Introduction
The talk of crypto town at the moment is very much the Ethereum Merge or simply The Merge which happened today.
I’m not talking about some kind of BBC drama by numbers whose formula consists of picking a verb at random and prefixing it with the definitive article.
No, we are talking about the shift by the Ethereum blockchain from the Proof of Work engine to Proof of Stake.
But what, how, why and where Lambo?
Sadly, I will only attempt to answer the first three… and (more sadly) throw in some obligatory tax content (otherwise Mrs Wood won’t let me write any more articles).
Crypto is full of jargon, which is saying something from someone who works in tax. I have tried to explain this away as much as possible. However, we have a very useful ‘cryptionary’ that might assist where I fall short.
Consensus Mechanisms
General
The challenge of any system of digital money lacking third-party oversight is how to prevent more nefarious characters from abusing it.
How can the network, made up of many nodes, reach agreement (or consensus) regarding the data it receives? What information is correct and what is incorrect?
Proof of work
The Bitcoin protocol introduced a mathematical solution to this problem. This is 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 the ‘hash value’ of the transaction, you can add to the ledger. It will transmit this data to all of the other nodes in the network who will also verify its validity.
The process of mining rewards a successful node with a “block reward” which is usually in the form of newly mined tokens.
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. For instance, as a positive, a bad actor might 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. On the other hand, the energy costs of POW blockchains such as Bitcoin led to criticism for having an 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 some other blockchains use (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.
Capice?
What is the Ethereum Merge?
Essentially, the Merge is the shift from POW to POS without closing down the Ethereum network.
You know I like an analogy. The more tortured the better. So here goes…
It is therefore the equivalent of changing a car from an combustion engine to an electric whilst driving down the M6 toll.
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.
Two separate blockchains?
You do ask a lot of questions.
Of course, one of these is the current blockchain which is officially called the Ethereum Mainnet. Alongside this, for some time, there has been a ‘shadow’ POS version of the blockchain called Beacon Chain.
Now the Merger has taken place, the POS blockchain has taken over.
One immediate result from the shift to POS is a 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!
However, the resulting coin, referred to as Ethereum 2.0, is not a new token.
What are the 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
Although we do not know for certain, the Merge might result in a fork of the Ethereum blockchain.
A fork might 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.
Blockchain forks have happened before with, most famously, with Bitcoin Cash being a fork of Bitcoin. Ethereum itself has previously undergone a hard fork in the past which resulted in the creation of Ethereum Classic or ETC (no relation!)
The rumour is many Ethereum miners are somewhat anxious about these developments (I can’t think why – other than they have warehouses full of much less profitable mining rigs.) As a result it is expected that there will be a ‘hard fork’ in the blockchain with the disgruntled miners keeping on their digital mining helmets and continuing to mine the token on their own version of the blockchain. This will be done by ETHW Core 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. As such, the costs for capital gains purposes will need to be split between the old and new tokens on a just and reasonable basis.
Conclusion
Undoubtedly, the move for Ethereum from POW to POS will be 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. In reality, Ethereum and Cardano are in a league of their own, with the others merely also rans.
Further, Ethereum is the father and / or mother of NFTS and, anecdotally, they say many potential investors were reluctant to explore this world of Bored Apes and Cool Cats because of the environmental concerns. The Merge may assuage this objection.
If you have any queries about the Ethereum Merge, tax on cryptoassets, or tax in general then please do get in touch.
For further resource on crypto assets please see www.cryptotaxdegens.com.
