Why Tax Regulations Are as Important for Crypto Companies as AML Requirements

The rise of Bitcoin, Ethereum, and other cryptocurrencies has already led to tax authorities demanding corresponding tax information from individuals. Now crypto service providers are next in the queue, and soon will also be subject to extensive tax reporting requirements.

In this article, we explore the question of how Virtual Asset Service Providers (VASPs), or Crypto Asset Service Providers (CASPs) as they are called in Europe, can best meet not only their own tax- and anti-money laundering (AML)-related needs, but also their customers.

What is about to change?

In the United States, not only are individuals obliged to disclose tax-relevant information to national tax authorities, but also VASP/CASP have to report specific transaction data. A similar system of “checks and balances” (i.e. tax authorities not only receiving information from individuals for their tax verification purposes, but also from VASPs/CASPs they use) is now also to be introduced not only within the framework of the Organisation for Economic Cooperation and Development (OECD), but also in the European Union (EU). 

Consequently, CASPs operating within member states of these organizations (and beyond), will face significant challenges related to implementing these tax-related reporting requirements. While regulation and harsh sanctions may still lag behind technological developments in this regard, they are, therefore, certain to come. Timely preparation and the existence of suitable solutions can thus avoid many headaches later on, not only for CASPs’ customers but also for themselves, especially concerning possible legal reviews and associated penalties, such as the withdrawal of essential licenses or high fines.

We have already seen the above with regard to AML, where companies that do not comply have been obliged to pay huge fines or have had their licenses restricted or even withdrawn. Just recently, Crypto Exchange Bittrex was hit with a $29m fine from the US Treasury Department for violating the AML law and sanctions on specific countries. Another example is UK fintech ePayments which had to close the business in 2020 due to AML lapses.

The closely linked fight against tax fraud is coming up next.

Who is affected? 

In the EU, the fundamental legal framework for any service provider in the field of crypto to take a closer look at is the Markets in Crypto-Assets Regulation (MiCA), which was adopted at the end of June 2022. A key aspect of MiCA is that it defines the term “Crypto Asset Service Provider” very broadly. To be specific, MiCA applies to any legal person or other undertakings whose occupation or business is the provision of one or more crypto-asset services to third parties on a professional basis. Such “Crypto-Asset Service” might be:

• the custody and administration of crypto-assets on behalf of third parties; 
• the operation of a trading platform for crypto-assets; 
• the exchange of crypto-assets for funds (i.e., banknotes and coins, scriptural money, or electronic money); 
• the exchange of crypto-assets for other crypto-assets; 
• the execution of orders for crypto-assets on behalf of third parties; 
• placing of crypto-assets; 
• providing transfer services for crypto-assets on behalf of third parties; 
• the reception and transmission of orders for crypto-assets on behalf of third parties;
• providing advice on crypto-assets; or
• providing portfolio management on crypto-assets.

Hence, each service provider in the crypto space should therefore question whether it offers any of the above services and is therefore subject to the obligations under MiCA.

While a comprehensive regulation based on the above CASP definition of MiCA has already been adopted with the Transfer of Funds Regulation (TFR), the following legal acts are also currently being negotiated in the EU: 

• In the area of AML, the 6th Anti-Money Laundering Directive (6AMLD), a new Anti-Money Laundering Regulation (AMLR), and the establishment of a new European AML-Authority (AMLA) are in the works, and
• In the area of taxation, the DAC8 (Directive of Administrative Cooperation) is expected to be finalized in the fourth quarter of 2022, imposing comprehensive tax reporting obligations on CASPs.

The latter is something that is often overlooked due to the multitude and prominence of AML regulations. However, the tax reporting obligations of CASPs should also deserve special attention since one thing is always certain: at the end of the year, tax authorities knock at the door.

What reporting requirements will CASPs face? 

Even if some CASPs could put crypto taxes on the back burner in recent years, this is about to change. Amongst others, the OECD is close to enforcing specific reporting rules under a common Crypto Asset Reporting Framework (CARF) to put a stop to tax evaders on a global scale. CARF will affect not only OECD’s 38 member states, including all member states of the EU, the US, UK, Switzerland, Australia, Canada, Mexico, Israel, Japan, and Korea, but also the member states of the G20 and those countries that have implemented the Common Reporting Standards.

