Canadian Tax Implications of The Ethereum Merge: A Guide from a Canadian Tax Attorney

The Long-Awaited “Ethereum Merge” a Success – An Introduction

The Ethereum blockchain was successfully upgraded on September 15, 2022, to switch from its previous “proof-of-work” approach, which relies on what is frequently referred to as “cryptocurrency mining,” to a “proof-of-stake” mechanism for confirming transactions. The Merge was a considerably more fundamental modification to the Ethereum architecture than earlier protocol upgrades to the blockchain, which sought to enhance the functioning of the blockchain. Its execution needed collaboration from a large number of developers and volunteers. Through the total elimination of energy-intensive Ethereum cryptocurrency mining, the “Merge” promises to boost ETH transaction speeds, scalability, and Ethereum’s readiness for further improvements as part of the Ethereum 2.0 roadmap.

A spike in interest in ETH from seasoned cryptocurrency investors and former market doubters is anticipated to occur after the Merge, just as it did prior to the successful changeover. However, how Ethereum is treated under Canadian tax law may also be changing for cryptocurrency users, investors, and dealers in Canada. The effects of a proof-of-stake paradigm and your future decision to use, hold or trade Ethereum as a Canadian taxpayer are once again hot topics. Should you be an individual or business in Canada who holds or transacts Ethereum, speaking with our expert Toronto tax lawyers might be highly necessary to discuss the possible tax consequences of your purchases and investments after the Merge, and the tax issues as a result of the shift from proof-of-work to proof-of-stake as a previous cryptocurrency miner.

What Exactly Was the Ethereum Merge, and What Did It Achieve?

A decentralized ledger system also referred to as a “blockchain,” is used by cryptocurrencies, in general, to record international transactions even without a central intermediary. Cryptocurrencies rely on consensus mechanisms fueled by user and developer activity to manage a decentralized ledger, check transaction authenticity, and protect the cryptocurrency network for others.

Ethereum used a “proof-of-work” model before the Merge to validate transactions that were added to the blockchain. In a rather broad sense, this required individuals (“miners”) to devote enormous computer processing power toward solving cryptographic riddles. After successfully resolving that arbitrary puzzle and adding transactions to the decentralized ledger, a miner would then be rewarded with cryptocurrency units. This helped guarantee the subsequent transactions recorded on the blockchain were genuine. The proof-of-work methodology has most often been connected with Bitcoin (“BTC”), which continues to have the greatest market cap among cryptocurrencies.

For many years, Ethereum developers had considered adopting a different “proof-of-stake” consensus mechanism. In a proof-of-stake model, network validators essentially consent to bind a specific quantity of cryptocurrency to a smart contract (holding the tokens in escrow) for a specified amount of time to become authorized validators. Validators are chosen at random from a pool of qualified users to check blocks received from other users or to build new blocks to report to others for posting. When a validator successfully validates a transaction on the network, they are rewarded. However, they run the risk of losing staked tokens under the terms of the smart contract if they neglect to maintain the hardware necessary to validate transactions, abstain from participating as needed, or maliciously contradict other validators. Therefore, a proof-of-stake model does not depend on miners with great computing capabilities to solve puzzles and earn token payouts. Instead, a proof-of-stake model counts on users to contribute their current holdings to keep the cryptocurrency network running.

After years of research and public testing, Ethereum developers, users, and enthusiasts collaborated to modernize the Ethereum blockchain by converting the cryptocurrency from a hybrid proof-of-work paradigm to a pure proof-of-stake model. To enable validation efforts on the Ethereum main network using proof-of-stake techniques, a new proof-of-stake layer (the “Beacon Chain”) was introduced in December 2020 to run separately from and in parallel to the proof-of-work layer that Ethereum has relied on since its inception. The Merge permanently replaced proof-of-work with proof-of-stake on the main network by merging the proof-of-work layer with the Beacon Chain.

Canadian Tax Effects of the Merge

The Canada Revenue Agency (“CRA”) has issued relatively little guidance about the taxation of cryptocurrencies in Canada, and the Canadian government has only passed a minor amount of legislation pertaining to cryptocurrencies and cryptocurrency transactions. Furthermore, no decision has been made by a Canadian court regarding the taxation of cryptocurrency transactions, investments, or trading practices. The tax implications for earning Ethereum using a proof-of-stake consensus method as opposed to a proof-of-work model raise complicated issues regarding the nature of the investment and any income generated from it.

Have there been any New Tax Obligations as a Result of the Merge?

The Merge changed Ethereum’s fundamental consensus mechanism, however, it had no effect on existing Ethereum holdings or caused any forks. A “hard fork” (also known as a “chain split”) is a modification to the blockchain’s underlying protocol that generates an equal number of tokens for cryptocurrency owners on two different blockchains that run on the original and modified protocols, respectively. The Ethereum blockchain split in 2016 as a result of security vulnerabilities relating to the smart contract software used by The DAO Project, and the development of Bitcoin Cash (“BCH”) and Bitcoin Gold (“BTG”) in 2017 are two of the most well-known instances of hard forks.

