Staking has become one of the most popular ways to earn a passive interest in the growing crypto ecosystem. However, regulators are now catching up, with the likes of the U.S Securities Exchange Commission (SEC) and Internal Revenue Service (IRS) narrowing down to Decentralized Finance (DeFi) projects. Most of these innovations have been built on the Ethereum blockchain and leverage a Proof-of-Stake (PoS) consensus to function effectively.
As such, the nascent DeFi innovations depend on staking to keep their networks operational and secure. Staking replaces the mining approach used by Proof-of-Work (PoW) blockchains with network validators, eliminating the need for intensive computational power. Ideally, Network validators in PoS networks commit their tokens to support transaction validation and security in return for network incentives.
With so much activity in the past year, DeFi and staking caught the eyes of global regulators and financial watchdogs. The IRS is among the tax agencies that seem to be taking a rigorous approach and will likely have more authority once the controversial infrastructure bill comes into action.
Currently, the IRS recognizes staking rewards as taxable income upon token creation. This means that crypto users who receive native tokens for staking their digital assets are required to report for taxing as soon as they receive the rewards. A stance that goes against U.S history, where the newly created property is not subjected to taxable income.
Settling the Scores
The uncharted crypto waters have plenty of fish to catch, but it now seems that the taxman wants his cut. Before jumping into the nitty-gritty, it is to understand how these staking platforms work and why some stakeholders view them as threats. For that, let’s take the example of YeFi.one, a DeFi staking platform that allows users to earn a passive interest by depositing crypto assets through the YeFi decentralized application (DApp).
Unlike traditional financial ecosystems, YeFi.one introduces a decentralized ecosystem where anyone with a compatible Binance Smart Chain (BSC) wallet can participate as a node validator. The platform uses smart contracts as the middleman, with pre-coded conditions that allow users to stake their crypto assets for one day or fifteen days. In return, the YeFi.one stakers are rewarded with network incentives.
This classic example of a DeFi staking platform brings us back to the issue of rewards taxation. At what point are the rewards allocated to YeFi.one stakers taxable? Going by the current IRS approach, staking rewards allocated to YeFi.one users should be reported upon token creation, with the taxable income pegged on the prevailing market price of the reward token.
While the IRS appears to have the upper hand, a recent filing in the Tennessee federal court has challenged the taxation of staking rewards upon token creation. The lawsuit was filed by Joshua Jarret, who has been staking on the Tezos blockchain. According to the plaintiff’s attorney, the IRS has no authority to tax Jarret’s newly minted tokens, given that they fall under new property and should only be considered for tax once they are sold or exchanged.
Like any property, cryptocurrency tokens can be income when they’re received as payment or compensation. But these newly created tokens are like crops harvested by a farmer — which are not taxed until they are sold.
said Jarret in a press release.
Crypto Staking Taxes in Other Jurisdictions
It is not only in the U.S where taxes on crypto staking are a contentious issue. The United Kingdom, through Her Majesty’s Revenue & Customs (HMRC), updated its tax treatment of crypto assets to incorporate staking.
This new update confirmed that passively earned digital assets would be taxed under capital gains or corporation tax on chargeable gains upon discharge to other parties. Notably, the HMRC also provided additional guiding requirements for the crypto assets to be subject to tax. The listed factors include the degree of activity, risk, organization, and commerciality.
In Australia, the country’s tax agency ATO recognizes staking rewards as ordinary taxable income at the time of receipt. Consequently, Australians who receive network rewards for acting as validators in PoS blockchain ecosystems must report within the income year they receive the staking rewards.
Many are still at the early stages of formulating a comprehensive tax regime for crypto assets as far as developing countries go. It will probably take some time before they catch on to more complex income sources such as staking.
Cryptocurrencies are still primarily an experimental niche; however, the potential in this upcoming asset class cannot be ignored. This calls for stakeholders from all sectors to collaborate towards creating a sustainable industry that plays by the book. As tax agencies navigate these murky waters, it would be best to liaise with industry participants to strike a balance. In doing so, cryptocurrencies will likely thrive and ultimately increase the tax base of most economies.