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Taxing Blockchain Staking Rewards (Part 1 of 3)

Author: Tailored Accounts

Executive Summary

  •  Agree with the Australian Tax Offices’ taxing of cryptocurrencies except for staking rewards.
  •  Current taxing of staking rewards does not accurately reflect underlying mechanisms of a Proof of Stake blockchain, attitude and purpose of investors who stake and can be detrimental to financial liquidity of investors.
  •  Staking rewards are akin to the creation of new assets, not proportional allocation of annual profit (as share dividends would be), therefore should be taxed on sale only, not distribution.

Blockchain stakeholders weather the storm of extreme volatility and risk

While many speculators buy and sell cryptocurrency for profit, another group of investors in blockchain assets enjoy the returns created through staking rewards. Staking rewards are part of the architecture of a Proof of Stake (PoS) blockchain and are designed to incentivise token holders and validators to secure PoS networks and promote good behaviour and decision making. From the perspective of blockchain technology, the main rationale behind staking rewards is not the short-term gain of stakeholders, but long-term capital appreciation resulting from good decisions and the value creation of a blockchain ecosystem.

A long-term investment strategy in blockchain assets, however, is not for the faint-hearted. Long-term token holders are generally called “hodlers” because they endure the wild swings (of up to 90%) on the crypto market by ‘holding on for dear life’.  Furthermore, as the chairman of the Australian Security and Investment Commission (ASIC), Joe Longo, recently warned Australian citizens, cryptocurrencies are not defined as ‘financial products’ and therefore are not afforded the protections of ASIC laws. This means, according to Longo, that there are no reimbursements or insurance against scams, hacks, or artificial volatility risks to be guaranteed by the government as it is with the traditional financial market(1).

The ATO taxes staking rewards at the point of distribution

To add to the burden of high volatility and risk the Australian Taxation Office (ATO) has ruled that staking rewards are deemed income at the point of distribution for the purposes of s15.2 of the Australian Income Tax Assessment Act 1997. The assessment of taxable income is based on the market value of the tokens at the point of distribution, and if the market value of the asset is greater at the point of disposal than at the point of distribution, it is also subject to a capital gains tax. As the implications of this ruling gradually impact investors in blockchain assets, it is clear a discussion needs to occur on whether this policy is having its intended effects, and whether, in fact, staking rewards are income at the point of distribution. 

To anyone who is unfamiliar with the staking rewards system, the ATO’s ruling might seem an obvious and fair conclusion. After all, isn’t the crypto investor receiving payment for staking their holdings on the blockchain? Isn’t it a form of income derived from an investment? As is commonly recognised, such returns are deemed income whether payment is made in Australian dollars or another form of property, such as crypto tokens. This conclusion is only partially correct. It is true that staking rewards are a form of income and are linked both to an investment and to a service, however, as a question of fact, staking rewards are not generated out of profits, and do not represent a payment of interest on an investment, nor are they strictly speaking a ‘distribution’, staking rewards are generated from two sources that change in relevance depending on the stage a PoS blockchain is in its development life cycle. 

Staking rewards are generated from two sources that change in relevance depending on the stage a PoS blockchain is in its development life cycle, a topic that shall be expanded upon in our next newsletter.

[1] ASIC’s warning to crypto investors: you’re on your own ASIC’s warning to crypto investors: you’re on your own. (2021). Retrieved 9 March 2022, source link
 

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