The R&D Tax Credit Aspects of Bitcoin and Blockchain Technology



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Bitcoin-Blockchain
        Cryptocurrency is a digital or virtual currency that uses cryptography for security. Bitcoin technology, a type of cryptocurrency, is "a purely peer-to-peer version of electronic cash."  It allows payments to be sent between parties without involving a third party, such as a bank. Bitcoin requires components such as digital signatures to function properly. It also employs the blockchain, which is a public ledger for all Bitcoin transactions. Increasingly, more attention is focused on future development of blockchain technology. Companies developing innovative software for online crypto-currency may be eligible for R&D tax credits.


The Research & Development Tax Credit

        Enacted in 1981, the federal Research and Development (R&D) Tax Credit allows a credit of up to 13% of eligible spending for new and improved products and processes. Qualified research must meet the following four criteria:

  • New or improved products, processes, or software
  • Technological in nature
  • Elimination of Uncertainty
  • Process of Elimination

        Eligible costs include employee wages, cost of supplies, cost of testing, contract research expenses, and costs associated with developing a patent.  On December 18, 2015, President Obama signed the bill making the R&D Tax Credit permanent. Beginning in 2016, the R&D credit can be used to offset Alternative Minimum tax and startup businesses can utilize the credit against payroll taxes.



Bitcoin

        Bitcoin is a cryptocurrency that relies on the blockchain ledger. Through a Bitcoin address, currency is securely exchanged between users. First, the Bitcoin wallet is downloaded on a computer or mobile device. Using QR codes or public key access, the Bitcoins are transferred to another wallet. Transactions will be confirmed before they are added to the blockchain. 

In order to confirm a transaction, it must be in a block that meets the cryptographic rules verified by the network. The rules will help prevent previous blocks from changing. After all, once one block is changed, all the blocks before it become invalid. Whereas Bitcoin is experiencing obstacles in overcoming privacy issues, blockchain technology is beginning to prosper within the financial industry. 


How the Bitcoin Process
Links with Blockchain:




   

Hashes and Timestamp Solutions

        Bitcoins are stored in addresses that consist of a private and public key.  The hashes (signatures) used for Bitcoin are SHA-256 (for transaction verification) and RIPEMD-160 (used after SHA-256 for digital signatures).  The process of a hash and timestamp solution is indicated below:

  1. Takes hash of a block of items.
  2. The hash must be time stamped & widely published.
  3. Timestamp proves the data existed at that time.
  4. In order to get into the hash, the data must be proven to be there at that time.

        Each timestamp is composed of the previous timestamp in its hash. This forms a chain in which each additional timestamp reinforces the one before it.  Bitcoin uses a proof-of-work system defined as mining to scan for a value after it is hashed.  The chart below illustrates the process of Bitcoin transactions:


Proof-of-Work

        A proof-of-work system (POW) is an economic measure intended to eliminate denial of service attacks (DoS) and spam on a network. It requires some work from the service requester, typically in the form of processing time by a computer. While this piece of data is costly and time-consuming to produce, it is easy for people to verify. Producing a proof-of-work can be a random process with low probability. As a result, a great deal of trial and error is required on average before a valid proof-of-work is generated.

        Bitcoin uses the Hashcash proof-of-work function as its mining core. Hashcash can be used as a method to prevent email spam. It will require a proof-of-work on the content on every email.  Mass spam emailers will have difficulty generating the required proofs. Similarly, hashcash proofs-of-work are used in Bitcoin for block generation. Miners must complete a proof-of-work for a block to be accepted by network participants. This encompasses all data in a single block. New blocks can be generated every 1 to 10 minutes. It is unpredictable which work computer in the network will generate the next block because of the low probability of successful generation.

        A block is valid when it hashes to a value less than the current target. In other words, each block indicates that work has been done to generate it. Each block has the hash of the preceding block so that each block has a chain of blocks. To alter one, a block requires regenerating all successors and redoing the work they contain. Because this is such an arduous process, changing a block is highly unlikely. Furthermore, this protects the blockchain from being tampered with and therefore increases its security.

        This most widely used proof-of-work scheme is based on SHA-256. The SHA-256 function hashes a block from the miner and checks for matching patterns to build it onto the existing block.  Bitcoin uses the same SHA-256 function for each block using the previous block to generate a hash. When the new block is created, the previous block's work becomes irrelevant.   In order to modify a previous block, "an attacker would have to redo the proof-of-work of the block and all blocks after it, then catch up with and surpass the work of the honest nodes."  As mentioned previously, this function is configured to provide minimum risk of attack.