However, it should be emphasized that the rules set forth under CARF are not to be applied directly, but are rather intended to serve as a basis for regional and multilateral agreements as well as individual national implementation laws. In this respect, CARF will also provide certain minimum standards for the forthcoming DAC8 in Europe. Hence, in order to get a more detailed understanding of the upcoming reporting requirements in the EU, let’s take a closer look at the key provisions of CARF below.

Reportable Service Providers

Under CARF “any individual or entity that, as a business, provides a service effectuating crypto-fiat or crypto-crypto transactions for or on behalf of customers, including by acting as a counterparty, or as an intermediary, to such transactions, or by making available a trading platform” shall be considered a reportable CASP. This rather functional definition covers not only exchanges, but also other intermediaries, such as crypto-brokers, crypto-dealers, and operators of crypto-ATMs, as well as certain decentralized exchanges. Such intermediaries are expected to have the best and most comprehensive access to the value of relevant crypto assets and corresponding transactions. Besides, these CASPs also fall within the scope of obligated entities for the purposes of the Financial Action Task Force (i.e. virtual asset service providers). As such, many of them are already required to collect and review documentation of their customers, including on the basis of AML/KYC documentation.

Reporting requirements

In addition to the above-mentioned requirements known from the AML regime, which require service providers to report user data such as name, address, and jurisdiction of residence to the relevant government authority, CASPs will now also have to report tax-related data on various types of transactions, including:

• exchanges between crypto-assets and fiat (i.e., Buy/Sell);
• exchanges between one or more forms of crypto-assets (i.e., Trading); 
• transfers of crypto-assets (i.e., Transactions leaving a platform); and
• high-value retail payment transactions (i.e., payment for goods or services over USD 50.000).

Such transactions shall be reported annually on an aggregate basis by type of crypto-asset and distinguishing outward and inward transactions. In order to improve the usability of this reported data for tax administrations, a distinction should further be made between crypto-crypto and crypto-fiat transactions. For crypto-fiat transactions, the fiat amount paid or received is reported as the acquisition amount or gross proceeds. For crypto-crypto transactions, it is proposed that the value of the crypto-asset (at acquisition) and the gross proceeds (upon disposal) must be reported in fiat currency. In addition, CASPs should also categorize transfers by transfer type (e.g., airdrops, income derived from staking, or a loan), at least in instances where they have such knowledge.

With respect to transfers to wallets that are not affiliated with a reporting CASP or financial institution, CARF requires CASPs to report the number of units as well as the total value of crypto-asset transfers effectuated by them to such wallets. Therefore, although CARF generally does not apply to mere peer-to-peer transactions, it shall cover certain transactions to and from self-hosted wallets.

Impact on Crypto-Taxation

Within the EU, CARF shall be implemented mutatis mutandis through the upcoming DAC8 (Directive of Administrative Cooperation), which will introduce similar minimum reporting standards in all 27 member states. In combination with the Transfer of Funds Regulation (TFR) and publicly available blockchain data, the accumulated information should in many cases be able to lay open the exact transaction history of any taxable person and entity. With this much data available, the first steps are taken to detach tax reporting duties from the individual and pass them on to the CASPs. Proactive countries like Austria already have specific tax laws requiring crypto exchanges to withhold taxes, as has been the practice for decades with banks, stock trading, and savings accounts.

How to comply with increasingly strict tax reporting obligations?

From a practical point of view, the increasing amount of AML and tax reporting obligations will be a significant challenge for many CASPs. Because of the comprehensive regulations in the European Union, we already see some CASPs considering setting up outside the EU to avoid these obligations. However, this will not be a solution either, because leaving the EU entails many restrictions, not only for operating in the EU market, but also for those operating within it. The question therefore arises as to how CASPs can deal with the increasingly comprehensive reporting obligations.