The fundamental characteristics of Ethereum as an asset or the quantity of tokens a Canadian taxpayer owns after the Merge remain unchanged. Because Canadian taxpayers have not received anything new, the Merge does not raise the same issues regarding income sources, cryptocurrency tax reporting requirements, or tax costs for new tokens that a hard fork may. As things stand, it doesn’t seem that the Merge has caused any new, unanticipated, or reportable tax debts for Canadian taxpayers who own Ethereum.

Are Staked Tokens Rewards Providing a Service or Acting as an Investment?

The Merge might, nevertheless, have an impact on future income reporting. Both business income from the sale of inventory and investment income received as a yield on the property are fully taxable forms of income for taxpayers under the Canadian Income Tax Act. However, only 50% of any capital gains in Ontario and across Canada from the sale of capital assets will be counted toward a taxpayer’s taxable income. From a Canadian taxpayer’s standpoint, the categorization of income as capital gains is a considerable tax advantage.

Cryptocurrency owners verifying transactions under the new proof-of-stake model must put tokens up as collateral for the right to do so and earn the possibility to acquire Ethereum in exchange for their network contributions. It is by virtue of owning tokens and purposefully staking them that a cryptocurrency owner earns a return in the form of new tokens. This is comparable to a shareholder receiving dividends from a corporation’s income or many other types of securityholders receiving distributions of income.

Staking rewards may legitimately be considered investment income under the Income Tax Act and hence be fully taxable. Additionally, in cases where it appears the owner is offering a service to offers by staking tokens to carry out validations, such rewards may be considered as business income. The level of Ethereum staking activity the taxpayer engages in and whether that activity shows a more passive or active engagement to earn income may be factors in making this assessment. In either situation, business income and investment income are regarded under the Canadian Income Tax as fully taxable income. As a result, taxpayers’ taxable receipts for that tax year include the entire fair market value of any cryptocurrency they receive as a reward at the time the tokens are received. To avoid double taxation upon a later disposition of the tokens, the tax cost of those awards tokens could therefore be increased appropriately under the Income Tax Act.

Whether that latter disposition of tokens counts as business income or a sale of capital property with a capital gain requires further analysis. Income is classified as coming from a company or investment, or as capital gains, according to comprehensive Canadian common law, and this analysis is quite fact-specific. The following conditions determine whether a property sale is viewed favourably as a capital sale, as a component of a trading firm, or as a fully taxed “adventure or concern in the nature of trade,” among others:

• The type of the sold property;
• The taxpayer’s ownership period’s duration;
• The regularity or quantity of other similar transactions by the taxpayer;
• The time spent working on or in relation to the property realized;
• The circumstances leading up to the sale; and,
• Most importantly, the purpose for which the taxpayer acquired the property and sold it.

That is to say, there are numerous factors that will influence whether your motivations and Ethereum trading activities constitute business income or capital gains. The determination of this issue will necessarily involve your decision to stake Ethereum, the level of your engagement in Ethereum staking, and any other cryptocurrency transactions you engage with. This is a particularly pertinent point in light of the Merge and how it fundamentally changed the process of creating new Ethereum tokens.

For the purpose of determining the tax status of your sales of Ethereum, it is also important to consider your motivations for engaging in Ethereum transactions both before and after the Merge. There are two ways an Ethereum Miner, although not a pure hobbyist, may be reasonably classified before the Merge:

1. The miner ran a cryptocurrency trading business with the intention of making a profit, amassing inventory by mining, selling those reward tokens, and disclosing earnings after the tokens were sold; or,
2. The miner mined Ethereum with the intention of rendering services for a fee with the purpose of protecting the Ethereum network and obtaining reward tokens in exchange, which would later become taxable.

A miner’s mining activities and how he or she handles the tokens obtained via mining will determine whether the miner can be classified as running a business or offering a service. Tokens gained in exchange for staking Ethereum, however, do not behave like inventory acquired from mining and are a fully taxable receipt for a former Ethereum miner running a cryptocurrency business. It follows that any miner who starts to stake Ethereum will find that their reward tokens are taxed in the year they are received, regardless of whether they could previously be considered to be running a business or providing a service.

An additional presumption that an Ethereum miner still has the primary goal of making a profit may have to be disproved if the miner continues to operate a business and engage in Ethereum activities after the Merge by switching to Ethereum staking. The miner may still be found to be running a cryptocurrency trading business while staking Ethereum, and the staked tokens may still be considered inventory rather than capital property depending on factors like prior experience and knowledge with cryptocurrencies, as well as the miner’s history of gains and losses from trading cryptocurrencies. Nevertheless, it should be conceivable to characterize staking as related to investment activity, which would eventually result in capital gains on the sale of those staked tokens, when the miner’s behaviours and motivations alter sufficiently to overcome the presumption of business activity.