Privacy Technology Challenges

        Bitcoin is a developing digital currency that cannot confirm authenticity of a transaction. For example, double-spending arises as an issue because a user may send funds to another and then instantly send those funds to a second person during the processing time (usually 10 minutes). The problem is the ability to copy digital assets.  For example, digital cash (which can be an image attached to an email) can be copied countless times. Because it is a decentralized currency, Bitcoin should find solutions to the privacy issues that may arise. 


Blockchain

        I. The Big Picture: Blockchain is a network that all users can access. Using unique 64-character hash functions, a "winning" block will be added to the blockchain. Usually a block that makes it to the chain will correspond with a certain number of zeros in the beginning that match the previous block on the chain, followed by different ending numbers.

        Blockchain made significant developments throughout the years since creation of Bitcoin in 2009. Its intended goal is to produce a reliable network for unrelated people to undergo transactions. An obstacle in this development is that some people who cannot be trusted may try to corrupt the network. Fortunately, they came to the solution of using majority rule to overrule disagreements in the blockchain.

        II. Payment Verification: Blockchains have "block headers" which appear on every block. If the user keeps a copy of the header, then going back in hashes is simpler. Using the longest proof-of-work chain and block header, it can be proven that the block with a payment exists. Once found in the network, it is confirmed. It is difficult to copy a long chain, so those chains are usually considered the "honest nodes." If there is any suspicion that an attacker has presence within the network, a precaution is to accept notifications about when the network suspects fraudulent activity or run them independently to have quicker responses. 

        In recent years, banks and other financial institutions found blockchains to be disruptive. Blockchain represents a digital ledger in a shared database where all participants can access each transaction that gets bolted to the next.  Banks see blockchain as a threat because without a uniform system among their closed and existing networks, banks will see incoming competitors as a threat.

        Threats that blockchain impose on present "financial playing fields" are becoming more evident as blockchain develops. Participants can see previous transactions and what others paid to one another which may leave hedge funds falling behind in recognizing ordinary trader transactions. 
   
        Blockchain has advantages but also disadvantages. Disbeliefs concerning blockchain exist in terms of security. Blockchain relies on "consensus and collective memory" to filter out forged and erroneous transactions that lead to fraudulent transactions with Bitcoin.

        III. Threat on the Banking Industry: Banks offer closed ledger systems and recognize that if they do not develop a common system, competitors will gain an advantage and work towards eliminating their power via the blockchain. Over 30 banks, including Goldman Sachs, are involved in a blockchain network development project called R3 CEV. This project plans to create a uniform system for banking institutions.  If banks can work together, this may eliminate threatening competition as well as form a more efficient system to operate normal banking businesses.

        IV. Blockchain vs. Credit Card Companies: Blockchain is "an open source software program that is shared on the Internet, and has the potential to remove multiple layers of processes and intermediaries in the sequence of steps that ‘settle’ or ‘clear’ payments from one party to another."  Concerns of credit card providers, such as Visa, MasterCard, and American Express, are rising due to the rapid growth of blockchain technology and the threat it imposes. Bitcoin is a unique visual currency that has potential to grow but the disbelief of "fantasy money" to consumers is too high. As Bitcoin came into play, blockchain technology was able to step in and grow off the concept of internet-based banking. Blockchain is decentralized and separate from Bitcoin. It is projected to have a much larger impact than Bitcoin on various industries. 

        Blockchain uses a chain of computer codes and debits and credits in the online ledger. The ledger can provide information about any currency (Bitcoin, dollars, etc.).  The reason blockchain technology can surpass the success of Bitcoin is because of the trust it provides. Blockchain instills a unique concept that is appealing in the financial world because no one owns it.   There is no way for an individual or private organization to gain on blockchain technology profits. This leaves no issue of parties trying to dominate in the ledger.