Overall, there are three major options in this regard: 

1) either CASPs try to solve their reporting obligations independently and create the corresponding internal resources, or 

2) CASPs seek external advice and then start building in-house solutions (usually accompanied by ongoing external monitoring), or 

3) CASPs decide to outsource these tasks to third-party providers.

Each of these options comes with certain advantages and disadvantages and, in most cases, the decision will crucially depend on how large a CASP already is and how much budget is available. 

As far as outsourcing to third-party providers in the EU is concerned, there are already some providers of related services in AML (for example, KYC or transaction monitoring), but barely any in crypto taxation. This is mainly because there are certain legal requirements that hardly any tax solution provider can meet. On the one hand, this concerns data protection, which is particularly strict in the EU. On the other hand, different tax laws apply in each EU member state, and therefore additional tax-relevant information might be required.

Why should CASPs also care about their customers’ tax issues?

Ultimately, most service providers envision offering a holistic solution for their existing and potential customers. This can include seamless fiat on- and off-ramping, a wide range of assets, and various investment products such as indices, stakes, loans, leverage, and much more. However, while such income-generating features are mostly a priority, it is crucial not to lose sight of customer needs, particularly with regard to their tax compliance. 

After all, service providers themselves are increasingly subject to comprehensive tax reporting obligations, and their customers have to determine and provide accurate information on their tax-relevant transactions to be legally compliant. In fact, one of the objectives of CARF and DAC8 reporting obligations is to provide tax authorities with a much larger pool of data that can be used for tax audits, as shown in the figure below: 

However, one has to be realistic. Providing customers with proper and accurate crypto tax management comes with many obstacles, mainly if you are serving cross-border markets and are facing this challenge by yourself. Tax systems usually differ significantly from country to country, treating various transaction types (e.g., trades, staking rewards, fees, airdrops) and asset classes (e.g., stablecoins, asset-referenced tokens, NFTs, derivatives) differently for tax purposes. Multiply all these variables by the need to calculate gains and losses for each transaction, and you find yourself with a Gordian knot to untie.

Hence, what might sound straightforward in theory quickly becomes complex in practice. If customers conduct more than a handful of trades, they will soon reach the limit of what can be managed with simple tools like an Excel sheet. And then there is also the issue of country-specific tax calculation rules and reporting forms. However, there are already certain solutions in place. In fact, there are different levels of support that CASPs can provide to their customers in fulfilling their tax obligations, which are listed below in order of their usefulness:

• Country-specific tax reports with calculated taxable gains and pre-filled report forms based on up-to-date regulation;
• Summary of gains and losses by category (e.g., value appreciation, staking rewards, margin profit);
• API for data extraction (to connect to a third-party tax software); or
• CSV export of their transaction history (to import in third-party tax software).

At the latest with CARF’s or DAC8’s reporting requirements kicking in, it would be very useful for any CASP to have one of the first two options mentioned above already in place, particularly as reporting obligations to tax authorities will demand such a level of information anyway. In fact, Plug-and-Play solutions to deliver these results are already available. However, we see that bigger CASPs have recently become more inclined to provide such information on their own platforms to avoid having to share clients and their valuable financial data with third parties. 

Despite this, the business model of most third-party crypto tax providers on the market has stayed the same for years. Users still need to access these external platforms and share their information to create a somewhat compliant tax report. In fact, Blockpit is the first infrastructure provider out of Europe that offers a tax solution that is directly integrated with the CASP platform. This can be done via a plug-and-play API that is integrated into the respective CASP based on its individual technical requirements. The fundamental building blocks required for these services are:

1) Blockpit’s unique server structure, which does not rely on third-party cloud services and is continuously audited against GDPR and other relevant data protection laws,

2) the extensive asset database, which includes not only “traditional” crypto assets but also derivatives, asset-backed token, NFTs and the like, and

3) the chronological pricing database and algorithms for specific tax treatment in different jurisdictions.

In this way, even those CASPs, who do not have the necessary internal resources or simply do not want to constantly deal with tax burdens themselves, can offer their users a comprehensive and legally compliant solution. Through this, automated tax management systems, such as those offered by Blockpit, can not only help CASPs to comply with upcoming tax regulations, but also significantly improve the experience of their users.