Introduction
The international tax regime was founded to tax brick and mortar transactions, but the highly disruptive new-age technology companies have flipped the rules of the global taxation to their advantage. These technology companies, who are Multinational Entities [“MNEs”], through their cloud-based business models have triggered a multitude of international taxation issues, primarily transfer pricing [“TP”] disputes. Several MNEs such as Amazon, IBM, Microsoft, Apple, and Google have been often involved in cloud-based transfer pricing disputes. With the threat of large-scale cloud-based TP disputes looming large, some taxation authorities have begun considering the employment of AI or Blockchain-based Regulatory technology (RegTech) to alleviate TP disputes. This brief research paper attempts to explore the possibilities and hurdles of adopting blockchain-based RegTech to tackle cloud-based TP activities. The paper will firstly discuss cloud-based TP activities and the challenges to regulate them; secondly, analyse the feasibility of regulating cloud-based TP activities through blockchain smart contracts; and finally, scrutinise the risks of regulating cloud-based TP activities through blockchain-based RegTech and provide possible solutions for the same.
Page Contents
Cloud-based TP Activities and Challenges to Regulate them
As MNEs involved in TP activities are bound by Arm’s Length Price [“ALP”] obligations, they employ Cloud Service Agreements [“CSA”] to charge sums above the ALP while dealing with related entities. For instance, a cloud computing MNE’s CSA with a related entity would encompass technical, maintenance and other service charges in addition to the rights to employ the cloud-based software program. Some MNEs employ Cost Contribution Arrangement [“CCA”], to charge sums higher than the ALP. According to a CCA, the costs incurred by an MNE’s related entities, which are present both in high and low tax jurisdictions, to develop/acquire and administrate (in)tangible assets (i.e., cloud-based services) are considered as a whole “with an expectation that the entities will enjoy the anticipated benefits to be derived from their contributions equitably”. Such terms in the CCAs are vulnerable to being manipulated by the MNE as they can simply record that a low-tax jurisdiction entity contributed the most to the development of the cloud-service and also generated the highest income, thereby, reducing their global tax liability.
In order to conduct TP analysis, it is essential to consider comparable transactions involving the sale of similar assets, but it is often difficult in the case of intangible assets like cloud services. Moreover, as previously stated, MNEs through CSAs include the value of the bundled programs along with the price of the primary cloud-software programs, hence it becomes difficult to determine the individual cost of the main cloud-software program. MNEs are spread across many jurisdictions, so only limited information can be collected from the MNE’s domestic entities (taxpayers) to conduct TP analysis. Income from intangible assets, other than patents, are often not recorded in the financial reports of MNEs and this is another barrier to conduct TP analysis. Many countries have borrowed the OECD BEPS Report (and its updated versions) recommendations to counter some of the abovementioned impediments, but there seems to be a lack of proper research on how cloud-based TP activities can be regulated by blockchain-based RegTech.
The Feasibility of Regulating Cloud-based TP Activities through Blockchain Smart Contracts
An internationally accepted definition of blockchain is “a particular type of data structure used in some distributed ledgers which stores and transmits encrypted data in packages called ‘blocks’ that are connected to each other in a digital ‘chain.’” On the other hand, blockchain-smart contracts are “programs that are written on the blockchain and are executed automatically by nodes on the network.” There are four types of blockchains which have varying levels of access, scalability and transparency as mentioned in the figure below.
Blockchains provide advantages such as (a)security, (b)transparency, (c)control and (d)real-time data. As blockchains are spread across many computers (nodes) globally, a single failure will not lead to a system-wide collapse. Moreover, any faulty transaction can be easily identfied due to the omnipresent nature of the blockchain.
On the other hand, the disadvantages of blockchain are issues relating to cybersecurity, data privacy and effective regulation. For instance, 51% of the users (known as “51% bad actor”) in a public permissionless blockchain can decide to make a decision for the entire blockchain regardless of the effect. Data of users of a public permissionless blockchain, which are available to all other users can be misused. Finally, due to the decentralised nature of the blockchain, there is no central regulatory body and this could lead to a variety of concerns. Regardless of the disadvantages, blockchain smart contracts can regulate TP activities in multiple ways.
(i) Automated Self-analysis Tool
If an MNE moves its TP and/or business transactions to a private permissioned blockchain platform, it can employ smart contracts that can automatically execute transasctions with related entities based on “if, then” conditions that are compliant with TP regulations. For instance, according to an MNE’s smart contract, if (1)the cost charged for a cloud service by the supplier entity is according to the TP regulations, (2)an invoice is raised by the supplier entity and (3)the amount is paid by the purchaser entity, only then a transaction can succeed between two related entities.
