Ethereum 2.0 Staking Reward Tax

video: au-video-https://www.youtube.com/watch?v=R1UtLawLH_c

What is Ethereum 2.0

Ethereum is one of the most popular and successful blockchains, with programming capabilities that allow users to develop different applications all with the Ethereum technology. Some of the most common developments include cryptocurrency wallets and other financial services that assist with the exchange of cryptocurrency.

The cryptocurrency associated with the Ethereum blockchain is called ‘Ether’. Ether can be used much like any other cryptocurrency, for investment purposes, storage or exchange; all while maintaining decentralisation from any central bank. Partially due to the desirable qualities of Ether but also due to the success and potential for the Ethereum blockchain, it remains one of the most popular cryptocurrencies today.

Ethereum is always looking to grow, which is why the blockchain is set to undergo numerous upgrades all contained under the label of ‘Ethereum 2.0’.

Change from a Proof of Work to a Proof of Stake Mechanism

Proof of Work (PoW) and Proof of Stake (PoS) are both verification methods that can be included in a cryptocurrency system to ensure independence from any third party regulator. PoW is the older and more common of the two systems, and while useful, there are some associated undesirable qualities.

Essentially, PoW allows for security by requiring the validity of all transactions to be ‘proven’. New transactions are included in the formation of a new ‘block’ once they are verified. Verification of these transactions comes by way of solving complex mathematical equations with computers. The PoW model is self-sustaining because verification must come from the solving of these equations and individuals are rewarded with some quantity of the cryptocurrency they are solving. Therefore, individuals are incentivised to assist in the verification of transactions, ensuring there is no need for an independent third-party verifier.

The fundamental issue with PoW verification is that it is a ‘race’ to solve the equation because only the first person to solve the equation receives a reward. As the mining process requires extensive computer hardware, electricity and internet use those without access to these requirements are essentially barred from participating in PoW. These high start-up and variable costs have the effect of monopolising PoW and excluding everyday participants from the verification process.

A PoS models differ as transactions are verified through a ‘forging’ process. Forgers are required to lock up a quantity of cryptocurrency in a special wallet. All the locked-up cryptocurrency is then used by the blockchain to verify transactions. Rewards are awarded according to the proportion of locked up cryptocurrency held by an individual as opposed to the ‘race’ approach under PoW. This is arguably more equitable because in theory anyone is able to participate in PoS (Although in reality there are often minimum limits of cryptocurrency that need to be locked up which has a similar effect to PoW in that it crowds out ordinary users).

PoS also has a more direct security preventing forgers from attempting to adversely impact the network. This is because forgers’ coins are held frozen in the staking wallet, meaning if they do anything wrong, they may lose their coins. The threat of losing coins is more direct than the threat of loss associated with hacking or other unconscionable conduct in PoW. Under a PoW system the loss is the cost of electricity and internet that has been used rather than the actual loss of cryptocurrency.

Currently, Ethereum uses a PoW method of verification but as part of Ethereum 2.0 will transition to a PoS. The minimum stake of Ether to participate in PoS on the Ethereum 2.0 network will be 32 units (Current market value of approximately $11,000AUD). While this is a considerable sum of money, it is vastly more feasible to participate in verification under this system than under PoW, as the hardware and variable costs associated with PoW far exceed $11,000AUD. This should have the effect of making validation more accessible to Ethereum users by reducing barriers to entry.

Improved efficiency in Processing Transactions

With the current Ethereum blockchain technology, blocks must be mined one at a time. This has the effect of limiting the speed at which transactions can be processed by essentially creating a ‘backlog’ of transactions waiting to reach the front of the queue for a block. This current system could prove to be problematic in the future if the popularity of Ether continues to increase as the technology is limited at processing approximately 15 transactions per second.

One benefit of Ethereum 2.0 is the introduction of ‘sharding’ on the blockchain which will allow transactions to be processed simultaneously as opposed to one by one as is in the current system. This will directly benefit the system by reducing backlogs and processing times in the future, also creating a network that is more suitable to handle the expected continued user increase.

The ATO's Treatment of Ethereum 2.0

Currently, the ATO has provided no guidance on how they will treat the change from Ethereum to Ethereum 2.0 with regard to the initial transfer of rights and also with regard to the change from a POW to a POS network.

Because this fork is still some time away and we don’t have all the details about how it will be implemented, we can’t currently say how the ATO view will apply. We’ll watch to see how the scenario progresses, and if needed will issue guidance material for Australian taxpayers.

As stated by the ATO on their community page as on 03 August 2020.

However, it is possible that the ATO may take the following approach:

Your Holding of Ethereum

It is possible that the ATO will treat the transfer between Ethereum and Ethereum 2.0 in a similar way to forking or chain splits. This is because Ethereum 2.0 will have different rights to Ethereum.

Working out which cryptocurrency is the new asset received as a result of a chain split requires examination of the rights and relationships existing in each cryptocurrency you hold following the chain split. If one of the cryptocurrencies you hold as a result of the chain split has the same rights and relationships as the original cryptocurrency you held, then it will be a continuation of the original asset. The other cryptocurrency you hold as a result of the chain split will be a new asset.

As stated on the ATO Website as of 03 August 2020.

If this approach were to be taken, the transfer from Ethereum to Ethereum 2.0 would constitute a CGT event.

Example

You purchase 3ETH at for a total of $1,500. During the transfer from Ethereum to Ethereum 2.0, your 3ETH become 3ETH2.0.

Your holding of ETH is complete. At the time of transfer from ETH to ETH2.0, the market value of ETH was $600 per unit.

You have made a capital gain:

$1,800 - $1,500 = $300

At some point in the future if you transfer your 3 units of ETH2.0, this will give rise to a CGT event where the cost base for each unit of ETH2.0 is $600.

Ethereum 2.0 earned from Staking

It is likely that the ATO's treatment of Ethereum 2.0 with regard to POS will be similar to the current treatment for POW. This is because POS and POW are both 'consensus mechanisms' and the ATO has previously stated when discussing POS that:

Other consensus mechanisms that reward existing token holders for their role in maintaining the network will have the same tax outcomes.

Stated on the ATO Website as of 03 August 2020.

The ATO's treatment of POS is that any proceeds from POS are to be treated as ordinary income:

A forger who is selected to forge a new block is rewarded with additional tokens when the new block has been created. The additional tokens are received from holding the original tokens. The money value of those additional tokens is ordinary income of the forger at the time they are derived.

Stated on the ATO Website as of 03 August 2020.

Example

You hold 100,000 Bitcoin in a pool for the purpose of staking. Your pool reaches consensus and you receive an additional 10,000 Bitcoin as a reward.

The additional 10,000 Bitcoin are worth $50 at the time you received them.

The $50 worth of coins you received are considered income for tax purposes.

In the future, if you exchange the coins, the CGT you pay will be calculated with the cost base being $50.