        Credit card companies fear the risk of being replaced by blockchain. According to Barrons.com, blockchain is an "internet technology," not a "financial industry technology, therefore [it] will still require the use of banks in their activities. In the future, banks will ‘play a role as underwriters for blockchain risk, guaranteeing deposits in local currencies around the world.’"   Cryptocurrency advancements and blockchain developments are very similar to the changes occurring in the payment industry. As new entrants continue to expand, it is important to adapt to the emerging changes. Without competition, new technology innovations will wipe out banks as long as payment technologies and blockchain developments. New market entrants impose a threat to established organizations. With growing markets in payment technology, cryptocurrency, and blockchain, new entrants have the ability to attract substantial capital investment.
   
        The payment industry is undergoing change that credit card companies ought to adapt to. There are several threats that can substantially reduce or remove credit card companies. For example, banks and credit card companies must adapt to:

  • Mobile payments, eCommerce, tokenization, crypto-currency, and blockchain technology
  • Bank’s role: Banks issue credit cards, plug your phone into blockchain, and all bank accounts will be reflected


Leading Blockchain Implementers

        Goldman Sachs: Goldman Sachs is one company that has hopes for blockchain technology. The investment bank filed a patent for an e-currency called "SETLcoin" that will be the virtual currency providing "nearly instantaneous execution and settlement."  The technology shows an efficient and fair way to execute transactions, which Goldman Sachs is anticipating for the success of blockchain technology.

        Other Investors: To start off 2015, Bitcoin had a decrease in value, which created doubts about future success for investors. For example, a Bitcoin exchange start-up called Bitstamp (UK and Slovenia) had its system hacked, where more than 19,000 Bitcoins were in possession.  Security concerns with the currency arise from events like this, and it proves the technology has potential with further innovation.

        Many developers and miners who keep a close eye on emerging Bitcoin trends show high interest in the applications that can be built on Bitcoin's blockchain. According to Fortune Magazine, blockchain is "the currency's foundational backbone" that allows the secure exchange of any form of value between two users.  In 2014, Bitcoin was adopted by many companies including Microsoft, PayPal, Dell and Dish Network, Target, Overstock.com, and WordPress.  It is anticipated to continue being adopted by more companies.

        Blythe Masters-Digital Asset Holdings LLC: According to Bloomberg Business Journal, Blythe Masters is seeking a new investment in blockchain technology. Being involved in the financial industry for many years, Masters takes this developing technology very seriously because it can evolve the way financial transactions are executed with the right innovation. She supports that blockchain technology does not rely on Bitcoin or require third party approval or control of transactions. Masters say that costs will decrease from using blockchain technology. As a result, revenues will increase. 

        Bank of America: On September 17th, 2015, Bank of America (BoA) released its patent-published app using cryptocurrency to protect wire transfers between customers. This technology will be supported by blockchain technology. 

BoA's wire transfer process consists of:

  1. Funds transferred to a cryptocurrency exchange
  2. Conversion to a cryptocurrency (such as Bitcoin)
  3. Sent to another exchange
  4. Converted into another currency for the recipient

        As BoA is moving towards a digital currency, it is predicted that many other financial institutions will make the same change in coming years. Finally, there have been many investments in blockchain start-ups including: Blythe Masters Digital Asset Holdings LLC and Boost VC. In fact, blockchain investments increased more in the first quarter of 2015 than in 2014.   It is expected to continue increasing.


R&D in Blockchain

        Blockchain requires innovative updates to continuously improve its technology. Improvements include security, accessibility, easily usable, and more. There are custom blockchains that companies are building to perform internal tasks more efficiently, along with pre-built blockchains that are ready to use. These blockchains require people with backgrounds in "math, cryptography, statistics and computer science."  With research and studies in blockchain technology, there is potential for R&D tax credits.


Conclusion

        Bitcoin is a new, unique form of virtual currency that is continuously improving. New developments continue to emerge with both Bitcoin and blockchain technology. Players in the financial and banking industries are seeing growth for blockchain technology in the near future and are planning to adapt to such changes. Blockchain requires uniformity among the banking institutions that exist today in order to gain an advantage against competitors. Although Bitcoin shows the potential to innovate and increase its presence, blockchain technology shows more of a capability to succeed in future years. Innovation related to Bitcoin and blockchain technology development provides an opportunity to receive federal and state R&D tax credits.

Article Citation List

   


Authors

Charles R Goulding Attorney/CPA, is the President of R&D Tax Savers.

Raymond Kumar is a CPA and Tax Manager with R&D Tax Savers.

Tricia Genova is a Tax Analyst with R&D Tax Savers.


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