Another brave new world: Transfer pricing in the blockchain space
Jay Das and Daniel Velazquez-Nunez of Deloitte Tax LLP provide a guide to the building blocks and control structure of blockchain ecosystems, and how intangible property rights and transfer pricing are adapting.
1. A blockchain primer
The core functionality concept underlying blockchain technology is deceptively simple: it is a decentralised and secure means of record keeping. However, the apparent simplicity of this concept belies its potential as a scalable tool that has rapidly evolved into a digital means of exchange and store of value.
While early perspective was focused on blockchain’s back-end usefulness, by 2022, this technology has come to be seen as an engine that may yet revolutionise the financial services industry (FSI), through a new blockchain-based financial infrastructure, and the prevalence of digital assets.
Blockchain offers a trading environment based on cryptographic proof. This means two parties in a network can transact directly without the need for a trusted third party. The parties transact directly, creating a “block” of information that is validated by other network participants, adding the newly created data block to the existing “chain”, and allowing the transaction to occur. Because this information is validated by other nodes in a network, it is tamper and censorship resistant.
Blockchain can enhance supply chains by providing secure, decentralised information verification, can expand the spectrum of viable digital payment forms, and can create new asset classes.
Over the past ten years, blockchain has grown from an untested technology platform primarily championed by technology enthusiasts to an integral part of regular business development and operations. According to Deloitte’s 2020 Global Blockchain Survey: From promise to reality, large multinationals had realised by 2020 that blockchain implementation was a critical strategic priority, with primary impact around TMT (technology, media, and telecommunications); financial services; manufacturing; and retail, logistics and distribution.
By 2021, the focus was on how blockchain was driving change in the financial system, from deposit taking to lending and investing. Over 75% of respondents in Deloitte’s 2021 Global Blockchain Survey: A new age of digital assets (the ‘2021 Deloitte Survey’) indicated that FSI organisations that failed to adopt blockchain and digital assets will likely be at a competitive disadvantage (Page 2 of the 2021 Deloitte Survey).
Use cases for blockchain include secure information validation in environments such as title transfer and identity verification, cross selling in the banking and insurance space, managing inventory, automating intercompany contracts, enhancing digital payment platforms, and facilitating peer-to-peer lending through decentralised finance (DeFi) markets.
As noted, blockchain is seen as a transformational area for the financial services and digital payment platforms sectors, with respondents to the 2021 Deloitte Survey noting that they expect digital assets to replace fiat within the next ten years. Long-established digital payment platforms now cater to consumers’ expectations, allowing for the ability to trade cryptocurrency (‘crypto’) from their platforms and the option to pay for routine goods and services using a wide variety of digital assets.
More broadly, respondents to the 2021 Deloitte Survey noted their belief that custody of digital assets, DeFi, and allowing for crypto payments were potential digital asset use cases for their organisations.
2. Building blocks of a blockchain ecosystem
A blockchain ecosystem can come about in different ways and operate across a wide spectrum of industries.
It may be fostered by a single development leader or by a consortium of participants;
It can be funded privately or by a government organisation;
It can have traditional profit maximisation goals or seek to expand the frontier of knowledge through a foundation with no immediate profit motive; and
It may seek to open decision-making processes in the business space to individuals through decentralised autonomous organisations (DAOs).
Regardless of the specifics, blockchain ecosystems share similar building blocks, which facilitate its operations. In general, such modules or components are the following.
a. The platform
This is the software code that allows for the operation of the blockchain; allows for a network of participants to store, share, and validate information in an irreversible, trustless, and censorship-resistant fashion; and performs the stated functions of the ecosystem’s value proposition (payment platform, transaction enablement, etc).
A specific element of the ecosystem is smart contracts, digital algorithms that trigger the automated execution of a desired action once specified circumstances have been met. Blockchain ecosystems routinely use open-source code, the impact of which will be discussed in a later section.
b. The digital assets
Digital assets are strings of binary code that represent certain usage rights and potential value. While these can include anything ranging from biometric data to voter information, for this discussion they will be defined as a specific subset that shares certain characteristics: they can be a store of value and serve as a medium of exchange or as a unit of account.
Assets with these characteristics include cryptocurrency, utility tokens, asset-backed tokens, stablecoins, equity tokens, and central bank digital currencies.
