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Are digital intermediaries, who are facing new tax reporting obligations, ready to broaden their skill set from coding to compliance?
In brief
- Tax authorities are taking steps to increase reporting and regulation around digital assets, such as cryptocurrencies, utility tokens and NFTs.
- In the absence of physical intermediaries, digital “middlemen” such as crypto exchanges and wallet providers are set to shoulder the reporting requirements.
- Unlike their financial sector peers, however, digital assets service providers are unlikely to have the robust systems and processes required for compliance.
Digital assets such as cryptocurrencies, utility tokens and NFTs present tax authorities with a reporting challenge. Their decentralized nature means digital assets not only bypass conventional intermediaries, such as banks and brokers, they also bypass conventional operational tax reporting mechanisms.
The OECD, EU and US are now taking steps to remedy this situation by extending the reporting net to include a new generation of digital “middlemen” – digital assets service providers such as crypto exchanges, custodians and crypto wallet providers.
With the release of the OECD’s Crypto-Asset Reporting Framework (CARF), this has now been set in motion with the CARF sitting alongside expected extensions of key reporting regulations such as the Common Reporting Standard (CRS), the eighth Directive on Administrative Cooperation (DAC-8) and the Foreign Account Tax Compliance Act (FATCA) to include digital assets service providers.
Crypto service providers face a steep learning curve
While jurisdictions hope this will dispel ambiguity around operational tax reporting, increase reporting levels and harmonize regulation in this area, digital assets service providers will be faced with a steep learning curve. For example, this sea change in reporting obligations will mean that service providers will most likely have to:
- Perform due diligence on all their customers’ accounts
- Ensure clients are registered with local tax authorities
- Collect and exchange financial information with other jurisdictions
- Certify customers and collect documentation
- Ensure data is collected and stored in a compliant manner
- Classify corporate client entity types
Tax authorities won’t just expect service providers to comply with CRS, DAC-8 and FATCA tax reporting regulations, they will also expect them to demonstrate that their processes and controls are fit for purpose, and company directors will ultimately be responsible for ensuring compliance.
New Financial Action Task Force (FATF) guidance was also published during 2021, requiring jurisdictions to license digital assets service providers. As a result, it is likely that companies will need to demonstrate they have robust customer due diligence processes in place to monitor anti-money laundering (AML) and combat the financing of terrorism (CFT) risk. They will also be obliged to collect, verify and store key information about the originators and beneficiaries involved in digital assets transactions, and alert authorities if AML/CFT risks are identified.
Deborah Pflieger, EY Americas’ Tax Information Reporting and Withholding Services Leader, says the US government has also added specific crypto reporting legislation to this increasingly complex landscape in the form of the recently signed US Infrastructure Investment and Jobs Act. This legislation will require reporting by brokers on the sale and transfer of digital currency. The Infrastructure Act will not become effective until 2023 at the earliest, but this will still be a challenging timeline for digital assets service providers.
More traditional financial institutions who are bringing digital asset custody products to market will also need to be aware of the changing landscape.
“As far as the US is concerned, the new rules and regulations won’t necessarily be a heavy lift for traditional banks and brokers. The new rules may present a challenge, bankers and brokers will need to develop systems and processes to do reporting, but this new reporting will not be monumental compared to the reporting those financial institutions have to do already,” says Pflieger. “For the newer entities (the digital wallet providers and crypto exchanges who are acting as middlemen), however, they will face a significant challenge because this is a new ask – they don’t have the robust systems needed to comply and they don’t have prior experience in financial reporting.” Dennis Post, EY Global Blockchain Tax Leader, confirms this viewpoint with respect to the European landscape. “We would hope and expect that new reporting regulations will be closely aligned with anti-money laundering and know your customer rules in each jurisdiction, making it easier for them to be implemented,” Post says.
How will jurisdictions implement new reporting rules?
David Wren, UK Tax Associate Partner, Financial Services, Ernst and Young LLP, says that the first thing that first impression of the OECD’s new Framework is the ambition in creating a comprehensive scope of the rules. The rules focus on transactions rather than holdings, and that makes them far more pervasive than existing rules for banks and others.
Along with the wider crypto ecosystem, the rules seek to address non-fungible tokens (NFTs), stablecoins, utility tokens, tokenization through security tokens and Central Bank Digital Currencies (CBDCs).
