Could the Ethereum ‘Merge’ leave you facing a tax bill?
by Tony Dhanjal, Head of Tax at Koinly
The impending Ethereum merge is the prevalent story in the crypto world as we all await with bated breath the outcome – exciting times ahead no doubt for the crypto eco- system, but there’s a little matter of “taxation” that should not be ignored.
Here’s a summary of what you need to know as a UK Ethereum holder for the merge.
Current ETH (Ethereum) holders are already staking (and locking) their ETH in exchange for ETH 2.0 on the beacon chain – the purpose of this is to facilitate the merge of the Ethereum mainnet – the current proof-of-work (PoW) blockchain, with the proof-of-stake (PoS) Beacon Chain, marking the end of PoW as the consensus mechanism for the Ethereum blockchain.
In the UK, ETH staking (and mining) rewards are generally classified as miscellaneous income (less certain allowable expenses) and subject to Income Tax upon receipt and capital gains tax on disposal. However, this also depends on the degree of activity, organisation, risk and commerciality that determines whether it is a business trade, and therefore subject to revenue and expense accounting and tax.
The staking rewards received by holders are potentially subject to income tax – but, this is a bit of a grey area as the staking rewards are locked up until after the merge – so there is an argument that no income tax is applicable, or at least until the rewards are actually received by investors.
The question is, therefore, will the chain split into two, resulting in a hard fork airdrop of ETH (PoW)?
If this does occur, then the value of the PoW coin is derived from the original ETH already held by the investor. After the fork, the PoW coins need to go into their own section 104 pool and any allowable costs (including the original purchase cost) are split between the new PoW pool, and the ETH (PoS) pool.
This is done on a ‘just and reasonable’ basis – HMRC have not prescribed any particular apportionment method so it’s up to the investor. A clear record should be maintained of the apportionment method in the event HMRC contest the methodology applied.
According to current guidance, it can be inferred no fair value based income tax is applied upon receipt.
However, even if ETH (PoW) is supported by Ethereum miners triggering a hard fork, the question is whether it’ll be supported by most DeFi protocols, stablecoins and oracles. If it is not, then a ‘just and reasonable’ apportionment could lend itself to the entire cost basis being apportioned to ETH (PoS). The investor may then seek to make a negligible value claim in respect of the ETH (PoW) coins.
HMRC, to its credit, has gone one step further and provided some guidance on what it describes as a one-way transfer – citing the Ethereum Mainnet to Beacon Chain upgrade. HMRC’s view is that section 43 of The Capital Gains Act 1992 will apply to this particular scenario.
Simply put, a taxable event subject to capital gains tax is not triggered at the point of the merge. Instead, the cost basis of your existing ETH is attributed to your ETH (PoS) token and any subsequent disposals will accrue a gain or loss as normal and everyone carries on as usual.
This clarifies the question as to whether the transfer from ETH (PoW) coins to ETH (PoS) coins could be classified as a crypto-to-crypto trade, and therefore taxable to CGT (capital gains tax) .
Does this mean it is probable the merge will conclude as a soft fork?
Well, yes, in my opinion – essentially this type of fork updates the protocol and is intended to be adopted by all. No new tokens, or distributed ledger, are expected to be created. Moving from ETH (PoW) to ETH (PoS) on a 1:1 basis – the former coins are simply burned.