Over the past couple of years, non-fungible tokens (NFTs) have become a salient feature of the environment. NFTs are uniquely identifiable tokens that assign property and exploitation rights over anything from artwork to marketing rights over specific times and locations.
c. The infrastructure
A blockchain relies on participants, or nodes, to execute certain functions and, as such, they are part of an ecosystem’s infrastructure. Specifically, participants perform mining or staking to validate transactions, thereby adding additional data blocks to the blockchain.
While mining involves the use of computing power to validate a transaction, staking involves putting some amount of assets ‘at risk’ to validate the information in a block. Once validated, the entity or agent engaged in the transaction receives a payment in crypto or tokens.
Another segment of the infrastructure is provided by custodians, whose main function is to hold the digital (or tangible) assets for the users or participants in the ecosystem. Because a custodian is effectively holding on to assets whose price can vary unexpectedly, it may bear the risks of holding those assets and, hence, can expect to be compensated accordingly.
d. The users/participants
Depending on the nature of the platform, these can include consumers, users, institutional exchanges, investors, controllers, treasury departments, and government agencies.
They will engage in transactions, within the blockchain platform, and may pay a transaction fee or commission. Users may further use the platform to store their own digital assets and may use the platform to enable their own transactions with unrelated parties.
3. Intangible property rights in the blockchain space
Traditional technology companies rely almost exclusively on proprietary technology, which is protected by patents, trade secrets, etc. While they can encounter competitors and alternative platforms in the marketplace, a traditional technology company knows that its platform is protected by certain legal rights, and this protection can provide it, at least for a time, with monopolistic profits.
A competitor seeking to challenge a technology incumbent may have to invest in the development of its own competing platform and bear the corresponding risks.
In contrast, many blockchain companies rely on open-source components or algorithms, which can be legally used by other competitors to create a platform ‘clone’. While this does not mean full dilution of property rights, it does mean such a platform faces the risk of failing to achieve the monopolistic profits that would be associated with a proprietary platform. Because of this, it becomes critical to understand which components of the ecosystem are open source, and how control over intangible property (IP) development is spread over the ecosystem.
4. Differentiating a platform from digital assets
For blockchain ecosystems, the pool of technology IP includes the code that constitutes the software platform, but may also include code related to smart contracts that give rise to utility tokens. These tokens are designed to be endemic to a particular ecosystem, such as the fiat currency of a particular country.
Tokens are issued through the execution of smart contracts, and have been used as a funding mechanism by start-ups, through a token issuance. After issuance, the tokens can be held by the issuing ecosystem, or be sold and purchased by interested customers. If traded in this fashion, they become an identifiably different and separate component of the blockchain ecosystem, and rights to the tokens can exist separately from their original platform.
Because of this, the correct approach to valuing blockchain technology IP may be dependent on timing, and on the intended use of future or current tokens.
To illustrate, consider a case where tokens are issued but not offered to the public. In this case, there may not be direct market measures of value for the tokens. In contrast, if tokens have been issued and are traded in secondary exchanges, a market-centric valuation method may become the most reliable method to value an IP transfer involving token IP.
A twist here is that even after tokens are issued, subsequent issuances of tokens may be performed by the entity that performed the original issuance, or by an alternate participant in the ecosystem. At this point, an economist could conceivably use models derived from monetary theory to calculate a reliable measure of value of the rights to issue the tokens.
5. A transfer pricing roadmap
Value in a blockchain ecosystem may be generated through:
The development of its software platform;
The trade of the digital assets; or
The performance of services within the blockchain infrastructure, such as minting, staking, or wallet/custodian services.
However, the lack of traditional benchmarks and the atypical features of blockchain technology do not necessarily allow for a routine application of traditional methods. This is especially true when considering transactions involving the transfer of IP.
Accordingly, a transfer pricing practitioner should consider the fundamental principles found in the U.S. Treas. Regs Section 482 (the ‘Treas. Regs. 1.482’), and the 2022 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the ‘OECD Guidelines’), inclusive of considerations related to hard-to-value intangibles (HTVI).
The Treas. Regs. 1.482 and the OECD Guidelines recognise that a transfer pricing analysis begins with the fundamental work of understanding value, and control over business risks. Accordingly, a practitioner should have a clear understanding of these functions, and a sense of how they map into each one of the blockchain building blocks discussed earlier.