(ii) Info-gathering tool for DEMPE Analysis
After the introduction of DEMPE Framework by the OECD, there has been an increase in the tax authorities’ appetite for information, thereby, burdening MNEs to disclose vast amounts of extremely accurate information regarding intangibles for TP analysis. Smart contracts can ease the burden of MNEs by automatically collecting information while transactions take place through blockchains of the MNEs.
(iii) ALP Calculation tool for MNEs
Determination of ALP by MNEs is dependant on several factors such as asset-inputs, risks and benefits of related entities. If MNEs transact with related entities through a blockchain, then smart contracts can be programmed to consider all the applicable factors and arrive at the ALP.
(iv) Auditing tool for Tax Authorities
According to OECD BEPS Action Plan 13, if an MNE generates an annual revenue of 750 million euros or more, then such an MNE will have to submit country-wise records and documents of profits, revenue, transactions and other financial actions carried out by its related entities. Blockchain-based RegTech will aid taxation authorities in monitoring an MNEs’ TP activities. Such RegTech can also facilitate the automated filing of regulatory filing. Moreover, MNEs can merely add tax authorities as nodes/participants of their private permissioned blockchains, wherein they can grant the latter with access to documents and information (in real-time) essential for TP analysis. This way, the entire process of reporting, auditing and conducting TP analysis can be sped up manifold.
Although Blockchain-based RegTech has its advantages, it also consists of potential risks which require a brief observation.
Probable Risks and Possible Solutions for Blockchain-based RegTech for TP Analysis
There are three primary risks/impediments with regards to Blockchain-based RegTech for TP compliance: (i) technological threats, (ii) judicial impediments and (iii) policy impediments.
(i) Technological Threats
Firstly, blockchains are prone to some technological risks, chief of which is the 51% bad actor attack. However, such an attack is existent only in public permissionless blockchains. MNEs can avoid such an attack if they carry out their TP transactions on a private permissioned blockchain, wherein only permitted entities can participate.
Secondly, MNEs can minimise the possibility of data leak by adopting a private permissioned blockchain, wherein the administrator can provide participating entities with varying levels of access. For instance, accounting/financial and regulatory compliance divisions of related entities/headquarters can alone have access to financial transactions and economic information. The tax authorities can also be granted access to documents (without breaching the MNE’s confidentiality terms) for auditing purposes relevant to their jurisdiction.
Finally, the decentralised nature of blockchains can cause jurisdictional and governance issues. Such issues can be diminished by adopting a private permissionless blockchain with the headquarter MNE acting as the administrator.
(ii) Judicial Impediments
Though blockchain-based RegTech collect comprehensive data, at the instance of a legal dispute between tax authorities and taxpayers (MNEs), the collected data shall be valid only if the same is permissible in a court of law. The acceptance of blockchain in courts has not been as widespread as the acceptance of e-documents. Howoever, in 2018, for the first time, an Internet Court in Hangzhou, China allowed blockchain-based evidence/proof in a copyright infringement case, wherein the court opined that the following factors must be considered while deciding on the acceptability of blockchain-based evidence: (i) authenticity of the source of electronic evidence, (ii) reliability of electronic data’s storage, (iii) integrity of the electronic data and (iv) relevance of electronic evidence. The Chinese Supreme Court has also confimed the holding of the Hangzhou Internet Court. Currently, there are three Internet Courts in China which possess the requisite infrastructure to process blockchain-based evidence. It is essential to note that China has banned cryptocurrencies, but has begun accepting blockchain-based evidence. This exhibits the high likelihood of other jurisdictions soon beginning to accept blockchain-based evidence regardless of their stance on cryptocurrency.
(iii) Policy Impediments
In order for blockchain-based RegTech for TP regulation to succeed, all stakeholders must accept such RegTech and also possess adequate infrastructure to process blockchain-based data. Hence, it is essential for the taxpayer, the tax authorities and the judiciary to possess sufficient infrastructure. As blockchain-based RegTech can be beneficial to the stakeholders, they must swifty adopt the required infrastructure. For instance, as the tax authorities of China did not possess in-house blockchain processing facilities, they partnered with Tencent in 2018, albeit to combat tax evasion.
Conclusion
It must be conceded that blockchain-based RegTech is still in its infancy, but several judiciaries and legal commentators have opined that “blockchain-related innovations are increasingly becoming relevant to legally authenticate evidence.” Furthermore some commentators have observed that, blockchain-based invoices are difficult to manipulate which makes it simpler for tax officials to unearth their source and authenticity/legality. Blockchain-based RegTech has the potential to revolutionise TP, despite its shortcomings, as it offers various possible mechanisms to regulate TP activities of MNEs. To conclude, if the multiple stakeholders of TP activities upgrade themselves and move to blockchain-based RegTech, then Blockchain-based regulation of transfer pricing will not be far-fetched after all.
Author Bio
