According to a report recently released by the International Monetary Fund (IMF), current anti-money laundering (AML) policies are inadequate for effectively dealing with tax evasion in the cryptocurrency industry. The paper emphasized the growth of centralized institutions in the trading of crypto assets, providing tax authorities with a chance to gather crucial ownership data.
Contrary to the initial vision of crypto designers, centralized institutions, particularly exchanges, now play a vital role in cryptocurrency transactions. These institutions possess the ability to gather ownership information, making them pivotal in ongoing efforts to acquire useful third-party data that can be shared with tax authorities. Incorporating AML provisions to cover services relating to crypto transactions is crucial in this regard.
According to the IMF, AML standards are essential in the fight against money laundering and in assisting tax authorities. The standards include “know your customer” (KYC) guidelines, the submission of suspicious transaction reports (STRs), and the inclusion of customer information with transactions (referred to as “travel rules”). The United States applied AML regulations to cryptocurrency transactions as early as 2013 while the Financial Action Task Force (FATF) published guidance on how to put those requirements into practice in 2015. Over in the European Union, past legislation in the block did not cover cryptocurrencies, with a proposal for an updated regulation that would align with FATF recommendations is currently pending Council approval.
KYC provisions have proven invaluable in serving “John Doe” notices to crypto brokers, allowing the Internal Revenue Service (IRS) to gather information on US taxpayers involved in cryptocurrency transactions exceeding $20,000 between 2016 and 2021. Similarly, the IMF points out, in the UK, HM Revenue and Customs (HMRC) has utilized KYC rules to inform and remind crypto owners of their tax obligations. Recognizing tax crimes as a predicate offence for money laundering enables tax authorities to access the information collected by financial institutions under AML rules. However, in practice, AML rules alone are often insufficient from a tax perspective.
The IMF report highlights the limitations of AML rules in facilitating effective taxation concerning cryptocurrencies and, more broadly. The OECD reported in 2015 that only 20% of tax administrations surveyed had direct access to STRs, relying heavily on financial intelligence units to share potentially tax-relevant information. Additionally, tax administrations face obstacles in accessing the information generated by compliant financial institutions due to non-compliance by some jurisdictions with FATF guidelines.
Tax authorities aspire to secure the direct and automatic sharing of information on crypto transactions to address these challenges, similar to the established practice for traditional financial transactions. In the United States, the Infrastructure Improvement and Jobs Act, passed in November 2021, mandates digital service providers to report customer transaction details annually to the IRS, mirroring reporting requirements for bonds and shares. Furthermore, businesses are required to report crypto asset transactions exceeding $10,000, resembling the pre-existing rule for cash payments. Similar measures have been introduced in Brazil, where legal entities and individuals are obligated to report operations involving crypto assets.
However, applying reporting rules to domestic institutions may inadvertently drive transactions to mechanisms not subject to these rules or foreign exchanges that do not share information with domestic tax authorities. The IMF states that research suggests that actions targeted at specific exchanges may decrease activity on those exchanges but increase legal avoidance activity in crypto markets overall. Effective cross-border exchange of information is crucial, but existing frameworks were not originally designed to accommodate cryptocurrencies, creating uncertainties and potential gaps. The OECD has proposed a framework for cross-border exchange of information on crypto transactions, which could be built upon by member states.
Tax administrations currently have a limited amount of directly usable data on crypto ownership and transactions. To learn more about blockchain topologies, users can use publicly accessible data on unpermissioned blockchains and forensic analysis tools. To discover potentially tax-relevant behaviours and create connections with data collected from sources outside the blockchain, artificial intelligence technologies and conventional investigative techniques can both be used.
While the challenges posed by quasi-anonymity and technical complexity persist, tax administrations can employ other measures to encourage self-reporting, such as taxpayer education and targeted nudges. Large-scale actions and seizures can serve as deterrents, sending a clear message that authorities can uncover sophisticated schemes and hold individuals accountable.
To effectively combat tax fraud within the cryptoverse, IMF research emphasises the need for stricter laws and global cooperation. By addressing the shortcomings of AML rules, implementing robust reporting requirements, and promoting cross-border information exchange, tax authorities can strive to ensure the integrity of tax systems in the evolving landscape of cryptocurrencies.