A further consideration is that changes in the fact pattern around the blockchain ecosystem may substantially impact the reliability of a particular method, even if other factors are held constant. For instance:
The availability of reliable forecasts may vary depending on whether the platform under consideration is a greenfield application for a new market offering, or one that will be incorporated into a product or service for which there are reliable forecasts;
From a buyer’s perspective, an open-sourced platform is associated with a different set of realistic alternatives relative to a platform built around proprietary technology;
Synergies and value attribution may be relevant if a blockchain ecosystem is developed to function in conjunction with a mature platform with a market track record;
Cryptocurrency exchange risks will be different for ecosystems with non-traded or illiquid tokens versus those with tokens that are traded in secondary markets; and
In the case of DAOs, the IP-generating function may be spread across many contributors who are not directly employed or affiliated with a company.
Source of technology, profit motive, token liquidity, synergies, aggregation, allocation of control rights in DAOs, and usage of crypto as a means of settling intercompany transactions are factors that may impact the selection of the most reliable method when valuing intangible transactions in the blockchain space. Accordingly, reliable methods can include variations on market capitalisation, discounted cash flow frameworks, and cost-based methodologies, and even less common approaches such as methods in quantitative finance or monetary theory.
Whichever methodology is selected at the time of a transaction, a taxpayer should take the appropriate steps to address the information asymmetry that is perceived by tax administrations.
Because the OECD Guidelines call for substantive evidence that explains gaps between ex ante pricing arrangements relative to ex post results, and because the absence of such documentation may result in adjustments based on ex post financial results, a taxpayer should carefully document and maintain information related to value drivers, risks, and functions at the time of a transaction.
Characteristics of the blockchain space – such as the atypically high industry risk, regulatory uncertainty, the prevalence of open-source technology, DAO structures, and high variability in the value of digital assets – have a direct impact on financial projections, discount rates, and the useful life of assets.
6. Control functions in the blockchain ecosystem
In addition to method selection considerations, a practitioner should determine that the economic substance behind a potential IP transaction, as well as the go-forward control over business risks, aligns with the contractual structure of the transaction.
More generally, a practitioner in the blockchain space should have a clear view of which participants and entities in the ecosystem exert control over business risks. Such control includes IP development, but can extend to digital asset management, token issuance, minting and staking functions, etc.
The OECD Guidelines define control over business risks as a party’s ability to take on or reject a risk-bearing opportunity, coupled with the decision-making behaviour related to the decision. Practically, this means that a decision maker should have the capability and functional performance to take on risk-making decisions.
It is important to note that the decision maker does not need to be engaged with day-to-day decision-making. The decision maker can outsource this risk mitigation activity as long as it can:
Determine the objectives of an outsourced risk mitigation activity;
Hire the entity or individuals who will perform that function; and
Adapt or terminate the contract with such individuals.
These principles do not allude to a certain headcount or other external metrics to determine the assertion of control, and, hence, can fit the slim headcount profile of a blockchain start-up, which may have a small number of critical decision makers located in an entity, with a relatively larger number of engineers or programmers situated in other jurisdictions. In this case, if the final decision maker has the credentials and authority to effectively manage risk, it is reasonable to state that they hold control over business risk.
Because of the factual nature of the analysis, it is important for blockchain start-ups to carefully document their asserted risk profile through intercompany contracts, confirm that they align with the actual behaviour of parties, and to systematically document their decision-making process, both in timing and substance. To this end, they can use procedures such as regularly scheduled board meetings and memoranda of understanding pre-dating transactions.
Determining control may become more complex in situations where the blockchain platform is integrated into a larger concern with a larger pool of stakeholders who may exert some control over business risks. As such, a practitioner should have a clear map of risk-taking capabilities across the entities and personnel who hold operational and financing authority with respect to development, enhancement, maintenance, protection, and exploitation functions.
As with companies in the financial services space, this exercise should differentiate between financial and operational risk. For instance, a blockchain company operating a cryptocurrency and token exchange may have an entity holding digital assets reserves to allow for regular day-to-day trading, but this entity, if bereft of decision makers, may only attract a return related to its holding of risky digital assets, rather than a return associated with the full business risk of the company.
The blockchain and digital asset space offers a rich sandbox for a practitioner, but one should be careful that the sandbox does not become a sand trap. A careful understanding of a blockchain ecosystem’s business model, value drivers, technology development, possible synergies, and overall control structure should be carefully assessed before a determination on intercompany pricing. Detailed documentation of the credentials and authority of the party exerting control (even if it is just a single person) is a critical discipline in the space.