HMRC Update (Aug 21, 2023): CRYPTO10300
Introduction to Cryptoassets: Consensus Mechanisms -
Proof of Work and Proof of Stake
Numerous cryptoasset networks operate without centralized control, often relying on a network of users to validate transactions and implement technological updates. This process is commonly referred to as achieving 'consensus,' as it necessitates a substantial portion of the network to agree upon a transaction or technical modification before its execution.
For instance, consider a scenario in which Party A intends to send 500 tokens to Party B. The transaction's legitimacy depends on confirming Party A's possession of the specified tokens. If the network collectively affirms this, the transaction is then recorded on the distributed ledger.
Proof of Work
One of the most recognized consensus mechanisms is Proof of Work, famously employed by Bitcoin and other cryptocurrencies. In this model, the privilege of appending a new entry to the distributed ledger is granted to the first individual to successfully solve a complex cryptographic puzzle generated randomly. This successful solver creates the new entry, which is then shared with all holders of the distributed ledger. The effort and energy expended to solve the puzzle serve as the 'proof of work,' granting the right to include the entry as a primary reward. The individual with this right is entitled to any fees associated with transaction inclusion within the entry. Furthermore, they receive a certain quantity of newly minted tokens introduced into circulation. This process, known as 'mining,' is instrumental in upholding the cryptoasset's network.
Proof of Stake
Conversely, Proof of Stake operates by having participants, or 'validators,' lock up tokens in the protocol for a defined timeframe (referred to as the 'stake'). When the protocol requires validation of new transactions on the distributed ledger, it randomly selects a stake. Larger stakes have a higher likelihood of being chosen. The validator linked to the selected stake is then responsible for validating transactions on the distributed ledger. Validating legitimate transactions grants the validator access to transaction-related fees, as well as a potential allocation of newly issued tokens introduced into circulation. However, attempting to validate erroneous or fraudulent transactions (or failing to validate any transactions) exposes the validator to penalties. These penalties are automatically enforced by transferring some of the staked tokens to an unusable public address, effectively burning a portion of the staked tokens. This penalization process is often termed 'slashing.'
Proof of Stake, therefore, introduces a risk factor for validators, as they could permanently lose some of their tokens. In contrast, the risk faced by miners in the Proof of Work model lies in potentially incurring costs (e.g., electricity) while not being the first to solve the cryptographic puzzle and thus failing to recoup those expenses.
For more detailed information regarding the tax treatment of rewards, please refer to the following resources:
CRYPTO21150 – Taxation for Individuals Engaged in Proof of Work Mining Transactions
CRYPTO21200 – Tax Implications for Individuals Participating in Proof of Stake Staking
CRYPTO40200 – Tax Considerations for Businesses Involved in Proof of Work Mining Transactions
CRYPTO40250 – Taxation Guidelines for Businesses Undertaking Proof of Stake Staking.
It's important to differentiate Proof of Stake staking from staking within the realm of Decentralized Finance (DeFi). Further insights into the meanings of lending and staking in the context of Decentralized Finance can be found in CRYPTO61120.
Crypto Tax Accountants UK
The professionals at Crypto Accountants UK are poised to provide comprehensive support for individuals, companies, and businesses embarking on cryptocurrency endeavors. Our team will assist you in accurately determining your tax liabilities and optimizing your profits within the parameters outlined by HMRC guidelines.
For inquiries, please explore our website: https://www.cryptoaccountants.live/