Tax implications of the Ethereum Merge

ETH Merge
In terms of taxes, the most significant event related to the merge is the announced hard fork introducing the Ethereum PoW (ETHW) chain, but also the transition to Proof of Stake on the main chain introduces new variables in terms of potential taxable events.

Before we go deeper into that, here is a short summary of the main events occurring in the merge in regards to Ether and Erc20 token:

  • The Ethereum Beacon Chain will become the centre of chain security, meaning all validators will do their transaction processing work on this chain and earn rewards for it. Next to the staking rewards (newly issued coins) validators will now start earning transaction fees as well. The Beacon Chain does not permit smart contracts or any native assets.
  • The known Ethereum 1.0 chain will become the first shard of the Beacon Chain and inherit the consensus. This shard will continue to use Ether (ETH) as gas token and hosting the smart contracts, including all Erc20 token.
  • Ether (ETH) will stay Ether (ETH). Potential derivatives under the name ETH 2.0 or similar could, depending on the respective platforms decision, expire and be converted into native Ether (ETH).
  • Every owner of assets on the Ethereum (ETH) chain will receive the same assets on the Ethereum PoW (ETHW) chain.

Why is this hardfork of ETHW a bit special?

The event is heavily discussed because of high risks involving a hardfork at this state, and the doubling of all your Ethereum assets (Ether, Erc20 token and even NFTs) will definitely impact most portfolios.

Hardforking a complex chain like Ethereum with its millions of tokens (fungible and non-fungible) and thousands of DeFi smart contracts could potentially result in massive chaos. We’ve gotten a small taste of it with the example of Terra 2.0 and Terra Classic, where – except for the Stablecoins – the complete ecosystem was cloned. We saw massive price action of LUNA and the heavily supply inflated LUNC, which not only kept traders on edge, but also the complete system built around Terra:

  • We saw oracle price hacks, as the data sources (Coinmarketcap, Binance, Coinbase, Uniswap etc.) of those contracts imported wrong data, for example the price of LUNA 2.0 for the LUNC token, which resulted in massive exploits on DeFi protocols. This could also happen for ETH and ETHW, whose futures are right now traded at ~ 1,6% of the ETH price.
  • But not only oracle price source data is an important dependency, the signature of transactions need to include the chain ID, if this ID stay the same for both chains, every transaction on one chain would be valid on the other.
  • NFTs who grant the user certain rights are now existing twice, so applications will have to decide which chain is their truth and ingore NFTs on the other chain.

First major exchanges already stated that they would support the Ethereum hardforks initially. Also, we already have a Proof of Work Ethereum hardfork from 2016 called ETC, that will not switch to Proof of Stake, resulting in three “major” Ethereum chains (ETH, ETC & ETHW).

What are the tax implications of the coming hardfork?

In most jurisdictions, these assets on the “new” chain can be regarded as acquired for free (0 cost basis), which does not trigger immediate tax liabilites, as no real profit is made yet. A later disposal of those assets could mean a realization of potential taxable gains though. A few examples:

  • Germany: Acquisition costs are split between hardfork coins and ETH. Presumably hardfork coins will have the market value of EUR 0 at the time of hardfork. New assets can inherit the acquisition date of the fork origin asset, e.g. meaning if the asset has been acquired a year ago, both assets would immediately be exempt from tax.
  • Austria: Hardfork coins have an acquisition cost of EUR 0. The hardfork itself is not a taxable event, but the later disposal of said coins could trigger a 27,5% capital gains tax on the proceeds.
  • USA: Hardforks are actually taxable upon receival in the US, so if there already is a market value for ETHW coins/tokens, a tax liability would incur, even if no action is taken by the holder.

What tax implications does the transition from Proof-of-Work (PoW) to Proof-of-Stake (PoS) have?

As always when it comes to taxation, we see differences in every country, but there are a few technical basics which are relevant for all.

While PoW (mining) relied on the use of expensive hardware, PoS (staking) mostly uses allocated capital for its consensus. Mining has clear classifications in most jurisdictions, relating it to income via labor and an immediate tax liability upon the receival of rewards. It is not so clear when it comes to Staking, as this process is often separated into two parties, the “Validator” and the “Delegator”.

  • Validator: Actually does the calculations needed to verify transactions and ensure consensus.
  • Delegator: Only assigns his assets to a Validator, increasing the Validators stake and therefore power and rewards.

On various chains there is a clear separation of Validator and Delegator directly within the chain architecture, not so when it comes to Ethereum. As Ethereum aims for a high grade of decentralization, there is only the Validator role available. Everyone who is “just staking” (not running the program necessary to validate transactions) does so not through the built-in consensus algorithm, but rather a 3rd party service he borrows his Ether (ETH) to.

First, the tax implications for a Validator based on our examples:

  • Germany: Any rewards generated are subject to income tax upon receival. There is a chance that running a validator node will be considered running a business, which would result in different tax treatment.
  • Austria: Rewards to not immediately incur taxes due to the staking exemption, a later disposal is subject to 27.5% capital gains tax. In contrast to Germany it is less likely to be classified as commerce, but still possible.
  • USA: The safe way would be to do it like in Germany, but there are voices who demand taxes to be only applied upon later disposal of the rewards.

While the authorities would like to regard any form of involvement in a PoS consensus as a commercial activity, the community in Germany and Austria is heavily lobbying against the interpretation, that running a Ethereum node for ~€ 400 per year is actually a business. The judicature on this is still outstanding.

For the Delegator, while it is most likely not regarded a business, the individual case is not necessarily clear. Depending on how a staking setup is constructed, the tax implications are controversial. Mainly regarding the counterparty receiving your assets and returning staking rewards. Roughly, there are three scenarios:

  • Staking Reward: You are interacting with a “pooling” smart contract, which runs a validator node on the asset stake of multiple parties and distributes staking rewards and transaction fees based on the allocation. It is not sure if such a setup will work, but certain staking pools already claim to offer it. In Austria, staking rewards are not taxable immediately, but only upon later disposal.
  • Lending Reward: You are lending your Ether (ETH) to a third party, which is a person or legal entity, and get paid regular interest on it. If the third party is actually using these assets for validator purposes might actually not be clear. Lending interest is taxable upon receival in most jurisdictions.
  • Trade: You lock your Ether (ETH) in a smart contract and get a receipt token for it, which is freely tradeable. An example would be the largest Ethereum staking provider Lido, who issues stETH for ETH, which is its own economic asset with an independent price, that you can later redeem for more ETH (your initial deposit + accumulated rewards). Such trade would trigger a tax relevant realization in Germany and the US.

We hope to give a short overview of the tax topics you should consider when it comes to the Ethereum Merge, especially if you think about staking your Ether or even running your own validator node.

Luckily there are solutions like Blockpit who will automatically import all relevant past and future data directly via your Ethereum public key to calculate tax liabilities and potentials for tax optimization in almost real-time. Check it out now if you haven’t: app.blockpit.io

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Disclaimer: The information provided in this blog post is for general information purposes only. The information was completed to the best of our knowledge and does not claim either correctness or accuracy. For detailed information on crypto regulations, we recommend contacting a certified legal advisor in the respective country. If any questions occur, feel free to contact us on our social media channels.

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