Latest cryptocurrency update from HMRC

When we first posted about the UK tax treatment of cryptocurrency there was very little guidance from HMRC. Whilst HMRC were initially unresponsive, they are now reacting more quickly to changes in the crypto landscape. This is evident from the latest cryptocurrency update from HMRC covering proof of stake and proof of work transactions. 

Overview

Before delving into the specific tax treatment of PoW and PoS, let's briefly revisit how HMRC has traditionally approached the UK taxation of cryptocurrency taxation. Essentially, cryptocurrencies like Bitcoin and Ethereum are generally considered taxable digital (or intangible) assets.

Therefore any gains realised from their disposal are subject to capital gains tax (CGT). Additionally, cryptocurrency transactions may also be subject to income tax or corporation tax, depending on the individual or entity's circumstances.

Previously HMRC have published controversial guidance on De-Fi transactions. This latest cryptocurrency update from HMRC is arguably far more straightforward.

What is proof of work and proof of stake?

One of those unique activities in the world of crypto is the consensus mechanism used to validate and secure transactions on a blockchain network. Proof of work (PoW) and Proof of Stake (PoS) are the two most prevalent mechanisms in the crypto space.

Proof of work (PoW)

Probably the most well known consensus mechanism for cryptocurrencies (chiefly Bitcoin) is proof of work (PoW). This requires crypto miners to solve complex mathematical puzzles in order to validate transactions and create new blocks.

Those Miners in PoW systems are ultimately rewarded for their work by receiving newly created cryptocurrency tokens and transaction fees for their work. This process is more commonly known as ‘mining’ and serves to maintain the network of a specific cryptocurrency.

Proof of stake (PoS)

The other prominent consensus mechanism is known as proof of stake (PoS). This requires a person to lock up (stake) cryptocurrency tokens in the protocol for a determined period of time (this is known as the ‘stake’). Those individuals and businesses that participate in these type of transactions are commonly referred to as validators.

When it is time for a new transaction to be validated, the protocol randomly selects a stake. The larger the stake, the greater the potential for it to be selected. The validator who originally provided the selected stake is then required to validate the transaction on the distributed ledger. 

If the validated transactions are legitimate then the validator is entitled to any fee available for validating those transactions.  They might also be allocated a quantity of new cryptocurrency that are then released into circulation. 

Conversely if the validator attempts to validate flawed or fraudulent transactions (or fails to validate any transactions at all) then they will be subject to a penalty. This process usually involves transferring a portion of their cryptocurrency to an unusable public address. This penalty process is sometimes referred to as ‘slashing’.

The tax treatment

The latest cryptocurrency update from HMRC emphasises that the tax treatment of cryptocurrencies, whether obtained through PoW or PoS, will continue to be assessed on the specific circumstances of the individual or business involved. 

Proof of work transactions

HMRC regards mined cryptocurrency  as income. Anyone rewarded with cryptocurrency as part of a PoW will be taxed on the £sterling equivalent of the cryptocurrency at the time of the award. If they receive this as individuals, miners will be liable to pay income tax on the value of tokens they receive. If they operate PoW activities  as a limited company, then corporation tax will apply to the mined cryptocurrency.

The same tax treatment will apply to any of those transaction fees that are paid in the form of cryptocurrency.

When miners dispose of their mined cryptocurrency or transaction fees paid in cryptocurrency, they may also be subject to Capital Gains Tax if the cryptocurrency has increased in value since  their acquisition.

Proof of stake transactions

HMRC considers that those cryptocurrency rewards received from PoS will be taxed as income in the £sterling equivalent. These rewards will either be subject to income tax for individual validators or corporation tax for validator businesses.

When validators dispose of their cryptocurrency rewards, they may also be subject to Capital Gains Tax if the cryptocurrency has increased in value since  their acquisition.

Are proof of work and proof of stake trading activities?

HMRC's latest tax update appears to indicate that the default position for any cryptocurrencies, whether obtained through PoW or PoS, is that they will be taxed as miscellaneous income. 

However proof of stake  introduces a risk to the validator that they will be permanently deprived of some of their cryptocurrency. In comparison, the risk to the miner in proof of work is that they will incur costs on producing the work, electricity and equipment, though ultimately never successfully solve the puzzle first in order to recoup those costs.

As with all cryptocurrency transactions HMRC will consider the specific circumstances of the individual or business involved and apply the badges of trade to determine whether these activities constitute a trading activity. So for example if there was sufficient financial risk involved (through significant investment in equipment) and there were a large number of transactions for a proof of work consensus mechanism it could be argued that this is a trading activity.

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