Introduction - The Long-Awaited "Ethereum Merge" Was Successfully Completed
On September 15, 2022, the Ethereum blockchain was successfully upgraded to adopt a "proof-of-stake" method for verifying transactions, as opposed to its prior "proof-of-work" model that relies on what is often referred to as "cryptocurrency mining" to function. Unlike previous protocol upgrades to the Ethereum blockchain, which have looked to improve the blockchain's functionality, the Merge was a much more fundamental change to Ethereum architecture, which required coordination from countless developers and volunteers to execute. The "Merge" promises to increase ETH transacting speeds, scalability, to significantly reduce Ethereum's environmental impacts by totally eliminating energy-intensive Ethereum cryptocurrency mining, and to increase Ethereum preparedness for future upgrades as part of the Ethereum 2.0 roadmap.
What is certain to follow the Merge, as it did prior to the successful transition, is a surge in interest around ETH from both established cryptocurrency investors and previous market skeptics. For Canadian cryptocurrency investors, traders, and users, however, treatment of Ethereum under Canadian tax law may also be in transition. The consequences of a proof-of-stake model, and how you choose to engage with, hold, or trade Ethereum moving forward as a Canadian taxpayer is once again a very live question. If you are an individual or business holding or transacting with Ethereum in Canada, you should absolutely speak with one of our expert Canadian cryptocurrency tax lawyers to discuss the potential tax consequences of your investments and purchases following the Merge, as well as the tax implications of the change from proof-of-work to proof-of-stake if you were previously a cryptocurrency miner.
What was the Ethereum Merge, and What Did it Accomplish?
Cryptocurrencies broadly operate through use of a decentralized ledger system, otherwise known as a "blockchain", as a means of recording global transactions without the need for a central intermediary. To operate a decentralized ledger, cryptocurrencies rely on consensus mechanisms powered by the actions of users and developers to verify the authenticity of transactions and secure the cryptocurrency network for others.
Prior to the Merge, Ethereum operated on a "proof-of-work" model for verifying transactions posted to the blockchain. In a very general sense, this required individuals ("miners") to invest substantial computing power into solving cryptographic puzzles. A miner could then be rewarded with units of cryptocurrency for having used those resources to successfully solve that arbitrary puzzle and to write transactions to the decentralized ledger, which helped ensure the next entry on the blockchain were authentic transactions. The proof-of-work model has most commonly been associated with Bitcoin ("BTC"), which continues to hold the largest market cap of cryptocurrencies.
Ethereum developers had been toying for many years with the adoption of an alternative "proof-of-stake" consensus mechanism. In a proof-of-stake model, network validators effectively agree to bind a certain quantity of cryptocurrency to a smart contract (in essence, having the tokens held in escrow) for a period of time to become authorized as a validator. Validators are randomly selected among the pool of qualifying users to verify blocks received from other users, or to create a new block to report to others to be posted. A validator is rewarded for verifying transactions on the network successfully, and risks losing staked tokens under the smart contract where they do not maintain the hardware to validate transactions, fail to participate as required, or otherwise contradict other validators in malicious ways. Thus, a proof-of-stake model does not rely on miners with substantial computational power to complete puzzles for token returns. A proof-of-stake model instead relies on users to contribute their existing holdings to enable the cryptocurrency network to operate.
The Merge was a coordinated effort by Ethereum developers, users, and enthusiasts, after years of research and public testing to modernize the Ethereum blockchain by transitioning the cryptocurrency from a hybrid proof-of-work model to a pure proof-of-stake model. A new proof-of-stake layer was introduced in December of 2020 (the "Beacon Chain") to run separate and parallel to the proof-of-work layer that Ethereum had operated on since its creation, and to support validation efforts on the Ethereum main network using proof-of-stake methods. With the Merge, the proof-of-work layer was merged with the Beacon Chain, to permanently replace proof-of-work on the main network with proof-of-stake.
Canadian Tax Implications Following the Merge
The Canadian government has only enacted minimal legislation concerning cryptocurrencies and cryptocurrency transactions, and guidance from the Canada Revenue Agency ("CRA") with respect to taxation of cryptocurrency in Canada remains very limited. As well, no Canadian court has rendered a decision on the taxation of cryptocurrency transactions, investments, or trading behaviours. The Canadian tax implications for earning Ethereum through a proof-of-stake consensus mechanism, as opposed to a proof-of-work model, invite complicated questions about the nature of that investment and any related income earned.
Has the Merge Itself Triggered any New Tax Obligations?
