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Info Service on UN Sustainable Development (Oct22/01) Geneva, 23 Sep (Kanaga Raja) -- Cryptocurrencies have become a new channel undermining domestic resource mobilization in developing countries, according to the UN Conference on Trade and Development (UNCTAD). In its Policy Brief (No. 102), UNCTAD said that while cryptocurrencies can facilitate remittances, these same digital technologies may also enable tax evasion or avoidance through offshore flows whose ownership is not easily identifiable. "In this way, they may curb the effectiveness of capital controls, a key instrument for developing countries to preserve their policy and fiscal space and macroeconomic stability," it added. In its Policy Brief, UNCTAD recommended policies to reduce the financial leakages from cryptocurrencies. Given the global nature of cryptocurrencies, UNCTAD highlighted the importance and urgency of international cooperation regarding cryptocurrency tax treatments, regulation and information sharing as well as of redesigning capital controls to take account of the decentralized, borderless and pseudonymous features of cryptocurrencies. According to the Policy Brief, developing countries face significant mobilization challenges to promote structural transformation and sustainable development while achieving the 2030 Agenda for Sustainable Development. According to UNCTAD estimates before the war in Ukraine, developing countries need around US$3 trillion per year from 2020 to 2025 - to close their financing gaps. It said financing for development requires a two-pronged approach. On the one hand, developing countries need to mobilize additional resources from several domains: international and domestic, public and private. On the other hand, they need to tackle financial leakages. Two crucial channels drain resources from developing countries: illicit financial flows and persistent net financial outflows. These channels erode tax revenues, shrinking developing countries' fiscal space and capacity to provide essential public services and infrastructure, said UNCTAD. "Moreover, they broaden the external financing needs of developing countries, leaving these countries on a debt treadmill." The emergence and the popularity of cryptocurrencies in developing countries has been associated with facilitating remittances and financial inclusion, said the Policy Brief. At their broadest, illicit financial flows are defined as "financial flows that are illicit in origin, transfer or use, that reflect an exchange of value and that cross country borders". According to UNCTAD, illicit financial flows not only include resources that originate from criminal activities (e.g. drug dealing, or trafficking in people) or for illicit activities (e.g. financing terrorism), but also to transfer income and profits legally generated but illicitly transferred abroad to avoid or evade taxes. It is estimated that illicit tax and commercial practices by multinational enterprises and wealthy individuals account for up to two thirds of total illicit financial flows, it said. UNCTAD said in 2021 alone, close to US$500 billion were lost in tax revenues worldwide due to cross-border tax abuse by multinational enterprises and individuals. "These lost resources, which, for example, would be sufficient to vaccinate the global population more than three times, harm low-income countries most, as they have fewer options to mobilize resources." Since the 2008 global financial crisis, several measures to reduce commercial and tax-motivated illicit financial flows, through trade mis-pricing, financial instruments or use of shell companies, have been undertaken at the multilateral and national levels, said the Policy Brief. "However, these efforts do not include cryptocurrencies, which have become a new channel for tax-motivated illicit financial flows." UNCTAD said that while attention has been given to the attractiveness and potential use of cryptocurrencies for criminal activities, estimates suggest that this represents a relatively small share of crypto-transactions, showing that less than 10 per cent of total transactions in Bitcoin could be attributed to criminal activity in 2020. However, the Policy Brief said that from the point of view of financing for development, cryptocurrencies remain problematic even when not related to criminal activity as the erosion of the tax base and the undermining of capital controls are crucial problems for developing countries. TAX HAVENS 2.0 Tax havens are jurisdictions where foreign earnings are typically not subject to taxation (or minimally so) and the anonymity of account holders is maintained, said the Policy Brief. "In the last 10 years, tax authorities and Governments have collaborated to encourage regulated banks to deliver information about account holders in order to protect the tax base and domestic resource mobilization." UNCTAD said that cryptocurrencies share all the characteristics of traditional tax havens - the pseudonymity of accounts, and insufficient fiscal oversight or weak enforcement. It said the key difference is that international transfers of cryptocurrencies do not rely on banks or related legal and accounting services, and that instead, cryptocurrency transactions are often channelled through unregulated