Pre-qualification and categorisation of block rewards of cryptocurrency consensus mechanisms in Swiss tax law
Marcel R Jung of MLL Legal analyses the perspectives of two Swiss federal governmental bodies – along with several academic and legal sources – on the taxation of rewards earned by blockchain trans-action validators.
Switzerland is one of the leading locations in the areas of distributed ledger/blockchain technology. A growing fintech and blockchain ecosystem has developed in Switzerland, particularly in the financial sector. This article explains and analyses the Swiss tax guidelines with regard to the qualification and categorisation of block rewards of mining and staking consensus mechanisms in Swiss tax law.
The taxation of income requires pre-qualification under Swiss private law and subsequent categorisation under Swiss tax law. For these qualification and categorisation purposes, it is important to understand how cryptocurrency consensus mechanisms technically operate.
2. Operation of cryptocurrency consensus mechanisms
Transactions on a blockchain must be validated and verified by the network participants (nodes). Each blockchain has its own consensus mechanism, which ensures the agreement of all participants about their data.
Two widely used mechanisms are proof of work (PoW) and proof of stake (PoS). These mechanisms are used to select the validator of a transaction. The validator receives for such validation a block reward that is newly created units of the cryptocurrency of the protocol. Block rewards may include transaction fees paid by the user whose transaction is validated.
2.1. Proof of work
The network participants select a block of transactions from the protocol’s pending transaction pool, compare the proposed transactions to the existing blockchain and validate the transactions.
In the PoW cryptocurrency protocol (e.g., Bitcoin), the right to validate new transactions and add them to the blockchain is allocated to the validator, who computes an acceptable solution to a cryptographic puzzle. It is the computational process for solving the cryptographic puzzle that is energy intensive.
If the validation process is verified by the other network participants, the proposed block is added to the blockchain and the validator is rewarded with newly created units of the cryptocurrency. If the proposed block is rejected, the network participant does not receive a reward.
The other network participants who are not selected do not receive a block reward but have sunk expenses from the unsuccessful cryptographic puzzle computational process and the validation computational process.
Trust is given to the network participant who is chosen because they can solve a cryptographic puzzle. The reward is received for validating the block and not for solving the cryptographic puzzle.
2.2. Proof of stake
In the PoS cryptocurrency protocol (for example, Tezos), the right to validate new transactions and add them to the blockchain is generally allocated to a network participant in proportion to the number of units of cryptocurrencies they stake with the protocol. Staking means that the network participant cannot transfer or otherwise use the staked cryptocurrencies for a certain period. Staking is a restriction on the disposal of cryptocurrencies.
The validation computational process is similar to the PoW consensus mechanism. Once allocated a validation right, the network participant selects a block of transactions, and compares and validates the transactions. If the validation process is verified by the other network participants, the proposed block is added to the blockchain and the validator is rewarded with newly created units. If the proposed block is rejected, the network participant does not receive a reward and their staked cryptocurrencies may be reduced (slashed) as a penalty.
Trust is given to the network participant who is chosen because they own, and have at stake, a significant amount of cryptocurrency. The staked cryptocurrencies are not transferred from the network participant to another network participant. The reward is received for validating the block and not for staking the cryptocurrencies.
2.3. Proof of stake delegation
Under the PoS cryptocurrencies protocol, a token holder may stake their cryptocurrencies and delegate their validation rights to a third-party network participant. The third-party validator generates block rewards by using the delegated validation rights in exchange for a percentage of the block rewards. Block rewards for delegated validation rights may be credited directly to the account of the delegator or the third-party validator.
If the proposed block is rejected, the third-party network participant does not receive a reward and the cryptocurrencies staked by the delegator may be reduced (slashed) as a penalty.
The staked cryptocurrencies are not transferred from the delegator to the third-party network participant. A percentage of the block rewards is paid in exchange for delegation of the validation rights and staking cryptocurrencies with the protocol.
2.4. Consensus mechanisms and block rewards
Under both cryptocurrency consensus mechanisms, the selection mechanism is not a lottery. The PoW protocol allocates the right to validate transactions to the network participant based on their ability to solve the cryptographic puzzle. The PoS protocol allocates the right to validate to the network participant based on a proportion of the number of units of cryptocurrencies they stake with the protocol.
Under both cryptocurrency consensus mechanisms, the validator receives newly created units of the cryptocurrency for the computational validation process.
3. Qualification of cryptocurrencies in Swiss civil law
There are two types of tokens from a Swiss civil law perspective.
