ETH 2.0 Explained – PoS and Taxes

Summary

Ethereum’s long-awaited merge finally came this September, switching the network from the intensive PoW consensus mechanism to a PoS consensus, marking the end of the energy-intensive mining era. The objective was to integrate the Ethereum mainnet with the Beacon Chain. It is a protocol upgrade with the approach of establishing a new consensus mechanism to determine the legitimacy of transactions, relying on validators to verify them and add new blocks.  If you are an Ethereum user you don’t have to do anything, because the migration will be done automatically. The merge itself is not taxable because it’s an update of the network, similar to a soft-fork; but some events could trigger taxation – like converting staked eth. But remember, there are generally other tax implications to keep in mind for eth 2.0 investors. Any staking rewards are taxable as ordinary income, any trades of your eth 2.0 (or the staking rewards) are taxable disposals and any other coins forked may trigger further taxes.

Ethereum 2.0: Deep-diving into the merge

The Ethereum roadmap involves interrelated protocol changes that aim to make the network more secure, scalable, and sustainable in the long term. Among the most famous of the upgrades is the merge, which has been one of the hottest topics in the crypto market. This long-awaited merge finally came this September, switching the network from the intensive Proof-of-Work (PoW) consensus mechanism to a more environmentally friendly Proof-of-Stake (PoS) consensus, marking the end of energy-intensive mining for Ethereum. 

Before the merge, the Ethereum network processed transactions by using the PoW mechanism, in which miners got rewarded in ether for validating transactions. With the Ethereum merge, the main intention was to integrate the Ethereum mainnet with the Beacon Chain creating a single chain, marking the end of the PoW era and transitioning to the PoS one,  reducing the energy consumption by around 99%. Both chains existed parallel to each other until the migration/upgrade of the new Ethereum blockchain was finally completed merging both. 

Before the merge, the Beacon Chain hadn’t processed Mainnet transactions yet. Instead, it had been functioning like a testnet; trying it out and agreeing on active validators and account balances. Once the transition was completed, the PoS validators assumed the miners’ role; they took over the processing of transactions, validation, and proposed blocks. Despite the Beacon Chain starting as a separate chain, the existing Mainnet was ‘merged’ with this new proof-of-stake consensus layer. The Ethereum Foundation explained that once a validator was “initiated,” it would be eligible to review and approve new blocks. 

Difference between PoW and PoS 

PoW: a consensus mechanism to validate transactions to the blockchain and create (mine) new coins via block rewards by putting these into new blocks. PoW (mining) is a form of adding new blocks of transactions to a cryptocurrency’s blockchain as miners solve complex algorithmic problems following a competition-based mechanism. The miner that matches the target transaction hash will receive the reward and the new block will be added to the chain. Modifying the chain would require someone to re-mine all blocks that follow and have their chain be seen as the largest chain, which mathematically is nearly impossible. Because of this, PoW is extremely secure with a large enough network. However, because of the computational power required it is very energy consuming, which makes it controversial when it comes to its environmental impact.

PoS: similarly to PoW, it serves the purpose of validating transactions and creating new coins via staking rewards as new blocks are generated by validators. It is a consensus mechanism for processing new blocks in PoS blockchains. Stakers lock-in their coins into the protocol which randomly selects a staker to validate the next block. The probability of being chosen is generally based on the amount of coins locked-in. The only catch is to hold and stake the coins which could require more technical set-up, however, stakers can also join staking pools or stake through exchanges. Due to the absence of solving an algorithm, PoS is substantially less energy consuming than PoW – running a node requires much less energy and shard chains allow splitting a database to spread the load. Because of this, PoS is seen as more environmentally friendly.