There are even greater tax repercussions for a miner who is now using redundant hardware and earning business income. The Income Tax Act mandates that any proceeds of sale in excess of the undepreciated capital cost of any capital property that a taxpayer disposes of being included in income (also known as “recapture”), which may result in a higher tax liability. However, the value of electronics and computer parts depreciates very quickly, thus any sale would almost certainly result in a loss. The Income Tax Act permits a taxpayer to write off any terminal loss upon the sale of a capital asset if the sale revenues are less than the property’s cumulative capital cost allowance. A miner should immediately get rid of any redundant hardware to reap any tax benefits that follow from its value loss.

Finally, if a former Ethereum miner stakes Ethereum for investment purposes with regard to those staked Ethereum tokens, a deemed disposition may also be brought about. It may be deemed a disposition and the miner may be required to pay tax if the miner changes the usage of tokens from inventory for sale by a business to the capital property for staking to earn investment income through reward tokens.

Tax Pro Tip: Figure Out How your ETH Staking and Disposal will be taxed.

Government regulatory authorities have continuously raced to extend and improve enforcement operations to combat tax evasion following the quick rise in public awareness of cryptocurrencies like Ethereum in 2015. In order to specifically look into tax evasion related to cryptocurrencies, the CRA joined the Joint Chiefs of Global Tax Enforcement (“J5”) in 2018. The CRA has made active attempts to find unreported assets and income belonging to taxpayers by conducting tax audits pertaining to cryptocurrency transactions and conducting external investigations.

For taxpayers, and particularly for taxpayers who have cryptocurrencies, the CRA crypto tax audit process is a very intrusive, challenging, and time-consuming process. The CRA may request thorough cryptocurrency records that include a timeline of transactions, the sources of the money used to buy tokens, and any potential passive income that was made while holding the cryptocurrency. You may be subject to reassessment if CRA determines that your records are unreliable or that you incorrectly reported revenue as capital gains rather than business income from trading. This might result in unanticipated taxes as well as possible penalties and interest.

It is certain that the CRA will continue to step up its enforcement actions in light of the Ethereum Merge, the rise of NFTs as investment vehicles, and the growing popularity of cryptocurrencies. It is your obligation as a Canadian cryptocurrency investor to keep accurate records of your cryptocurrency deals and trades, including your staking income and any other cryptocurrency-related activity you may engage in. You should consult with one of our expert crypto tax lawyers in Canada for guidance and legal representation if you are involved in Ethereum trading or staking or if the CRA is auditing your cryptocurrency transactions.

FAQs:

1. What exactly was the Ethereum Merge?

The Ethereum Merge was a successful collaborative community effort to update the Ethereum blockchain by changing the previous “proof-of-work” approach for Ethereum transaction verification to a “proof-of-stake” model. After the Merge, all additional Ethereum tokens are created through staked Ethereum holdings rather than mining in order to power the blockchain consensus process. Users of Ethereum were not affected by the upgrade in the same way that a hard fork would have been.

2. What Aspects Help in Determining Whether Income Is a Capital Gain or Income from a Business?

A multi-factored approach may take into account (but is not limited to) the following factors when determining whether income is derived from capital gains or from a business: The type of property sold, how long the taxpayer owned it, how many times or how many times they had similar transactions, how much time was spent working on or in connection with the property realized, what conditions led to the sale, and why the taxpayer bought the property and decided to sell it.

3. What Tax Effects Will There Have If I Switch from Cryptocurrency Mining to Cryptocurrency Staking?

First, an Ethereum miner’s prior history and ongoing engagement with Ethereum will determine whether the sale of staked tokens results in income or capital gains when disposed of. A former Ethereum miner who switches to Ethereum staking will need to consider if their activities still have the same business-like nature or now show a focus on investing. Second, no token payouts from staked Ethereum will be treated like inventory and instead will be taxed upon receipt, as was the case in the past for Ethereum miners running a business. Third, to benefit from any drop in value for tax purposes, depreciable mining hardware should be sold as soon as possible. Fourth, if a miner wants to switch to investing, a change in usage of Ethereum tokens that were previously classified as inventory and are now used to earn returns through staking may result in a deemed disposition.

About the Author

---

David J. Rotfleisch

David J. Rotfleisch, a leading Canadian tax lawyer, is not only a certified specialist in taxation but also a chartered professional accountant. Most recently, David is a pioneer in Canadian crypto taxation.

As of April 2020, he was one of 12 Ontario Certified Specialists In Taxation™.

Learn more about David J. Rotfleisch