Bigger than Bitcoin: Smart Contracts on the Blockchain

As I noted in a previous post, blockchain applications are emerging rapidly, and tax leaders should keep a close eye on this disruptive technology. This is especially the case for smart contracts – a crucial aspect of the underlying blockchain technology that makes Bitcoin and other digital currencies possible.

Although many media outlets are likening the current trajectory of digital currencies to the early days of the Internet, that comparison is a bit off the mark. A more accurate analogy would discuss digital currencies as akin to email and smart contracts which are akin to the World Wide Web, as the web had a far more profound impact on business.

Smart contracts are computer protocols that represent the terms of an agreement as code residing in a distributed, decentralized blockchain network. Smart contracts are self-executing, automatically triggering specified actions when conditions are met, so they reduce the risk of non-performance. They are constructed as software that is reviewed and activated in a peer-to-peer fashion by the parties, eliminating the need for intermediaries such as notaries, escrow services and even banks. Because smart contracts exist in distributed digital ledgers that are extremely difficult to tamper with, they offer security advantages over current technologies.

“Smart contracts represent a next step in the progression of blockchains from a financial transaction protocol to an all-purpose utility,” according to this Deloitte Insights article. “They are pieces of software, not contracts in the legal sense, that extend blockchains’ utility from simply keeping a record of financial transaction entries to automatically implementing terms of multiparty agreements.” The article lists several use cases companies are already piloting, such as insurance claim processing and managing payments at electric vehicle charging stations.

Tax authorities, like everyone else, are scrambling to understand and use the technology. Deloitte principal Eric Piscini suggests that governments and regulators will drive blockchain adoption in this Coindesk article. He expects government agencies to leverage blockchain for a range of initiatives this year, including digital identities, regulatory reporting and payments.

One way smart contracts might help tax authorities relates to the knotty problem of taxing digital assets, including micro-transactions and machine-to-machine transactions within the Internet of Things (IoT). In the online economy, transactions flow easily across traditional boundaries, which often makes nexus nebulous. But a smart contract that includes the relevant tax can ease those challenges, according to IBM blogger John Palfreyman: “Through inclusion in the blockchain business network, government regulation and taxation administrators have full access to the changes in ownership and location of the digital asset. This would eliminate opportunities for tax evasion and maximize tax revenue collection.”

Palfreyman’s premise bets on the identity of all parties interacting on public blockchains becoming known, which is not currently the case. However, given the recent rumblings coming out of the G20, that’s a bet I’d willing to take. The era of tax-inclusive smart contracts may still be a ways off, but it will surely come.