To treat staking rewards that have as their source newly minted tokens resulting from inflationary monetary policy as taxable income at the point of distribution without including the impact of dilution results in systematic over-taxation and in some cases, impossible accounting burdens.
Overall, the article recommends an amendment to the ATO’s current taxation of blockchain assets in its policy as it relates to staking rewards. The acquisition of staking rewards should not be treated as an income realisation event. Staking Rewards should be considered akin to new property and should be taxable on disposal
Minted staking rewards dilute ownership in the underlying blockchain technology
During the early stages of blockchain development, the main source of staking rewards is a token reserve that forms the basis of an incentive mechanism crucial to the development and operation of a decentralised PoS blockchain. Without this incentive a decentralised blockchain most likely would not exist. It is wrong however to think of staking rewards that have as their source newly minted tokens resulting from inflationary monetary policy as taxable income at the point of distribution. To do so results in systematic overtaxation and in some cases impossible accounting burdens. In the context of staking rewards, overtaxation is defined as the excess of income under a strict income realisation approach that does not include a dilution component, compared to true economic income inclusive of dilution.
Perhaps this point is justifiably misunderstood because of the way in which staking rewards have been represented to provide a passive income. However, this is not the case. Or, if it is the case then this must be established as a question of fact based on an analysis of the source of the token rewards. When one looks more closely at the sources of staking rewards during the development period that tokens are minted from a token reserve, then this is as much a dilution of one’s holdings in the underlying technology as it is an income realisation event. In short, it is never a strict income realisation event, it also has the impact of generating a loss due to the addition of new tokens (ownership units) to the total supply.
Cryptocurrencies consist of several tokens (units of accounting) in a network. If one accepts the uncontroversial premise that the value of a cryptocurrency network does not depend on the exact number of tokens it contains, then the creation of new cryptocurrency units results in dilution. Unlike random fluctuations in network value, which can give rise to both capital gains and losses, this dilution is sure to happen and sure to be detrimental to a taxpayer’s wealth.
To state the issue of ‘dilution’ as it relates to the minting of new coins in more technical terms, the capital appreciation of a stakeholders stake in the underlying asset (i.e., the blockchain technology) needs to be split into two components:
the change in the whole value of the asset proportional to the stakeholder’s initial share and
the dilution component, defined in terms of the current asset value multiplied by the change in the fraction owned because of the minting of new coins – independent of any purchases or sales by the stakeholder.
To treat the minting of new tokens as only an income event and not to also include the impact of dilution is to systematically overstate the net income of the stakeholder. In some cases, the overtaxation of stakeholders in PoS blockchains is having a detrimental effect on the adoption of this ground-breaking technology. In others, pegging a calculation of income derived from such tokens to their market value at the point they are minted results in a tax on a token whose value is mostly speculative and subject to extreme swings of market value. In some cases, this can lead to the liquidation of an investors capital in order to pay the assessed income on staking rewards.
It will be appreciated that the issue of dilution as it relates to minted staking rewards raises several accounting questions for which there is no one simple answer on the best method for resolving this problem.
Work has been conducted in the United States jurisdiction on the issue of dilution as it relates to staking rewards. This work provides a summary of the possible different accounting methods that deal with
the dilution of a crypto tokens aggregate network value
the taxpayer’s ownership balance and
the rate at which dilution happens – all of which vary over time.
This is not the place to provide an analysis of each of these methods, suffice it to say that while it is concluded that any one of the methods proposed is preferable to an approach of strict income realisation that ignores dilution entirely, the approach that is said to make the most accounting and legal sense is that the acquisition of minted reward tokens should not be treated as an income realisation event. Rather, such an event should be postponed until the minted token is disposed of. Where this is done the taxable income would include both the value of the minted token at the point of distribution plus the capital appreciation or depreciation. Under this approach the impact of dilution would be priced into the change in capital value.
Minted token rewards are new property and taxable on disposal
To conclude this article, the only amendment recommended to the ATO’s current taxation of blockchain assets is its policy as it relates to staking rewards. It is accepted that for tax purposes, blockchain tokens are property and not currency and that the sale of a token may be a taxable event, just like the sale of any other property. It is also accepted that a purchased token will result in a taxable gain if and when it is sold at a higher price, and like the sale of a token, a taxpayer’s receipt of an existing token may also be a taxable event. Likewise, a token sent from one person to another as a payment or compensation for services will be that recipient’s taxable income, at its proper dollar valuation. As is the case with other forms of existing property (e.g., an ounce of gold, or a bushel of wheat) a digital token can be taxable income, just like dollars.
However, the question raised by this article, and one which goes to the root of the incentive structures that underwrite the security and long-term growth of PoS protocols, is the tax treatment of newly minted tokens, in particular the tokens commonly called staking rewards. As has been pointed out, the use of newly minted tokens as a basis of rewards is not only crucial to incentivising early adoption of the technology but also the good behaviours necessary to building a blockchain ecosystem.
Understood as new property, essentially property not received from someone else as payment or compensation, or as payment of interest or profits, but newly created or discovered by the taxpayer, staking rewards that are the result of an inflationary monetary policy are never immediate income to its first owner. Understood as new property, minted tokens should give rise to taxable income when they are disposed. At that point the calculation of the tax does not need to carry forward the dilution of ownership as it is built into the market price at disposal. Property in this sense comes into existence all the time: when crops are grown, livestock born, minerals mined, canvases painted, truffles unearthed, widgets manufactured, books written. As new property minted staking rewards gives rise to taxable income when disposed, not when created.
Source: Harry Hoang | CEO of Tailored Accounts
Discover the highly volatile and risky market of cryptocurrency. Uncover the debate on whether staking rewards should be considered income in the eyes of the ATO.
Staking rewards for both delegators and stake pool operators are taken from two sources: the Reserve and Transaction fees. Staking rewards generated from the two sources change in relevance depending on the stages in the development cycle a PoS blockchain is in.
