How will digital currencies affect taxes | EY

CBDC development is now a global phenomenon

By mid-2023, 130 countries (representing 98% of global GDP) have found the benefits of CBDCs compelling enough to start developing their own central digital currency. Of these countries, 64 were in an advanced state of exploration (development, pilot or launch).2

The Chinese digital yuan and the Bahamian sand dollar, which are among the most advanced CBDCs in general circulation, give a good idea of ​​how this fast-moving space is likely to evolve and affect taxation.

The sand dollar became one of the first CBDCs to advance past the pilot phase when it launched in October 2020. More than 1 million sand dollars were in circulation in July 2023.3

The digital yuan is part of China’s long-running efforts to centralize digital payment systems, which are increasingly dominated by technology companies. China is testing its CBDC in a range of scenarios, including e-commerce, stimulus payments and payment on public transport.4 The country is now considering the use of the digital yuan for cross-border payments5.

Elsewhere, the European Central Bank has established industry working groups to help lay the groundwork for the EU’s digital euro. Like many jurisdictions, the trade bloc’s CBDC program was in response to the launch of Facebook’s Libra (later renamed Diem) cryptocurrency in 2019, which has since been shut down. In the US, the Federal Reserve Bank of Boston and the New York Reserve Board are exploring the potential benefits of digital currencies for general commercial use that facilitate wholesale bank-to-bank transactions.

Stablecoins: mitigate volatility but generally taxable

Stablecoins utilize the same blockchain technology as other forms of cryptocurrency; however, they are tied to a stable asset, such as a fiat currency or a commodity such as gold, to avoid the volatility associated with other forms of crypto.

This makes properly regulated stablecoins a useful store of value, unit of account and medium of exchange. Investors often use stablecoins to protect their money from sudden price swings associated with other cryptocurrencies.

Like CBDCs, stablecoins can promote tax transparency, transaction security and reliability, and simplified cross-border payments. This has led some of the world’s largest banks to develop their own stablecoins to capitalize on these tax and financing advantages.

However, unlike CBDCs, stablecoins are generally taxable. As with any other cryptocurrency, the majority of jurisdictions treat stablecoins as property for tax purposes and therefore any gains or losses from the purchase, sale or exchange of stablecoins are reportable and may be subject to income and capital gains taxes.

Programming digital currencies to automate tax processes

Smart contracts are another potentially huge facet of tax innovation for digital currencies. Like conventional cryptocurrencies, CBDCs and stablecoins can contain software that can be programmed to take specific actions once certain conditions are met.

No central bank has yet successfully embedded a smart contract into a CBDC, but they could theoretically enable central banks to control how digital currencies are spent and what kinds of transactions can and cannot be made. For example, they can be used to prevent money laundering and financial activities related to crime and terrorism.

In theory, smart contracts could also be used to automatically calculate and trigger real-time tax remittances and tax withholding. This functionality will be particularly useful in cross-border transactions, with smart contracts that withhold payment until a product or service is successfully delivered, or any other conditional element required for payment is met. Organizations can also leverage CBDC programmability to enable real-time tax planning.

Meanwhile, at a public policy level, smart contracts could in theory enable countries to develop flexible and targeted tax policies, such as dynamic tax rates and conditional tax incentives.

Overcome the challenges associated with programmable digital currencies

No central bank has yet overcome the technical hurdles to incorporating smart contracts into CBDCs, but there are potentially at least three approaches that jurisdictions are exploring.

Intrinsic functionality involves embedding a smart contract directly into a digital currency’s blockchain layer. One of the biggest challenges with this approach is that taxes are rarely straightforward. Using current technology, the level of energy and computing power required to calculate tax pass-through and withholding across the full, complex range of scenarios may not be possible.

An alternative approach, known as integrated functionality, involves building and operating a smart contract alongside a digital currency, without embedding the software within a blockchain layer. As the name suggests, the third option, known as external functionality, features a completely separate system that monitors individual transactions and calculates the tax consequences. For example, this can be performed by a tax engine.

External integration is likely to be the least problematic way for CBDCs to leverage smart functionality, but is unlikely to achieve the same levels of tax efficiency and effectiveness as intrinsic or integrated smart contracts.

How tax teams can prepare for digital currencies

The potential offered by digital currencies is huge, so it is essential that corporate tax teams are well prepared for this new era by taking steps such as:

Understand​​​​underlying technology and how it interacts with existing systems

The advent of digital currencies will require tax teams to engage with new technology. For example, understanding how secure digital wallets work will be essential for receiving, holding and transacting in CBDCs and stablecoins as well as transferring taxes.

Achieving regulatory compliance

Digital currencies are likely to be accompanied by new regulations that directly affect taxation. Keeping abreast of the latest developments will be essential.

Strategic planning

Digital currencies are likely to bring new opportunities to innovate tax models, systems and processes. Tax teams must take a holistic approach and work with partners to enhance the value they derive from this new and exciting landscape.