3.1. Cryptocurrencies: factual intangible assets
Cryptocurrencies are tokens that primarily represent value (Vermögenswerte) within the blockchain (for example, cryptocurrencies such as Bitcoin). According to the prevailing position (for example, Mirjam Eggen, Sebastian Gobat, Müller/Reutlinger/Kaiser), cryptocurrencies represent factual, intangible assets. Swiss civil law does not impose any requirements for the transfer of cryptocurrencies. There is no contractual relationship between the token holder and the other users of the blockchain.
According to a minority position (von der Crone/Kessler/Angstmann), cryptocurrencies convey a claim to a token holder against all other users of the blockchain. According to this stance, a contractual relationship exists between the token holder and all other users of the blockchain. However, whether a contractual relationship can be concluded with non-identifiable persons is a disputed point.
3.2. Tokens: value rights and register value rights
Different from cryptocurrencies, value tokens (Wertrechte) represent a legal position (for example, claim, membership, right in rem). There is the possibility of electronic registration of these value rights, which are referred to as register value rights (Registerwertrechte) and the underlying register as a value rights register (Wertrechteregister).
4. Categorisation of block rewards in Swiss tax law
There are no special provisions and no leading rulings by Swiss courts for the taxation of distributed ledger/blockchain technology transactions and, in particular, block rewards of cryptocurrency consensus mechanisms.
The Federal Tax Administration published VAT guidelines in 2019 and a working paper in 2019. In 2020, the Federal Department of Finance published a report on a possible need to amend Swiss tax law. An updated version of the working paper was published in 2021. In addition, the Swiss Tax Conference, in cooperation with the Federal Tax Administration, published guidelines in 2021.
4.1. 2019 VAT guidelines
Payment tokens are designed as pure payment tokens and do not serve any purpose other than their use as a means of payment for the purchase of supplies from one or more suppliers. Payment tokens do not entitle the holder to purchase specific or determinable goods or services.
The guidelines state that there is no (identifiable) counterparty that pays a compensation for the receipt of a service if the validation activity is compensated exclusively by means of newly created cryptocurrencies. There is therefore no taxable relationship, which is why the block reward represents a non-remuneration. The validation is therefore not an entrepreneurial activity that triggers VAT liability and corresponding entitlement to input VAT deduction.
If the validation activity is compensated in the form of a transaction fee paid by the user whose transaction is validated via the blockchain to the validator, there is generally a taxable relationship between the user and the validator. If the validation activity is also compensated by means of newly created cryptocurrencies, this has no influence on the categorisation as exchange and the entitlement to input VAT deduction.
4.2. 2020 report
The report states that Swiss VAT law would have to be amended if the validation activity is to be qualified as entrepreneurial activity. However, an amendment cannot solve the difficulty of system anonymity or the identification of the recipient, which is why only the introduction of a tax exemption without an entitlement to deduct input tax would come into consideration. Such introduction would lead to a distortion, which is why the Swiss VAT law was not amended.
Likewise, the report identified no need for action regarding Swiss income tax. Only in the case of Swiss interest and dividend withholding taxes was a need for action identified, for the purpose of levying withholding tax on income from asset tokens. However, the Swiss tax law was also not amended and the developments should be observed.
4.3. 2021 working paper
Payment tokens are digital assets that are suitable for use as a means of payment. If the payment tokens were issued by an entity, the issuer has no obligation to the token holder to make a specific payment or provide a service.
Payment tokens are a tradable and intangible asset that is a movable capital asset. The buying and selling of payment tokens generally represent, in the case of private taxpayer, tax-free capital gains or non-deductible capital losses.
The paper states that newly created cryptocurrencies received in the context of PoW are taxable income. It refers to the general income charging provision but does not specify under which category of income the newly created cryptocurrencies fall in the hands of a private taxpayer. It further states that the newly created cryptocurrencies must be recognised as revenue from self-employment if the requirements for the self-employment activity are met.
The paper is inconclusive on newly created cryptocurrencies received in the context of PoS. It is merely stated that there must be an examination as to whether the individual acting as a validator meets the requirements of the self-employment activity. The paper, however, further states that expenses that are directly related to the generation of income and are necessary in the context of the administration of the assets may be deducted from the income of the movable property. Therefore, newly created cryptocurrencies in the context of PoS are also taxable income in the hands of a private taxpayer. Again, the paper does not specify under which category of income the newly created cryptocurrencies fall in the hands of a private taxpayer.
4.4. 2021 guidelines
The guidelines state that mining activities require a focused strategy and significant investment to generate sustainable profit. These activities generally lead to the fulfilment of the requirements of the self-employment activity. The guidelines do not explicitly state that block rewards must be recognised as revenue. That seems to be as a matter of course.