The merge set a new basis for Ethereum and a new consensus mechanism to determine the legitimacy of transactions, relying on validators to verify them and add new blocks. This Ethereum upgrade was not a hard fork because it doesn’t involve a separate blockchain or a new fork (original eth will become part of the PoS 2.0 chain, to increase its scalability in the long term). This is an evolution of the current Ethereum ecosystem. Vitalik Buterin has dismissed the possibility of a potential fork harming Ethereum drastically and has said that “Pretty much everyone in the Ethereum ecosystem is supportive of the move to proof-of-stake validation and quite united.”

Implications

Since there is around $188 billion managed on Ethereum as of today and it hosts numerous dapps and Defi protocols, the outcome of the merge can affect the network plus tons of services that rely on it. On the other hand, some miners will be affected by this change and have to move on to other PoW blockchains to continue benefiting from mining rewards. Besides, many people see this as a positive decision for Ethereum branding and environmental awareness. 

How did the merge go?  

The merge was a successful event, transitioning to a PoS protocol and doing away with mining completely. It went as smoothly as the community could have expected with transactions working seamlessly. The Ethereum energy consumption is expected to decrease by 99.9% after this historical event. 

Eth 2.0 has a new risk profile 

While the energy consumption is much less, centralization concerns have risen due to the merge. Huge stakes in the networks are controlled by big companies like Coinbase or Binance due to the large amounts of ether from their users. Some crypto enthusiasts claim that this is all leading towards a centralization of the network in the hands of exchanges. Further, the Securities and Exchange Commission Chairman Gary Gensler recently said that cryptocurrencies that allow users to stake their coins might pass the Howey test, putting ethereum in potential “security” territory and SEC jurisdiction. While Gensler clarified that his comments were not about a specific coin, it is worth considering.

Ethereum 2.0 Upgrades

The full transition to Ethereum 2.0 includes a number of separate but related network upgrades. Vitalik Buterin outlined a 5-step plan explaining these upgrades.

The Merge: The first network upgrade with the implementation of sharding increasing the scalability of the blockchain to access and store data. 

The Surge: This upgrade will introduce sharding which will split functions of the network across shards, allowing for much faster computation and major scaling benefits. This should increase the network’s TPS significantly. At this moment, there is no date for this upgrade but it is expected in 2023.

The Verge: This upgrade will aim to optimize data storage and node size by introducing “verkle trees” which will also increase scalibility.

The Purge: Next is the Purge that intends to remove historical data to reduce the amount of data needed to be stored by a validator.

The Splurge: This is the final step to ensure all previous upgrades are running smoothly and any issues are addressed.

There are many upgrades and changes that will come to the network, but these are the main ones to keep in mind for the future of the Ethereum ecosystem. 

Eth 2.0 isn’t a hard fork

  • Ether will continue to be the native token on the new Ethereum blockchain (once the network upgrade is finalized, the network will not end up with multiple new chains).
  • There will be a migration of the contracts to the new chain with the help of shard chains (data will be kept unchained and so will the functionality).
  • ETH 2.0 is not a contentious hard fork (like Ethereum Classic), instead, it is a protocol upgrade.

Misconceptions about the merge 

  • Will reduce gas fees (FALSE). Since the merge is not about expanding the network capacity there will be no changes in fees, it is only a change of consensus mechanism.  
  • There are two types of Ethereum nodes: nodes that can propose blocks – that require the commitment of economic resources and nodes that don’t but still play a crucial role in securing the network (TRUE
  • Transactions will be much faster (FALSE). Transactions will remain at the same speed on Layer 1.
  • Staking withdrawals aren’t enabled with the merge yet, the Shangai upgrade is required to enable staking rewards (TRUE
  • When withdrawals are enabled, stakers will not exit all at once because of the limitations for validator exit rates (TRUE) 
  • Staking APY is expected to increase exponentially after the merge (FALSE). Recent estimates predict a minor increase in APY rewards post-merge 
  • The merge update is designed to transition to proof-of-stake with zero downtime (TRUE
  • Ethereum is moving from mining to staking to validate transactions (TRUE
  • Investors can easily cash out their staked Eth after the upgrade is over and dump it on the market (FALSE). There are regulations backed by algorithms to prevent this from happening. 

ETH powers smart contracts and enables the creation of Defi, dapps, nfts, farming protocols, liquidity pools, and many more things related to decentralization. Because of the intensive increase in traffic in the last few years, gas fees skyrocketed. 

If you are an eth holder,  you may have been confused over the multiple versions of the coin on Binance, Coinbase, and other popular crypto exchanges. The idea is that when users stake their Eth it is converted from ETH into ETH2 (Ethereum price is identical for both) and as soon as the network upgrades are completed, these two versions of Ether will be combined into a single token. This update will pave the way for devs to build more dapps on Ethereum and add tons of new features to the resultant network. Many enthusiasts believe that as more innovation comes into the Ethereum blockchain, it could eventually eclipse Bitcoin in the long term, surpassing its market cap. Currently, staked eth and associated rewards cannot be withdrawn until the migration is over.

A group of ETH miners that stand to lose from the switch to PoS created a potential fork of the Ethereum blockchain, and the resultant token is called  EthPoW, which is a hard fork of the Ethereum merge to create a network that remains with the PoW mechanism, and EthPoW is the main token of it. Therefore any income derived from its trading activity is a taxable event. To be eligible for receiving ETHW you would have to:

  1. Hold ETH in a private wallet or exchange supporting the fork to be eligible to receive the EthPoW coin (before the merge date).
  2. All eligible wallets on the Ethereum network will receive the equivalent of the token (based on a specific conversion rate) in the EthereumPoW network. 
  3. To access these rewards you must install the EthereumPoW network if you are on a private wallet (click on this link for further information and guidance on how to do it)
  4. Keep in mind that the Ethereum core developers have claimed that most of these hard fork initiatives are subordinated events, so be careful while interacting with them. 

Tax implications of Eth 2.0

The tax implications of any transaction will depend on the jurisdiction in which you file your taxes. However, most countries that tax your capital gains and crypto income will likely handle the merge similarly whenever we see formal guidance. This is because the merge is an upgrade to the protocol and the same asset is owned from the taxpayer’s standpoint.  There are a few issues to consider regarding ETH 2.0 taxes. 

Is the merge taxable, and if not, what events can trigger a tax?

In the United States, hard forks are taxable under Rev. Rul. 2019-24, however, the merge is not a hard fork and more closely resembles a soft fork, which according to Question 30 of the IRS FAQs are not taxable events. 

“Because soft forks do not result in you receiving new cryptocurrency, you will be in the same position you were in before the soft fork, meaning that the soft fork will not result in any income to you.

The protocol is realizing an upgrade by moving from PoW to PoS, therefore it falls outside of the scope of the hard fork definition (the original protocol continues to operate apart from the forked protocol). In this case, it is a merge + upgrade of the network with only one coin continuing to exist. 

Many other countries such as the UK and Australia follow this logic, and it appears that the merge itself is not a taxable event. After all, the crypto investor is still holding the same asset and while transitioning from ETH to ETH 2.0, token holders are using a 1:1 basis for ETH 2.0. 

However, some events could create a taxable disposal

Coinbase is letting you convert your staked ETH2 into cbETH (some type of wrapped ETH). If you choose this, you are trading your ETH2 for another crypto. Even though it is cbETH, and the taxation of wrapped coins is yet another complicated issue, the most accepted practice is considering a trade into a wrapped coin a taxable event. So while the merge is not taxable, if you trade, sell, or convert eth, it will be taxable.  

Whenever you sell your ETH 2.0 in the future for other cryptocurrencies like Cardano, Bnb, Btc, or turn it into USD; you trigger a capital gain tax event in which you will realize a gain or loss based on the market price of ETH 2.0 at that disposal time.  

If you participate in the ETH PoW hard fork and get new ETHW coins, this would constitute a hard fork that would be treated according to hard fork taxation rules. That means that citizens in the USA would have to pay taxes on the forked ETHW.

Income from Staking ETH 2.0

When it comes to the income from staking rewards, most jurisdictions around the world agree that the staking rewards themselves are taxable income. Generally based on the value of the rewards at the time they are received. The issue comes when you don’t have control of such rewards due to the coins being locked-in, making the timing of recognition of this income one without a clear answer. Many tax authorities have not issued any guidance yet. 

Staking eth 2.0 is a taxable eventall earned rewards will be treated as income equal to their fair market value at the time when the ether is originally received. The reason for this is that at the moment eth 2.0 rewards are locked up, nobody can withdraw the funds or trade them. Therefore, you could report staking rewards as they are credited to your account. However, there is another point of view that these ETH 2.0 rewards should not be taxable until the taxpayer is given control of them (i.e., given the ability to trade/sell). This also raises the question of valuation, based on that day’s value, or on the value of the rewards when accrued. When we consider the price volatility of ETH during the time that holders have been able to stake, the timing of recognition of this income could have a substantial impact on your taxes. Also, this is ordinary income that you cannot offset with capital losses, other than $3,000 per year for US taxpayers.

To conclude, the rewards from staking are taxed, as they accrue (as earned) or once you are allowed to trade (when the taxpayer has control); regardless of approach, your tax basis will be the income reported from the staking rewards. Selling or trading the rewards is a taxable event because you realize capital gain or loss based on the digital asset’s market value at the moment of the transaction and your tax basis in the rewards.

ETH 2.0 Tax Implications Summary by Country

USA Tax Implications of the Merge

Merge: According to Question 30 of the IRS FAQs soft forks are not taxable events. While the merge is not technically a soft fork, the IRS states that “A soft fork occurs when a distributed ledger undergoes a protocol change that does not result in a diversion of the ledger and thus does not result in the creation of a new cryptocurrency.” Based on this definition and the outcome of the merge, it is safe to conclude that the merge is not a taxable event. 

Trading of ETH 2.0: Trading of ETH 2.0 would result in taxable disposals no different than any other crypto trade. 

ETH PoW: This hard fork would be taxed based on the guidance of Rev. Rul. 2019-24, as ordinary income based on the fair market value of the coins at the time the taxpayer obtains control.

Staking Rewards: as discussed above, while certainly ordinary taxable income, the timing of recognition of the income is not clear.

Trading of ETH 2.0 Rewards: Trading of staking rewards would result in taxable disposals no different than any other crypto trade. 

UK Tax Implications of the Merge

Merge: HMRC have provided guidance for soft forks, and since there is no token or distributed ledger created, these are not taxable events. HRMC have also added a paragraph about the beacon chain merge in their One-Way transfers analysis. They state that TCGA92/S43 applies to this type of transaction, which tells us that a portion of the cost from the original asset should go to the new asset. Since 100% of the cost of your ETH would be moved to ETH 2.0, it would appear that carrying over your tax basis to the ETH 2.0 is the right answer, with no taxable gain or loss. In other words, imagine that nothing happened, similar to a soft fork since no new token is created. 

Trading of ETH 2.0: Trading of ETH 2.0 would result in taxable disposals no different than any other crypto trade. 

ETH PoW: Any airdrops of other coins forked (such as ETH PoW) would be treated under hard fork rules, which tell us to allocate a portion of our original tax basis to the new forked coins. 

Staking Rewards: Any staking income from staking ETH 2.0 would be treated the same as other staking income, miscellaneous income with the timing of recognition of this income undetermined.

Trading of ETH 2.0 Rewards: Trading or selling ETH 2.0 or rewards, would be subject to capital gains tax similarly to any other disposals of crypto assets. 

Germany Tax Implications of the Merge

Merge: The BMF  has not given much guidance for the Ethereum merge or for soft forks. Since 100% of the cost of your ETH would be moved to ETH 2.0, it would appear that carrying over your tax basis to the ETH 2.0 is the right answer, with no taxable gain or loss.  

Trading of ETH 2.0: Trading of ETH 2.0 would result in taxable disposals no different than any other crypto trade. 

ETH PoW: This hard fork wouldn’t be taxable based on the guidance of the BMF but a portion of the original tax basis is allocated to the new forked coins and the acquisition date of the forked coins is the same as the original coins (ETH).

Staking Rewards: Any staking income from staking ETH 2.0 would be treated the same as other staking income, miscellaneous income with the timing of recognition of this income undetermined.

Trading of ETH 2.0 Rewards: Trading or selling ETH 2.0 or rewards, would be subject to capital gains tax similarly to any other disposals of crypto assets. 

Australia Tax Implications of the Merge

Merge: The ATO has not given much guidance for the Ethereum merge or for soft forks. However, they have provided guidance on chain splits, which is the term they have chosen for hard forks. Regardless of terminology, what is important is the definition and reasoning, a chain split produces a new asset (e.g., BTC > BTC + BCH). Since the merge does not result in a new asset (ETH is still ETH), this would appear to be a nontaxable event where your cost basis in your ETH is simply carried over to the ETH 2.0 as if nothing had happened. 

Trading of ETH 2.0: Trading of ETH 2.0 would result in taxable disposals no different than any other crypto trade. 

ETH PoW: For any coins that are a result of hard forks (such as ETH PoW), Australia does not tax chain splits either, rather you acquire the coins with a $0 cost basis, meaning that when you dispose of the assets, you will pay tax on 100% of the proceeds. 

Staking Rewards: The timing of the recognition of the staking rewards is also unclear, but the income is taxable as other income.

Trading of ETH 2.0 Rewards: Trading of staking rewards would result in taxable disposals no different than any other crypto trade. 

Austria Tax Implications of the Merge

Merge: The Ministry of Finance in Austria has not given much guidance for the Ethereum merge or for soft forks. Since the merge does not result in a new asset (ETH is still ETH), this would appear to be a nontaxable event where your cost basis in your ETH is simply carried over to the ETH 2.0 as if nothing had happened. 

Trading of ETH 2.0: Trading of ETH 2.0 would result in taxable disposals no different than any other crypto to fiat trade.  

ETH PoW: This hard fork would not be taxed based on the guidance of the Ministry of Finance in Austria and the cost basis would be $0. 

Staking Rewards: Staking rewards would not be taxed based on the guidance of the Ministry of Finance in Austria and the cost basis would be $0.

Trading of ETH 2.0 Rewards: Trading of staking rewards would result in taxable disposals with a cost basis of $0 if disposed for fiat currencies.

Switzerland Tax Implications of the Merge

Merge: As Switzerland does not impose a tax on capital gains, the merge is an irrelevant event for tax purposes, you will pay a tax based on the value of your portfolio at year end. 

Trading of ETH 2.0: As Switzerland does not impose a tax on capital gains, trading ETH 2.0 is not a taxable event, you will pay a tax based on the value of your portfolio at year end.  

ETH PoW: The hard fork is not a taxable event and not subject to income tax, you will pay a tax based on the value of your portfolio at year end. 

Staking Rewards: Any staking income from staking ETH 2.0 would be treated the same as other staking income and is taxable based on value when received.

Trading of ETH 2.0 Rewards: As Switzerland does not impose a tax on capital gains, trading ETH 2.0 rewards is not a taxable event, you will pay a tax based on the value of your portfolio at year end. 

To get a complete overview of how crypto taxation works check out Accointing.com’s resources. 

How can crypto Tax software help me?

Using cryptocurrency software like Accointing.com can help the automation of the process of classifying transactions for Eth 2.0; involving staking, swapping, and many more in order to generate a proper tax report. 

The information contained in this article, including any supplemental materials, is for general information purposes and does not constitute financial, investment, legal or tax advice. The present content is not intended as a thorough, in-depth analysis, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please consult your tax advisor.

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