Introduction
Last September, the talk of crypto town was the Ethereum Merge or simply The Merge.
This title encapsulates the shift by the Ethereum blockchain from the Proof of Work engine to Proof of Stake.
Crypto is full of jargon, which is saying something from someone who works in tax.
However, a fair chunk of this article is designed I have tried to explain this away as much as possible.
In addition, there is a helpful ‘cryptionary’ here on the ETC Tax website.
Consensus Mechanisms
General
The challenge of any system of digital money lacking third-party oversight is how do you prevent nefarious characters from abusing it?
In other words, how can a network that is made up of many, many nodes, reach agreement (or consensus) regarding the data being sent to it ?
What information is correct and what is bobbins!?
Proof of work
The Bitcoin protocol introduced a mathematical solution to this problem.
This solution is known as the “proof of work” (“POW”) consensus mechanism. The idea is that it makes the economic cost of attacking the system disproportionate to the potential benefit of such a move.
Let us say that I want to purchase some cryptocurrency and I execute this through my wallet using a decentralised exchange. Here, each node will attempt to validate this transaction by competing with other nodes to solve a complex mathematical puzzle.
Where a node is successful in being the first to find what is known as the ‘hash value’ of the transaction, it is permitted to add it to the ledger. It will transmit this data to all of the other nodes in the network who will also verify its validity.
The successful node is rewarded with a “block reward” which is usually in the form of newly minted tokens. This process is called “mining”.
Determining the correct hash requires computer processing time which in turn requires energy (and sometimes a lot of it!).
This is a double-edged sword for POW consensus mechanisms:
- Firstly, a bad actor might need to invest a huge amount of resources in making sure that he or she is first to find the hash. However, it would be highly unlikely that the rest of the network would accept the nefarious player’s block of transactions. As such, our bad actor has expended a lot of energy and cost for no result. This is a good thing for the blockchain.
- However, on the other hand, the energy costs of POW blockchains such as Bitcoin have led to outcry about its adverse environmental impact.
The Ethereum network, up until the merger, also used POW (albeit being a variation on the one used by Bitcoin).
However, the Merge represents a shift to something called Proof of Stake (“POS”).
Proof of Stake (“POS”)
This is a mechanism already used by some other blockchains (e.g. Tezos and Cardano).
Here, only members of the network with a financial stake may add blocks to the distributed ledger. Rather than battling with other members of the network to solve a problem, so-called validators in a POS network do not compete with each other. Instead, they must prove that they own an amount of the network’s tokens in order to be able to generate a block on the ledger.
The rationale is that the greater a person’s financial investment in a network, the lower the likelihood that the person will be a bad actor.
As such, influence is proportional to the number and value of tokens a person holds in the relevant network.
What is the Ethereum Merge?
Essentially, the so-called Merge heralded the shift from a POW mechanism to POS without closing down the Ethereum network.
But why is it called The Merge?
Well, this is because, from a technical perspective, it is doing exactly what it says on the tin. In other words, the event is the merging of two separate blockchains.
The two blockchains being:
- Ethereum Mainnet; and
- The Beacon Chain: a ‘shadow’ POS version of the blockchain
Now the Merger has taken place, the POS blockchain has taken over.
However, importantly for tax purposes, the resulting coin (Ethereum 2.0) is not a new token.
The Merge’s green credentials
An immediate result from the Merge is an anticipated 99.9% reduction in the energy used by the blockchain.
Indeed, it has been described by Ethereum co-founder Vitalik Buterin as one of the biggest de-carbonisation events ever.
So, a bit more than not leaving your TV on standby!
What are the US tax implications of the Ethereum Merge?
On Friday 21 April 2023, the Internal Revenue Service (“IRS”) published a memorandum[1]regarding the tax treatment of a change in consensus mechanism.
As you might have gleaned, this is exactly what happened last year as a result of the Merge.
It is the IRS’ opinion that this type of ‘upgrade’ does not result in a tax charge:
“the existing units of [cryptocurrency] remain unchanged by the protocol change and there is not an exchange of [the cryptocurrency].
Accordingly, [Mrs Taxpayer] continues to own the same 10 units of [crypto] before and after the upgrade and the protocol upgrade does not result in a realization event from which [Mrs Taxpayer] realizes gain or loss on [her] existing 10 units of [crypto].”
As such, on the basis that the person holds materially the same asset before and after the upgrade, there is not a disposal for tax purposes.
The above is relevant for US tax purposes but I would expect the same for UK tax purposes.
Indeed, in my article last year, ‘A canary down the crypto mine’ I came to the same conclusions.
I outline this in the next section.
What are the UK tax implications of the Ethereum Merge?
Where there is simply a merger of the two blockchains and one essentially owns ETH tokens under a POS system rather than a POW consensus mechanism.
As such, I cannot see how there is any disposal for tax purposes. In other words, we are not exchanging one distinct cryptocurrency for another which, as you may be aware, would usually be a disposal for tax purposes.
I think this view is supported by HMRC’s manuals.
The shift from mining coins to staking / forging is unlikely to change the taxpayer’s income taxes position either. Generally speaking, for average investors, this will be treated as Miscellaneous Income. Those who mine or stake on a more deliberate and organised basis will likely be within the trading income rules.
But is there a potential, ahem, canary down the crypto mine?
For fork’s sake
The Merge also resulted in a fork of the Ethereum blockchain.
Forks occur where there is some disagreement in the coin’s community as to how a particular coin might develop. As such, the blockchain splits and the two different communities go their own way.
Forks are relatively common. Most famously, with Bitcoin Cash being a fork of Bitcoin. Ethereum itself has previously undergone a hard fork resulting in the creation of Ethereum Classic.
Following the Merge, Ethereum miners were somewhat perturbed about the switch to a POS engine. Of course, this might have had something to do them owning warehouses full of less profitable mining rigs!
As a result, a ‘hard fork’ took place with the disgruntled miners keeping on their digital mining helmets and continuing to mine the token on their own version of the blockchain.
This is done under the highly creative moniker ETHPOW with its token called ETHW.
Where new tokens are issued as a result of the fork then it is likely that TCGA 1992, s. 43 (“Assets derived from assets”) will apply in relation to the new tokens.
The practical effect is that the costs for capital gains purposes will need to be split between the old and new tokens on a just and reasonable basis.
Conclusion
The move for Ethereum from POW to POS is significant.
As stated above, it massively reduces the energy input required to keep the blockchain living and breathing.
Of course, bitcoin is the biggest and most well-known of the cryptocurrencies.
However, without angering the bitcoin maximalists, the Ethereum is much more useful. Indeed, as per the figures produced by Outlier Ventures for Q4 2021, it is the blockchain with the most active developers.
Further, Ethereum is the father and / or mother of NFTS and, anecdotally, it is said many potential investors were reluctant to explore this world, we are told, due to the environmental concerns. The Merge may assuage this objection.
If you have any queries about this article on the Ethereum Merge, or crypto tax matters in general, then please get in touch.
This is an update of my article which first appeared on the ETC Tax website on 15 September 2022.
[1] https://www.irs.gov/pub/irs-wd/202316008.pdf