The guidelines further note that privately operating a computer to generate block rewards will not generally result in an excess of revenue over expenses. This activity is therefore considered as a hobby. Again, the guidelines do not explicitly state that block rewards are taxable income in the hands of a private taxpayer. That seems to be also as a matter of course.
The guidelines state that a private taxpayer will pursue staking activities for the most part in the form of a hobby. The investment required is limited. The guidelines refer only to the general income charging provision. The guidelines seem to assume that block rewards are taxable income in the hands of a private taxpayer. They further state that block rewards must be recognised as revenue from self-employment if the requirements for the self-employment activity are met.
The token holder who delegates the validation rights is generally considered to be a private taxpayer. The guidelines state that block rewards are taxable investment income from movable capital assets but do not specify under which category of income the block reward falls in the hands of a private taxpayer. The fees retained by validators are deductible asset management expenses.
The paper is inconclusive on Swiss withholding tax. A parenthetical note indicates that block rewards are income from capital assets. The guidelines seem to assume that the percentage of the block rewards falls under the category of interest under a staking delegation agreement.
5. Comparative law considerations
5.1. The manufactured property argument
In particular in the United States, academics (such as Abraham Sutherland) and taxpayers (Joshua Jarrett v United States, No. 3:21-cv-00419, M.D. Tenn. 2021) have taken the position that staking rewards received by a validator should not be included in gross income on the portion of newly created cryptocurrency. This position is mainly supported by the manufactured property argument. It is argued that the software that generates the new units of cryptocurrencies is not a person and, therefore, the new cryptocurrencies cannot be received in an exchange between persons. For that reason, the portion of newly created cryptocurrency is self-created property.
The manufactured property argument, however, has been rejected, for example, by the New York State Bar Association (see Report No. 1461, April 18 2022) and academics (such as Omri Marian). Although it is not clear whether an exchange exists, the comparison to an exchange in which network participants take part in an exchange is more convincing.
A similar position which has been taken – for example, in Germany (e.g., Bundesministerium der Finanzen) – assumes that all units of cryptocurrency are already embedded in the creation of the genesis block. In the context of the cryptocurrency consensus mechanism, the totality of the network participants grants the release of the already created units to the validator as a reward for the validation of the block. In this respect, there is a difference between the validator, who receives a block reward for the validation of a block, and the issuer of cryptocurrencies, which in fact creates them itself in the context of an initial coin offering and sells them for consideration to a third party.
Against the manufactured property argument is also the fact that newly created units of the cryptocurrencies are not generated by the validator but by the software.
Besides, an approach that bifurcates block rewards into newly created cryptocurrency and transaction fees would be difficult to administer.
5.2. The like-kind property argument and the argument of the absence of market prices
Particularly in the United States, academics (for example, Avi-Yonah/Salaimi) have taken the position that due to the high volatility and the frequent lack of market value, a taxable event should not occur until cryptocurrency is exchanged for fiat money. This view is supported by strong administrative reasons on the side of the taxpayer and the tax administration. The like-kind property argument is also put forward. However, equal treatment considerations provide a counter-argument against a special statutory treatment of cryptocurrencies.
6. The Swiss approach
The Swiss guidelines rightly do not stand on the ground of the manufactured property argument. In Swiss income tax law, the concept of income is based on the principle of factuality. For this reason, it does not matter whether the portion of newly created cryptocurrency was received in a contractual or factual exchange, or just in a similar manner. The Swiss guidelines assume that block rewards are realised and, thus, taxable at fair value at the time of receipt under both cryptocurrency consensus mechanisms.
For Swiss income and withholding tax purposes, a block reward can never be an interest, neither in direct staking nor in delegated staking. The staked cryptocurrencies are not transferred to another network participant and the block reward is not paid for staking. The 2021 working paper and the 2021 guidelines should therefore be amended and clarified accordingly. The activity of delegated staking is comparable to the category of relinquishment of the exercise of a right and consequently falls under this category and not under the category of income from movable capital assets.
For Swiss VAT purposes, while a taxable relationship is required, a factual relationship would be sufficient in itself. However, in the context of the cryptocurrency consensus mechanism, the counterparty cannot be identified in order to determine the recipient of the service. The Swiss guidelines assume that block rewards are a non-remuneration and, thus, there is no factual relationship and, thus, no supply of a service. However, whether a factual relationship can be concluded with non-identifiable persons has become a disputed point.