Taxation of digital assets: challenges and way forward

Given high adoption of cryptocurrencies, there is significant potential for revenue collection

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ISLAMABAD:

The landscape of global finance is undergoing a massive transformation through the adoption of blockchain technology, a digitally distributed and immutable ledger that can either function as a decentralised public or private network.

Blockchain technology is the bedrock on which digital assets and decentralised finance (DeFi) operate, facilitating their creation, protection, transparency and decentralised transfer. Digital assets and the DeFi are helping revolutionise major industries including finance, real estate and the creative sectors such as arts and entertainment, through a decentralised system that enables lending, borrowing, trading and other financial activities without the need for intermediaries.

The evolution of blockchain technology has allowed individuals and businesses to record, authenticate and transfer ownership of digital assets. The markets and economies are rapidly adapting to the rise of digital assets, while regulatory institutions are working to regulate these assets as their adoption picks up pace.

At the inception, digital assets were perceived to be a passing fad, however, their adoption continues to grow. People around the globe are radically changing the ways of making transactions through blockchain technology, which reduces the reliance on intermediaries such as central and commercial banks.

Unlike the traditional financial systems that rely on intermediaries, blockchain technology operates through a decentralised system, potentially shifting the control back to its users.

A few months ago, I represented Pakistan in an international course on digital assets organised by the Malaysian Tax Academy in collaboration with the International Bureau of Fiscal Documentation where there were tax officials from 12 participating countries, including Malaysia, India, Ghana, Indonesia, Cambodia, Mauritius and Morocco.

I was surprised to find out that almost all of these countries were already adopting digital assets and were either actively developing a legal framework for taxing digital assets or had already introduced such laws in their respective jurisdictions. Pakistan was the only country where no such active discussion to regulate digital assets was happening at the time, despite the fact that it ranked sixth in the global crypto adoption index in 2022. However, now with recent developments, it is heartening to see that Pakistan has launched its first Crypto Council with the appointment of a talented crypto expert Bilal Bin Saqib. This could potentially make Pakistan a modern economy that is receptive and adaptable to rapid changes in the global financial system.

According to IMF estimates, the capital gains from crypto raised about $100 billion worldwide in the year 2021 alone, not adjusting for capital losses in subsequent years. Given the high adoption of cryptocurrencies in Pakistan, there is a significant potential for revenue collection.

Countries all over the world are developing and evolving legal frameworks for taxation of digital assets despite the lack of global consensus on how to tax them – whether as capital gains or income. For example, in 2022, India introduced a flat 30% tax on digital assets along with a 1% tax deducted at source on all transactions. Indonesia has already introduced a 0.1% income tax and a 0.11% value added tax on specific crypto transactions.

Following suit, Morocco introduced a regulatory framework on the use of cryptocurrencies in 2024 and is actively developing tax laws for digital assets. It is high time for Pakistan to take decisive action in adopting digital assets and find a way to integrate them into the financial system.

The unregulated digital assets market is raising concerns among users and policymakers. A number of high-profile enforcement actions have taken place globally to recover billions of dollars' worth of cryptocurrencies linked to money laundering investigations.

The increasing global scrutiny of digital assets is evident in the legal battle between the Securities and Exchange Commission (SEC) of the United States and Binance Holdings Ltd, which has been temporarily paused for reviewing regulatory guidelines on digital assets. In short, digital assets are here to stay and it is critical to develop a comprehensive taxation framework for them.

An important issue in taxing digital assets is the classification of them. Should they be classified as property and taxed for capital gains or as currency and taxed for income on transactions?

Similar to property taxation, selling crypto for profit incurs a capital gains tax. In some cases, cryptocurrency transactions may be subject to income tax when earned through payments for goods and services, mining, staking, airdrops, business transactions, etc. The lack of global consensus on the classification of digital assets leads to inconsistencies in their tax treatment around the world.

Another major challenge in taxation of digital assets is expanding the definition of permanent establishment to recognise digital presence. Nepal, through its Finance Act 2024, has amended its definition of permanent establishment to include 'digital presence'.

The Federal Board of Revenue (FBR), through Finance Act 2023, inserted a new clause under the definition of permanent establishment to include 'virtual presence', which is arguably not the same as 'digital presence'. For instance, a foreign company could be considered to have a permanent establishment in Pakistan, if it operates a crypto exchange, a non-fungible token (NFT) marketplace or any DeFi service accessible in the country.

It is essential for Pakistan to amend its tax treaties with over 60 countries in order to incorporate 'virtual' or 'digital' presence since the current definition in the tax treaties is based on having a 'fixed' place of business in Pakistan. The lack of clarity in tax laws creates significant ambiguity and litigation, resulting in millions of rupees in revenue stuck in legal disputes.

One of the major challenges the tax administrations face in enforcing digital taxation laws is tracing ownerships and transactions across borders, which are often anonymous. A highly skilled digital asset forensics unit needs to be established for tracking transactions between digital wallets.

To effectively monitor these activities across borders, Pakistan also needs to join the OECD's Crypto Asset Reporting Framework (CARF), which enables tax administrations to exchange crypto transaction data across participating countries.

The time is right for the government to regulate the use of digital assets by amending State Bank of Pakistan (SBP) Act. Meanwhile, the FBR needs to actively engage in global discussions on digital asset taxation while developing effective enforcement strategies in line with the global best practices.

Regulating digital assets will help Pakistan keep pace with their global adoption, possibly protect users from financial frauds and help the economy by boosting revenue collection.