Ethereum completed its highly anticipated Merge on September 15th, 2022, at 6:43 AM UTC. The Merge changed Ethereum’s consensus mechanism from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) system. If you held Ether (ETH) on the PoW chain, you didn’t have to do anything to transfer those tokens to the PoS chain. Your coins were automatically upgraded onto the PoS chain as a part of the Merge.
The purpose of the Merge was to have one unified Ethereum blockchain operating under a PoS consensus mechanism. However, a group of miners decided not to comply with the PoS chain and created two new PoW chains (EthereumPoW (ETHW) and EthereumFair (ETHF)) that also contained the history of the original ETH blockchain. The diagram below illustrates the aftermath of the Merge.
We previously discussed the tax implications of the legacy chain’s transition into PoS in our Ethereum 2.0 tax guide. Ethereum’s transition from a PoW to a PoS chain is akin to a soft fork which is not taxable under the IRS guidance (IRS FAQ 30). However, the emergence of ETHW and ETHF chains (in addition to the PoS chain) and the creation of new coins (ETHW & ETHF) arguably create a hard fork event, which is taxable.
As you can see in the diagram above, ETHW and ETHF split from the existing Ethereum blockchain after the Merge, creating two new separate chains. They share the same history and blockchain up until the split. As a result of this hard fork, everyone holding ETH tokens before the split automatically received an equivalent amount of the newly created cryptocurrency.
For example, if you had one ETH in your wallet before the Merge, you would automatically receive one ETHW and ETHF after the hard fork. This event can have different tax consequences depending on your country.
US taxation of hard forks
US taxpayers can refer to IRS FAQs 22-25 and Rev. Rul. 2019-24 to determine the tax implications of receiving ETHW & ETHF coins.
A hard fork results in ordinary income when you can exercise dominion and control (D&C) over the asset (not when you exercise D&C). In simple terms, D&C is established when you have the ability to transfer, sell, exchange, or otherwise dispose of the cryptocurrency.
Where you hold crypto assets can have a significant impact on when D&C is established and the timing of your income.
Cryptocurrency held in accounts managed by exchanges
If you held ETH on an exchange, you would gain D&C when the exchange credits the new asset (ETHW or ETHF) to your account, and you have the ability to transfer, sell, exchange or otherwise dispose of the cryptocurrency. (Usually, it takes some time for exchanges to support the new coin and give you D&C over it.) Some exchanges might report this income on Form 1099-MISC box 3 as “Other Income.”
Say Chris held 1 ETH on a centralized exchange account. Although the fork occurred on September 15th, Chris did not get access to his ETHW until October 1st, 2022. When Chris got access to ETHW, it was trading at $10 a coin. Here, Chris gains D&C on October 1st, 2022, and needs to report $10 of ordinary income.
Currently, exchanges have varying degrees of support for the forked chain and the resulting coins.
Cryptocurrency held in self-custodial wallets
If you held ETH in a self-custody wallet at the time of the Merge, you are deemed to have D&C over ETHW and ETHF at the time those chains emerged, and you had the ability to transfer, sell or dispose of the new asset. This is when you can theoretically exercise D&C over the new asset.
For example, Chris held 1 ETH on his MetaMask account. The ETHW and ETHF chains originated on September 15th, 2022. On this day, ETHW and ETHF were trading at $10.58 and $17.45, respectively. Chris learned about the hard fork on September 25th and added the chains to his Metamask wallet when ETHW and ETHF were trading at $11.39 and $2.03, respectively. Chris theoretically had D&C over assets on September 15th, even though he didn’t know about them yet. Therefore, Chris should report $10.58 ordinary income from ETHW and $17.45 ordinary income from ETHF. These would also be the cost basis for these coins.
Suppose Chris sold his ETHW for $15 on September 30th. Here, Chris would have a $4.48 ($15 - 10.58) short-term capital gain.
Canada taxation of hard forks
The CRA hasn’t officially issued direct guidance on taxing hard forks and airdrops. However, we can use general tax rules to infer how hard forks may be taxed.
If you are in the business of mining or trading cryptocurrencies, the value of the new coin at the time of receipt will be treated as income. Individual investors may not face any taxable income due to hard forks. To compute the adjusted cost base (ACB), you will use any expenses related to the acquisition of the property. The cost to acquire a hard-forked asset is $0. When you subsequently sell the hard-forked token, it will be subject to capital gains tax.
Australia taxation of hard forks
The Australian Taxation Office (ATO) has issued clear guidance on hard forks. According to ATO guidance, you will not have to report any income due to hard forks; you will have to report capital gains when you later sell the coin.
For example, Adam received 1 ETHF after the hard fork. Here, Adam doesn’t have to report any income. The cost basis of ETHF is zero. If Adam sells this coin later for $1,000, he will have a $1,000 ($1,000 - $0) capital gain.
UK taxation of hard forks
HM Revenue and Customs (HMRC) have also issued guidance on blockchain forks. Each cryptocurrency must enter its own Section 104 pool when a hard fork occurs. Any allowable costs in the original cryptocurrency (ETH) are split between the two Section 104 pools for the original and the new cryptocurrency. The cost must be divided on a “just and reasonable basis.” HMRC don’t prescribe any particular apportionment method. If your exchange chooses not to support the new cryptocurrency, you may seek to apportion all the allowable costs to the original token.
India taxation of hard forks
It is not entirely clear how the Income Tax Department (ITD) views hard forks as they have not released any specific guidance. You could argue that a hard fork is similar to a gift because you didn’t have to do anything to receive the new cryptocurrency; all you had to do was own the original cryptocurrency that it forked from. A gift is taxed to the receipt only if it exceeds Rs. 50,000. If the amount you received from the hard fork is greater than Rs. 50,000, it would be taxable under this approach.
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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.