While the Merge altered the underlying consensus mechanism of Ethereum, it did not result in any forks or alterations to existing Ethereum holdings. A "hard fork" (otherwise called a "chain split") is an alteration in the underlying protocol of a blockchain that creates equal numbers of tokens for cryptocurrency owners on two blockchains, that operate on the original protocol and the amended protocol respectively. The most well-known examples of hard forks include the creation of Bitcoin Cash ("BCH") and Bitcoin Gold ("BTG") in 2017, and the Ethereum blockchain split in 2016 in response to security issues related to The DAO Project's smart contract software.
The underlying nature of Ethereum as an asset, or the number of tokens a Canadian taxpayer owning Ethereum has following the Merge has not changed. The Merge thus does not give rise to the same concerns about sources of income, tax reporting obligations and tax cost for new tokens that a hard fork may, because Canadian taxpayers have not received anything new. As it stands, it is not apparent that Canadian taxpayers holding Ethereum have incurred any new unforeseen and reportable tax debts as a result of the Merge.
Staked Tokens Rewards: Are They Engaged in Offering a Service, or as an Investment?
The Merge may have consequences for reporting income going forward, however. Under the Canadian Income Tax Act, business income from sale of inventory and investment income as a yield from property are fully taxable sources of a taxpayer's income. In contrast, only one-half of any capital gains from sale of capital property will be included in a taxpayer's taxable income. From a Canadian taxpayer's perspective, the characterization of income as capital gains is a significant tax advantage.
Under the new proof-of-stake model, a cryptocurrency owner verifying transactions must put tokens up as collateral for the privilege of verifying and earning the chance to receive Ethereum in return for their contributions to the network. It is by virtue of holding tokens and deliberately staking them that a cryptocurrency owner generates a return in the form of new tokens. This is somewhat analogous to a shareholder receiving distributions of income earned by a corporation in the form of dividends, or many other forms of securityholders.
Staking rewards could plausibly be treated as income from property under the Income Tax Act, and thus be fully taxable investment income. It is also possible that those rewards could be treated as business income, where it appears the owner is providing a service for offers by staking tokens to perform validations. This determination may fall on the level of Ethereum staking activity the taxpayer is engaged in, and whether that reflects a more passive or active engagement to earn income. In either case, both business income and investment income are treated as fully taxable income under the Canadian Income Tax. Thus, the fair-market value of cryptocurrency received as a reward at the time the tokens are received is fully included in a taxpayers' taxable receipts for that taxation year. The tax cost of those rewards tokens could then be increased accordingly under the Income Tax Act, to prevent double taxation on a subsequent disposition of the tokens.
An additional analysis is involved in determining whether that later disposition of tokens qualifies as business income, or a sale of capital property resulting in a capital gain. The characterization of income as from a business or investment, or as capital gains, follows extensive Canadian common law and is a very fact-specific analysis. Whether a sale of property is treated favourably as a capital sale, as part of a trading business, or as a fully taxable "adventure or concern in the nature of trade", follows many criteria, including (but not limited to):
- The nature of the property sold;
- The length of period of ownership by the taxpayer;
- The frequency or number of other similar transactions by the taxpayer;
- The work expended on or in connection with the property realized;
- The circumstances that were responsible for the sale; and,
- The taxpayer's motive for both acquiring the property, and for making the sale.
That is to say, there are many ways your motivations and Ethereum trading activities will contribute to determining whether profits from a sale of Ethereum constituted business income or capital gains. Your decision to stake Ethereum, the scale at which you engage in Ethereum staking, and any other surrounding cryptocurrency transactions you engage are highly relevant to determining this issue. This is especially a live question following the Merge, and how it has fundamentally altered generation of new Ethereum tokens.
Your motivations prior to the Merge for engaging in Ethereum transactions, and following the Merge, are especially relevant for determining the tax treatment of your sales of Ethereum. An Ethereum miner who was not purely a hobbyist could reasonably be classified in two ways prior to the Merge:
- The miner operated a cryptocurrency trading business with commercial intent, acquiring inventory through mining and selling those reward tokens, and reporting income once those tokens were sold; or,
- The miner mined Ethereum as a provision of services with commercial intent, with the goal securing the Ethereum network and receiving in exchange reward tokens, which would become taxable at the time of receipt.
Characterizing a miner as either operating a business or providing a service would depend on the nature of the miner's mining activities and how the miner treats the tokens acquired through mining. However, for a former Ethereum miner operating a cryptocurrency business, tokens now received as a reward for staking Ethereum do not behave like inventory earned through mining and are a fully taxable receipt when earned. That is to say, regardless of whether a miner could be previously characterized as operating a business or offering a service, any miner who continues to stake Ethereum will find those reward tokens taxable in the year they are received.