crypto-exchanges. Hence, it said that cryptocurrencies are under-regulated, enabling individuals to bypass tax authorities' efforts to address offshore tax evasion. "In effect, cryptocurrencies can serve as tax havens version 2.0 or super tax havens," said the Policy Brief. It noted that cryptocurrencies have quickly attracted the interest of wealthy individuals and firms. Taking Bitcoin as an example (the first cryptocurrency among the existing 19,000), over 80,000 Bitcoin accounts (referred to as "addresses") hold a balance of at least $1 million. While some of these accounts may belong to trading platforms, others pertain to wealthy individuals and firms. According to the Policy Brief, the size of the largest Bitcoin account (as at April 2022) is equivalent to the 2022 gross domestic product (GDP) of the Bahamas, and together the biggest 33 Bitcoin accounts with over $1 billion each correspond to the GDP of Guatemala (US$78 billion in 2020). "The top richest 100 Bitcoin addresses account together for US$115 billion, equivalent to the GDP of Morocco (US$114 billion in 2020) and greater than the GDP of 135 individual countries." UNCTAD said balances kept in cryptocurrencies are essentially untaxed. Despite recent regulatory tightening in developed countries (67 jurisdictions applied tax laws on cryptocurrencies by November 2021), most developing countries do not have tax regulation on cryptocurrencies, including with regards to the legal status of these private digital currencies. Moreover, UNCTAD said that even in countries where tax regulation exists, its efficacy is not assured as the lack of a universally agreed approach to cryptocurrency tax treatments creates a patchwork system that is prone to regulatory arbitrage. Finally, users of cryptocurrency have little or no incentive to report their holdings, it added. CRYPTOCURRENCIES UNDERMINE CAPITAL CONTROLS The popularity of cryptocurrencies in developing countries, including among middle-class households, means that the use of these digital assets is not limited to wealthy individuals, said the Policy Brief. It said that in cases of political or macroeconomic instability, a broad range of households could potentially use cryptocurrencies as a hedge against exchange rate and inflation risk and as a channel for capital flight. "This situation is potentially damaging in developing countries which typically rely on the use of capital controls to deal with the draining of domestic resources through capital flight." The decentralized, borderless and pseudonymous features of cryptocurrencies pose challenges for the effectiveness of capital controls for three main reasons, said the Policy Brief. First, capital controls work through regulated intermediaries that are required to verify the nature of transactions and to identify transacting parties. Second, said UNCTAD, in many countries, the legal status of cryptocurrencies is often unclear, and regulatory bodies may currently not have a mandate to regulate these transactions and crypto-exchanges, e-wallet providers and decentralized finance (DeFi) platforms. Third, supervision and enforcement of these crypto-services providers are more difficult since they operate cross- border. UNCTAD said Bitcoin, for example, was used to circumvent Chinese capital controls prior to the country's ban on cryptocurrencies. Moreover, cryptocurrency miners are usually remunerated in cryptocurrencies while their mining costs (particularly energy) are incurred in domestic currency, thus enabling capital outflows, it added. RECOMMENDED POLICIES According to the UNCTAD Policy Brief, the following policies provide the potential to halt the financial leakages via cryptocurrencies: 1. To improve taxpayer compliance rates and combat tax evasion, tax authorities should clearly define the legal status of cryptocurrencies and require crypto-exchanges, e-wallet providers and DeFi platforms to report gross inflows and outflows on all business and personal accounts. 2. Given the fast-evolving nature of cryptocurrencies and their ecosystem, countries urgently need to agree and implement a global tax cryptocurrency regulation that considers the needs and challenges of developing countries and gives them adequate representation. 3. Apart from global tax coordination, a comprehensive system of information sharing on cryptocurrency holding and trading is necessary, such as through a common reporting standard. Such measures would support countries to detect evasion of capital controls and enforce taxes. 4. Although cryptocurrencies may facilitate remittances, given the negative socioeconomic impact these private digital currencies bring about, countries should consider imposing higher taxes on them in comparison to other financial assets to discourage holding and transacting cryptocurrencies. 5. Countries should redesign their capital controls to include flows channelled through cryptocurrencies. Alternatives include imposing financial tax on cryptocurrency trading and limiting the amount of individual transactions on crypto-exchanges. Moreover, central bank digital currencies could be designed to allow for the functioning of capital controls. Without adapting to new digital alternatives, the effectiveness of these controls may be undermined. +
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