Thinking | 28 January 2020

Ethereum 2.0 – Don’t forket the tax rules

Ethereum’s functionality and success has come as a double edged sword. Its popularity with businesses using blockchain solutions has resulted in a massive uptake, which has in turn led to scalability issues.

In fact, Joseph Lubin, the co-founder of the Swiss-based EthSuisse which has contributed heavily to Ethereum, stated in September 2019 ‘we knew it wasn't going to be scalable for sure’.[1]

Rest assured, a solution has been in the works for some time - Ethereum 2.0. We won’t delve into the technical nuances of Ethereum 2.0, or how it will interact and integrate (eventually) with Ethereum, but we can talk about some of the likely tax implications.

Another fork stuck in the road

The implementation of Ethereum 2.0 may result in a chain split, as Ethereum 2 will function as its own separate blockchain for up to three to four years, and it is possible that some users will refuse to participate with the upgrade.[2] Some commentators also believe that it may be possible for both Ethereum chains to operate simultaneously - hence another path to a chain split.[3]

We have previously discussed the tax implications of contentious hard forks in our article Cryptocurrency and tax – hard forks. The ATO also provides some high level guidance on its website.

In short, the ATO states that where new cryptocurrency is received as a result of a hard fork (for example, Bitcoin Cash being received by Bitcoin holders), taxpayers do not derive ordinary income or make a capital gain at that time. Rather, a capital gain will arise when the new cryptocurrency is disposed of, and, for the purpose of determining any capital gain, the new cryptocurrency will have a nil cost base.

While this is generally a positive result from a tax perspective, we continue to caution reliance on the ATO’s guidance without further analysis. This is because it is not legally binding upon the ATO, and also because in our view, the tax law does not neatly apply to hard forks.

You can read our full article for a more detailed discussion.

Stake it up

Part of the Ethereum 2.0 upgrades include a move away from proof-of-work (PoW) to proof-of-stake (PoS), planned to take place sometime in 2020.

Again, without delving too far into technicalities, PoS is the concept that a miner/user:

can mine or validate block transactions according to how many coins he or she holds. This means that the more Bitcoin or altcoin owned by a miner, the more mining power he or she has.[4]

Generally, the reward is more of the coin or cryptocurrency that is staked. As an example, if you hold 500 Ethereum 2.0 you can ‘stake’ it to assist in validating transactions on the blockchain and in-turn receive a reward in additional Ethereum 2.0.

This model is generally regarded as being more scalable, as it offers an alternative to the energy heavy PoW. Some commentators have also suggested that it offers an added protection to a potential ‘Tragedy of Commons’ network attack.[5]

To date, there has been no guidance released by the ATO in relation to the tax implications associated with PoS. The ATO has, however, released some general commentary in relation to cryptocurrency mining on its online community webpage.

Some questions which remain unanswered include:

  • Whether the PoS activities will amount to the carrying of a business or an isolated profit-making undertaking?
  • Whether the reward received as a result of staking a coin or cryptocurrency will be held as trading stock?
  • Whether the reward received as a result of staking a coin or cryptocurrency will be assessable income, perhaps similar to the receipt of a dividend from holding a share?
  • Whether any costs associated with the PoS, such as energy costs, would be deductible?
  • Whether the costs of capital assets such as hardware and software are deductible or can be depreciated?
  • Whether the small business instant asset write off of $30,000 would apply?
  • Whether losses (if any) from a PoS business or isolated profit making undertaking will be deductible?
  • Whether the non-commercial loss provisions will apply?

Frankly, the answer to all of these questions will depend on the facts and circumstances of every taxpayer and every scenario. Nonetheless, some added guidance from the ATO would be welcomed.

PoS is a concept that has been in use for some time, and there are a number of PoS cryptocurrencies already in existence. There are certainly already people out there who will need to have the above questions answered.

The excuse that it is ‘too hard’ won’t be accepted by the ATO.

Conclusion

We have previously discussed the fact that cryptocurrency is firmly on the ATO’s radar, and that it is vital for taxpayers to understand their tax position, record keeping and lodgment obligations.

Unfortunately, or interestingly, depending on your outlook, cryptocurrency as an asset class offers many nuances which have not been tested within the framework of our existing tax laws. Added to this is the limited guidance which is provided by the ATO.

If you think that you need some cryptocurrency tax related advice, feel free to call Anthony Bradica or Adam Dimac. Otherwise, feel free to peruse our previous articles which may be able to help.

Cryptocurrency and tax – cryptocurrency to cryptocurrency transactions

Cryptocurrency and tax – the ATO’s expectations in relation to record keeping

Cryptocurrency and tax – determining the ‘market value’ of cryptocurrency

Cryptocurrency and tax – hard forks

Cryptocurrency tax reviews are here… are you prepared?

Tax, blockchain and cryptocurrency – what’s all the fuss about?

BizTips – Bitcoin and other cryptocurrencies: your tax reporting and record-keeping obligations

[1] https://www.coindesk.com/scam-or-iteration-at-devcon-ethereum-diehards-still-believe-in-2-0; https://twitter.com/notgrubles/status/1175188890736631809
[2] https://www.coindesk.com/5-takeaways-on-ethereum-2-0-from-vitaliks-beast-mode-blog-posts; https://magazine.cointelegraph.com/ethereum-hard-fork-istanbul-2019/
[3] https://www.coindesk.com/scam-or-iteration-at-devcon-ethereum-diehards-still-believe-in-2-0
[4] https://www.investopedia.com/terms/p/proof-stake-pos.asp
[5] https://www.investopedia.com/terms/p/proof-stake-pos.asp

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