An Ethereum miner who operated a business and continues their Ethereum activities after the Merge, transitioning to Ethereum staking, may have to overcome an additional presumption that the miner continues to have that predominant intention to make a profit. Factors like the miner's prior cryptocurrency experience and knowledge, and history of profits and losses from cryptocurrency trading, may still support a finding that the miner operates a cryptocurrency trading business while staking Ethereum and that those staked tokens form inventory, and not capital property. It should nevertheless be possible where the miner's behaviours and motivations change sufficiently that the presumption of business activity can be defeated, in favour of characterizing that staking as related to investment activity and which would result in eventual capital gains on the sale of those staked tokens.
For a miner earning business income now left with redundant hardware, there are even more tax implications. The Income Tax Act requires that any proceeds of sale over the undepreciated capital cost of any capital property a taxpayer disposes of be included in income (otherwise known as "recapture"), which can result in an additional tax bill. Computer components and electronics depreciate very quickly in value, however, and it is very likely that there will be a loss generated on any resale. The Income Tax Act allows a taxpayer to deduct any terminal loss after a disposition of capital property, where proceeds from that dispassion are less than the accumulated capital cost allowance on that property. A miner should dispose of any redundant hardware quickly to crystallize any resulting tax benefits from that hardware's loss in value.
Finally, a deemed disposition may also be triggered where a former Ethereum miner engages in investment activity by staking Ethereum, with respect to those staked Ethereum tokens. A change in use of tokens from inventory for sale by a business to capital property for staking to generate investment income through reward tokens may result in a deemed disposition and possible tax payable for the miner.
Pro Tax Tip: Determine How Your ETH Staking and Disposition Will be Taxed
Following the rapid rise in public awareness about cryptocurrencies like Ethereum in 2015, government regulatory bodies have continually raced to expand and improve enforcement efforts to combat tax evasion. In 2018, CRA joined the Joint Chiefs and Global Tax Enforcement ("J5"), an international effort with the goal of specifically investigating cryptocurrency-related tax evasion. The CRA has taken active efforts to uncover taxpayers' unreported income and assets through external investigations and subjecting taxpayers to audit concerning their cryptocurrency dealings.
The CRA crypto audit process is a very invasive, complicated, and demanding process for taxpayers, and especially so for taxpayers holding cryptocurrency. The CRA may ask for extensive cryptocurrency records providing a timeline of cryptocurrency dealings, sources of funds used to purchase tokens, and what passive income may have been generated while holding that cryptocurrency. If CRA believes your records are not reliable, or that you have misreported income as capital gains as opposed to business income from trading, you may be subject to re-assessment, which can result in unforeseen taxes and possible penalties and interest.
With the Ethereum Merge, rise of NFTs as investment vehicles, and continued popularity of cryptocurrencies, it is certain that CRA will continue to ramp up its enforcement measures. It is your responsibility to document your Ethereum trading activities and income earned from staking, in addition to any other cryptocurrency dealings or trades you may make, and to report your crypto income correctly. If you are engaged in Ethereum trading or staking, or if your cryptocurrency dealings are under audit by the CRA, you should absolutely speak to one of our expert Canadian cryptocurrency tax lawyers for advice and legal representation.
1. What was the Ethereum Merge?
The Ethereum Merge was a successful joint community effort to modernize the Ethereum blockchain by substituting its prior "proof-of-work" model for verifying Ethereum transactions for a "proof-of-stake" model. Following the Merge, all new Ethereum tokens are generated as rewards for staked Ethereum holdings to power the blockchain consensus mechanism, rather than through mining. The upgrade did not affect the cryptocurrency holdings of Ethereum users as a hard fork would have.
2. What Factors are Relevant for Classifying Income as a Capital Gain or Income from a Business?
Characterizing income as from capital gains or from a business is a multi-factored analysis, which can include (but is not limited to): The nature of the property sold; the length of period of ownership by the taxpayer; the frequency or number of other similar transactions by the taxpayer; the work expended on or in connection with the property realized; the circumstances that were responsible for the sale; and, the taxpayer's motive for both acquiring the property, and for making the sale.
3. What are the Tax Consequences for Switching from Cryptocurrency Mining Activity to Cryptocurrency Staking Activity?
First, for an Ethereum miner, whether the sale of staked tokens will result in income or capital gains when disposed of will depend on the Ethereum miner's prior history and continuing engagement with Ethereum. An Ethereum miner previously engaged in mining and transitioning to Ethereum staking will need to observe whether the character of their actions now reflects a view to investing, or preserves its character as a business. Second, all token rewards from staked Ethereum will be taxable on receipt, and will not be treated like inventory as could be the case before for Ethereum miners operating a business. Third, depreciable hardware for mining should be sold quickly to crystallize and benefit from any loss in value for tax purposes. Fourth, a miner looking to transition to investing activities may be struck by a deemed disposition due to change of use on Ethereum tokens previously treated as inventory, and now used for earning returns through staking.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.