While the new rules and regulations will undoubtedly increase transparency within the digital assets sector, comprehensive reporting is not necessarily guaranteed under the coming regime, according to Wren. Access to decentralized finance applications will mean that there may not be a traditional custodian or broker to report on transactions. In extreme cases, individuals equipped with a reasonably powerful laptop and some specialist knowledge will still be able to circumvent reporting by setting up their own Bitcoin node. They will then be able to hold and trade as much crypto as they like without going through any third parties.
“Tax authorities need to be really careful with how they implement the new regulations because there’s a real risk we’ll arrive at a situation where service providers only report on people who are already compliant,” says Wren. “The same debate took place back in 2014 when FATCA was first introduced. In that instance, the regulation was fine-tuned in an attempt to prevent that, but it was a huge debate at the time, and it could be even more prevalent in the crypto space.”
The adoption of a US-style transaction-level reporting approach. Wren says this may be more straightforward for US companies to achieve, but it would be a greater challenge for organizations in other jurisdictions who may not have the systems and processes in place for transaction-level reporting.
Whatever reporting posture jurisdictions adopt, it is still likely to lead to a short-term culture shock for many digital service providers who have never been exposed to operational tax reporting and may still be struggling with the fact that they need to collect operational tax information at all.
“One of their chief concerns is that their customers will simply go elsewhere when they request this information,” Wren says. “The digital service providers that introduce reporting first will definitely feel exposed as far as customer experience and customer loyalty risk are concerned, and they may be concerned that they will lose some business in the short term.”
But as Pflieger points out, reporting will be a non-negotiable legal requirement – with investor declarations made under penalty of perjury in the US, for example.
The first three steps towards reporting compliance
So, how should digital assets service providers prepare themselves for their impending challenge of achieving reporting compliance? Wren suggests three critical steps.
The first is to carefully consider how operational tax reporting will fit within the organization’s existing regulatory obligations. This will include ensuring that customer data capture is as accurate and joined-up as possible, for both the customer and the organization. Crypto customers may not be familiar with being asked for their tax number and country of tax residence, for example, so it is good practice to only do this once.
Accuracy is also key to avoiding conflicting reporting information, which may trigger unwanted audits and erode customer experience. “The size of this task should not be underestimated. Organizations genuinely struggle to get the right processes in place,” says Wren.
The second step is deciding how best to respond to tax authorities’ demands for information in the absence of a harmonized global reporting regime. For example, the UK’s HMRC already asks some of the sector’s biggest crypto service providers to share operational tax information. “It’s up to the organization to decide how they comply with this request and how they balance reporting obligations with the organization’s obligations to inform its clients,” says Wren.
The third step involves horizon scanning – tracking the progress of evolving regulation and reporting rules expected during 2022 and beyond. This is likely to be a complex and time-consuming task considering the number of jurisdictions involved and the layers of regulation in each. It is an essential exercise, however, if digital service providers are to manage risk and avoid unwelcome surprises going forward.
While preparing for this new era of reporting and regulation, best practice for digital assets service providers is to increase their communication with clients in order to manage their expectations. The aim should be to reduce the impact of what some clients may see as intrusive tax questions by setting them within a global, industry-wide context, explaining that reporting is a legal requirement across the whole crypto sector.
Conclusion: The power of partnership
There is no escaping the fact that crypto exchanges, wallet providers and custodians face new challenges regarding financial sector compliance issues discussed here. Fast-growth crypto service providers have inherently focused on other core competencies and may just be now discovering they may need additional resources, personnel and international regulatory expertise to design the systems and processes needed to achieve compliance and embed them within their operating model.
That is why outsourcing can be a particularly attractive solution for many organizations, enabling them to partner with a specialist team dedicated to monitoring evolving compliance risk globally and equipped to respond to it in a market-leading and cost-effective manner. Unburdened by the task of managing reporting risk, digital assets service providers can then continue to focus on their primary objectives and play within their core skill set.
However companies decide to address this new challenge, the bottom line is that service providers must ensure they are compliant or they may have to subject their customers to punitive withholding taxes – even worse, they may have to cease trading until they can comply. Doing nothing is not an option.
Summary
Digital assets service providers face a daunting tax compliance challenge, the solutions to which are likely to lie outside their core skill set. Organizations are well advised to begin scoping and designing their compliance strategy now, with particular consideration to co-sourcing and partnership options with third-party reporting and regulation specialists.
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