The Cardano Foundation helps shape policy through its role in the Proof of Stake Alliance
(Written by @ElliotHill of the Cardano Foundation)
This week, we are taking a break from our usual Shelley blog series to explore some important news within the proof of stake (PoS) blockchain ecosystem, in which the Cardano Foundation has been directly involved. Our technical post-Shelley blog series will resume next Wednesday with a feature on managing digital identities with blockchain technology.
In June, the Cardano Foundation’s General Secretary, Hinrich Pfeifer, published an op-ed in leading British financial newspaper City A.M., sharing the importance of taking a proactive part in the wider blockchain industry, and helping to shape legislation within the entire blockchain space, through education and leadership.
Within that article, Hinrich shared the work that the Cardano Foundation has been doing in collaboration with the Washington-based Proof of Stake Alliance (POSA), a representative alliance formed to bring legal and regulatory clarity to PoS technology, and advance the interests of those taking part in PoS blockchains.
Shaping legislation is one of the Cardano Foundation’s five core missions, and we help to lead global industry and policy bodies to design legislative drafts and discuss their implementation with regulators, ensuring regulatory clarity for stakeholders in the Cardano ecosystem and also throughout the broader blockchain community.
To meet this goal, in February 2020, the Cardano Foundation and the POSA sent the US Securities and Exchange Commission (SEC) a whitepaper which outlined how proof of stake networks provide infrastructure services rather than financial products. Following on from this, members of the POSA and a bipartisan group of Congressmen, part of the Blockchain Caucus, have now formally requested the U.S. Internal Revenue Service (IRS) review their approach to staking reward taxation.
We are delighted to be able to share some of the outcomes of this initiative here, but first, let’s explore why staking and delegation is a complex landscape for regulators, and why good taxation structures are crucial for our ecosystem.
Why is this an important cause?
In the oft-quoted words of one of America’s founding fathers Benjamin Franklin, “…in this world, nothing can be said to be certain, except death and taxes.” For stake pool operators and those taking part in delegation, taxes will be a necessary part of the process and must be factored into the associated costs of staking and delegation.
However, in the U.S. at least, current tax reporting and legislation do not adequately cover this nascent industry, and it can be difficult as a stake pool operator to report your income to the IRS.
For both new stake pool operators exploring running a pool for the first time as a hobbyist, or for veteran stake pool operators who approach stake pool operation as a business venture, tax reporting can be an overwhelming task—and may even restrict or limit participation in consensus on PoS blockchains.
The Cardano Foundation recognizes that in order for Cardano and indeed the entire PoS blockchain space to grow, more must be done to appeal to lawmakers and decision-makers in order to promote our space and legitimize the staking process for taxation purposes—one of the key drivers of our participation in POSA.
In short, attaining regulatory and legislative recognition is of principal importance to the Cardano Foundation and it’s ecosystem partners, as it is directly related to the adoption of blockchain technology and its products—the number one deciding factor between a struggling or thriving blockchain ecosystem.
Staking—income, infrastructure, or investment?
Staking and delegation rewards, which are now available on Cardano through the release of Shelley, are rewards paid in a protocol’s native token or coin for participation in consensus on the blockchain. However, these rewards could be viewed for tax purposes as a form of income, an investment that may increase in value, or similar—which is not necessarily reflective of staking’s true scope.
For example, say Alice is a stake pool operator on the Cardano blockchain. She helps the Cardano protocol reach consensus through validating transactions, and receives ada as block rewards. Some regulators or lawmakers may see this as an income-generating event. In other words, in this scenario, Alice may be taxed as if she was ‘working’ for the Cardano protocol, and is being paid accordingly for her services.
However, we know that Cardano, and other PoS blockchains, are decentralized protocols with no central authority, and there is no implied employer-employee relationship. Likewise, the onus is on Alice to provide her own infrastructure, market her own stake pool, and oversee its performance.
Therefore, it is not appropriate to tax Alice’s staking rewards as income. The same would apply to those delegating to Alice’s pool—as their rewards are also paid by the protocol and not by Alice directly. Similarly, Alice—and by extension, those delegating to her stake pool—are not buying ada with fiat as a speculative investment.
Instead, Alice is ‘creating’ her staking rewards from her own computing effort, using her own infrastructure, and by attracting delegates to her pool—similar to how a farmer would use their resources to produce crops, an end product of economic value, but not an income or wage in the traditional sense.
Congressmen and POSA send letter to the IRS
On 29 July 2020, the efforts of the POSA and its partner organizations culminated in a letter, co-signed and sent by Congressman David Schweikert, