What is the Ethereum Merge?
Before we talk about the tax implications, bear with me as I answer the following question: what is the Ethereum merge?
The so-called ‘merge’ involves the world’s second-largest, behind only Bitcoin, cryptocurrency: ETH and its blockchain Ethereum. The merge is effectively an upgrade, hence the term ‘Ethereum 2.0’ being used, and involves switching from a proof-of-work (PoW) blockchain to a proof-of-stake (PoS) blockchain. This switch is a significant change to the mechanism that validates transactions and adds new blocks to the chain. Without getting too technical, the difference is:
- Proof-of-work (PoW) verifies transactions through energy-intensive mining (i.e. solving complex cryptographic puzzles)
- Proof-of-stake (PoS) verification doesn’t require mining and instead requires validators to stake tokens to verify transactions
Many critics of blockchain and cryptocurrency have rightly pointed out environmental concerns due to the high energy usage involved in proof-of-work verification, but this upgrade to proof-of-stake is estimated to reduce the usage by 99.95%. Further to this, this method will split the data into smaller blocks with the aim of creating much faster processing and allowing the Ethereum network to be more cost-effective and to scale.
According to insight from the Ethereum Foundation, it’s expected that this merge will take place at some time around Thursday 15th September, after being in the works for six years. This merge won’t be without its uncertainty and risk, so we won’t truly know the impact until after it has taken place.
Could this merge have a tax impact for those that hold Ethereum in their portfolio?
Dependent on the transaction, it’s often a minefield with determining the tax that should be applicable in crypto. Often it comes down to the question: is this transaction classed as income or capital? However, sometimes and in the case of this merge, the question for those that hold Ethereum cryptocurrency (ETH) will be: is it a taxable event at all?
“There are proponents in the crypto tax community who are concerned HMRC may interpret the merge as a crypto-to-crypto trade, thus a taxable event.” Tony Dhanjal, Head of Tax at crypto tax software Koinly, told us. “In any case, a few possibilities exist, so I can only suggest clients speak with crypto expert accountants like UHY to help them navigate the tax aspect of this event”.
Ordinarily, there’s likely to be a taxable event whenever you dispose of cryptocurrency or earn cryptocurrency income. Therefore, where it’s expected that this is an upgrade to the existing blockchain and all new PoS ETH will have the same rights and responsibilities as the prior PoW ETH, it can be assumed no tax would be payable. The cost basis for your ETH will carry over to the new PoS ETH and remain the same (i.e. as to what you originally purchased it for).
What if you’re airdropped a new unit of cryptocurrency after the merge?
Whilst positive news for the environment, this merge is bad news for Ethereum miners, as the PoS blockchain will no longer require mining. Therefore, there has been speculation that Ethereum miners will continue a PoW version of Ethereum. This would represent a ‘hard fork’ of the Ethereum network and whilst it’s expected to be difficult to do logistically, it could involve providing existing ETH holders with the new PoW ETH tokens on a 1:1 basis of their existing holdings.
This would be akin to an 'airdrop' and if this did occur and you received new units of cryptocurrency after the merge, then would these be taxable? HMRC's Cryptoasset Manual outlines that airdrops or rewards are subject to Income tax if they are be be 'earned'. In this case, as the token holders did nothing to earn the PoW ETH, it would be interpreted that no income tax would do and they would have a zero cost basis.
20/09 Update: We now know that ETHW (POW) tokens were distributed on a 1:1 basis (although not everyone can access these). The interpretation here is that as nothing was done to ‘earn’ these tokens, no income tax would be due. These tokens would have a zero cost basis and Capital Gains Tax could be due if sold in the future.
Would it be taxable if I stake my ETH for rewards?
Now that Ethereum will be a proof-of-stake (PoS) mechanism, it will increase the opportunities to earn ETH beyond the miners. However, as we mentioned earlier, earning cryptocurrency income is likely to be a taxable event. In this case, whilst it will depend on the nature of the transaction, where you are staking ETH to earn a yield or reward, it’s likely that HMRC would view this as liable to income tax.
Need advice?
At UHY (East), we’re able to support our clients with compliance and tax advice with their cryptocurrency affairs. Please contact James Foster at j.foster@uhy-uk.co.uk or your usual UHY advisor for further advice.
