TaxGrid uses a distributed ledger and zero-knowledge proof to share tax information across tax agencies, banks and investors in near real-time.
EY’s Tax Lab just tested a solution to an international tax problem using blockchain technology and a zero-knowledge proof approach to privacy and security. TaxGrid has the potential to replace a manual and paper-based tax refund process that costs investors money and creates fraud headaches for tax collectors.
Tax Grid uses fungible and non-fungible tokens to track dividend income. This makes it easier for tax agencies to apply the appropriate tax rate to transactions.
“The shared ledger carries the information in realtime as to who owned the stock at the time of sale, the type of entity, the country of location and the appropriate tax rate,” said John Robotham, chief technologist at EY Tax Lab.
TaxGrid uses tokens to track dividends paid on a share. Robotham said the tokens represent a “dividend entitlement,” not a unit of cryptocurrency.
“We are doing the accounting, not moving cryptocurrency,” he said.
EY used a permissioned Ethereum network across multiple cloud providers including AWS, Azure and IBM Cloud to build Tax Grid. EY hosted some nodes on behalf of some partners while other participants hosted their own nodes. The same software ran across all nodes.
Robotham said that a digital, automated method for processing refund claims will reduce the opportunities for fraud created by the current paper process.
“People are allegedly filing multiple reclaims for the same event and it’s almost impossible to track today,” he said.
The zero-knowledge proof element of the system ensures that sensitive data is private and verifiable, and was a crucial part of the proof-of-concept project, according to Robotham.
“It’s the first time that we know of that an application like this involving multiple government and financial institutions was built using zero-knowledge proof,” he said.
Robotham said Tax Grid provides a complete and detailed picture of a transaction for tax agencies while protecting individual investor privacy and confidentiality.
“Without the zero-knowledge proof, everyone would be able to see all the information from the transaction,” he said. “With the zero-knowledge proof, everyone can have the cryptographic assurance that whatever transaction they were relying on was done correctly.”
Robotham said this initial test proved the feasibility of the solution, which is an important first step.
“Now it’s time to work with other ecosystem participants to work through the governance issues and additional tech issues to scale this out to production scale,” he said.
In a report about the project, EY identifies two key questions for the next phase of the project:
- What legal changes are necessary to use distributed ledger technology to manage tax withholding policies?
- What level of cooperation is needed between government and industry to support this approach?
Robotham said the TaxGrid architecture could be used to manage other financial transactions, such as customs and global trade.
Built with a 100% remote team
Robotham said the project started four years ago when an EY leader in Hong Kong started building support for the idea among industry leaders, government officials and international investment companies. The technical team formed about two and a half years ago.
Robotham said that the technical work for the project started just as the pandemic hit in early 2020.
“We did everything virtually,” he said.
EY finalized the list of participants in July 2020 and then the engineering team set up the blockchain network. Testing started in November and in early 2021 the EY team started on the report that recaps the accomplishments of the project, “What happens when government, industry and investors seek common digital ground?”
Robotham said the project was a global effort with team members in Costa Rica, India, China, Europe, the US and the UK.
“EY has an extensive network of blockchain software engineers around the world and tapped into that expertise,” he said.
The technical requirements of the project included:
- Multiparty data sharing, exchange and documentation
- Smart contracts and tokenization of dividend events
- Automation via systems integration that allows parties to extract key information from their systems to confirm withholding tax rates on dividends
- Data privacy for investors
- Audit and verification, for near real-time validation of dividend events and withholding rates
- Document exchange between parties in near real-time
Solving an expensive problem
TaxGrid is a new solution to the familiar problem of withholding tax rates on dividend income from global investments. When an investor in one country profits from investments in a company based in another country, the standard tax rate is 30%. The correct rate varies based on multiple factors. Pension funds pay lower rates than individuals, although they typically pay the highest tax rate due to the complexity of calculating withholding taxes.
Investment companies use a manual, paper-based process to apply for a tax refund and the process can take several years, according to Robotham.
The EU estimates that the bill for withholding tax problems is about 8.6 billion euros per year. Robotham said that the numbers breakdown like this:
- 6 billion euros in tax refunds
- 1.6 billion euros spent to support the current paper-based system
- 1 billion euros in additional potential investment
These organizations participated in the project:
- Her Majesty’s Revenue and Customs (HMRC)
- Netherlands Tax Authorities
- Norwegian Tax Administration
- BNP Paribas Securities Services
- JP Morgan Securities Services
- Northern Trust
- Vienna University of Economics and Business
- Tax Administration Research Centre, University of Exeter
- APG Asset Management N.V.
- PGGM Investment Management