Saturday, 15 August 2020

Taxing crypto assets

Let’s first understand what a crypto asset or a crypto currency is?
Money laundering and terror financing, cobbled with the visit of inspectors from the Asia Pacific Group (APG) and Paris-based Financial Action Task Force (FATF), have been the media headlines in the last couple of weeks. The handing over of the 26 point recommendations by the APG and the FATF team members, for compliance before September 2019, is a gigantic task before the Pakistan government in order to be excluded from the FATF’s notorious grey list. Despite a seemingly robust methodology, the FATF still appears to be losing control over several money laundering practices because of technological advancements and their perfect usage by the money launderers all over the world. One such practice is the rising trend of the exchange of crypto assets, not only for avoiding the government taxes but also for free movement of assets, beyond the control of banks and other government institutions, in ane-regime requiring no permissions from the government. In this regard, the frequent use and exchange of crypto-currencies globally needs a specialised focus of the anti-money laundering and tax agencies. The APG and the FATF also need to devise a robust methodology to contain this weak area of international monetary governance.

Let’s first understand what a crypto asset or a crypto currency is? It is equally pivotal to investigate the e-phenomenon through which its usage and exchange take place. Due to their rising exchange worldwide, the crypto currencies exchange is increasingly becoming a global phenomenon. Although most people are aware of the crypto currencies, it still has, however, a limited understanding in the tax departments, financial institutions, banks, accounting firms, central banks and anti-money laundering agencies worldwide. According to online resources, the credit of the invention of crypto currencies goes to an unknown scientist, Satoshi Nakamoto, who developed the revolutionary crypto currency ‘bitcoin’, authored a white paper on it alongside suggesting the currency’s original reference implementation.

Like many other inventions in the world, crypto currency was also invented accidently as a byproduct of another invention. About a decade ago, when it was invented, Satoshi Nakamoto called it as a ‘Peer to Peer Electronic Cash System’. The crypto assets, such as bitcoins, have five major transaction characteristics that may enable them escape the anti-money laundering and tax control by the governments. They are irreversible, pseudonymous, quick and international, secure, and sans permission. Furthermore, most governments still have feeble understanding of this technology despite its vast usage internationally. Even the APG and the FATF methodologies do not seem to be robust enough to effectively check the frequent usage and exchange of crypto currencies in the world.

Satoshi, indeed, wanted to make some advancement on the front of creating ‘digital currency’ for which many researchers had failed before. He termed bitcoin as an electronic cash system capable of avoiding double-spending in a decentralised environment with no server or authority over it. Therefore, the innovative part of crypto assets is their characteristic of being a decentralised digital cash system. This is perhaps the most worrying dimension for the tax and anti-money laundering agencies.

The government should think preemptively and attempt to devise strong regulation and technological interventions for controlling the exchange, trade and storage of crypto assets

The exchange of crypto assets requires a payment network with accounts, transactions and balances. In order to avoid double-spending, generally, a central server is used that keeps the record of balances. In the exchange of crypto currencies, however, there is no such central server. Therefore, one needs to have every single entity of the network to avoid double-spending. This suggests that each peer in the network will have to check whether the future transactions, regarding crypto assets exchange, are valid or just an attempt to double spend. Here the major challenge is to keep the consensus of the records. Achieving consensus, through decentralised system, is the most innovative part of crypto assets and the most fascinating success of its inventor. In simple words, therefore, crypto assets or crypto currencies are electronic entries in databases that can’t be altered without meeting certain electronic conditions.

Comparing crypto currency with physical currency, such as notes and coins, it is not difficult to understand that money is basically a sort of entry into a database of accounts, balances and transactions. In case of physical currencies, such databases are centralised. In case of crypto currencies, however, the databases are decentralised making them secure, irreversible, fast, and pseudonymous, that is quite suitable for tax evasion and money laundering purposes. In this regard, the real challenge is to effectively check these decentralised transactions, through well researched methods and robust procedures, so that they could be brought into the tax net alongside discouraging the associated money laundering practices.

The decentralised databases of crypto currencies, such as bitcoin, are a kind of network of peers. As there is no concept or application of a centralised server, each peer has individually got a complete chronology of the transactions history and their associated account balances. The transaction of crypto currencies, as per relevant literature, is a kind of file aiming to transfer, for example, one million bitcoin from Mr Amjad to Mr Aamir. The file is accordingly signed by Mr Amjad’s private key. Once the file is signed, it is circulated among the network peers. This is a decentralised peer to peer (p2p) technology with limited scope of tax and anti-money laundering agencies interventions.

Many big economies in the world, such as Russia, are requesting the FATF member states to effectively control the exchange of crypto currencies, their storage and associated transactions. According to the Russian news outlet Daily Izvestia, the FATF introduced some changes in its methodology last month to control the exchange and storage of crypto assets. The changes hold the virtual asset service providers responsible for money laundering and other illicit forms of financing. The updated FATF methodology also aims to register such service providers for better monitoring. However, so far, it appears that there is no robust control over the crypto related transactions both legally and technically.

Russia has recently suggested controls over crypto assets above the threshold of Rubles 600,000. It is nearly equal to USD 9120. In case of Pakistan, this amount can be rounded off to PKR 1 million. So far, there is no tangible regulation in Russia that could control the transfer, trade and storage of crypto assets. Same is the case with Pakistan except its banning.

Russia, according to media reports, has floated a draft bill for controlling crypto related activities awaiting the parliament’s approval. Pakistan may also consider drafting such an updated regulation after necessary research and requisite financial analyses. In this regard, State Bank of Pakistan (SBP), Federal Board of Revenue (FBR), Federal Investigation Agency and Securities and Exchange Commission of Pakistan need to devise a joint strategy that could help draft a technically robust regulation. If some work has already been done, such as the banning of crypto assets, it may further be aligned and refined with the world’s best practices for which the Russian draft bill could be consulted.

In April, the SBP had banned all kinds of crypto currencies such as bitcoin, pakcoin, and one coin, terming them as illegal tender not guaranteed by the government of Pakistan. However, it is not enough to control the crypto assets exchange and storage. It could rather be counterproductive.It is because the crypto assets trade takes place through the ‘block chain technology’ (BCT) with the ability to keep record of the virtual currencies in a secure and irreversible manner. That means people can find out other ways and means to continue with the crypto assets trade by manipulating the BCT. In this regard our article “Handling FATF”, co-authored with Dr Suresh Kumar of IBA, Sukhur (Daily Times, Oct 27, 2018), also explains some basic features of the BCT working. Some analysts argue that the trading of crypto currencies is not on the rise in Pakistan. However, even if true, the government should think preemptively and attempt to devise strong regulation and technological interventions for controlling the exchange, trade and storage of crypto assets. Once such regulation is in place, it will be easier to effectively tax them.

By Dr.Muhammad Babar Chohan
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