentially increase their monitoring costs and decrease their usefulness.

Tax authorities will need to balance the costs of monitoring/auditing blockchain transactions in a manner that does not impede the characteristic convenience and low intermediary cost associated with these innovative ways of performing contractual agreements.

[i] “Blockchain technology and its potential in taxes,” Deloitte, December 2017. Available at: https://www2.deloitte.com/content/dam/Deloitte/pl/Documents/Reports/pl_Blockchain-technology-and-its-potential-in-taxes-2017-EN.PDF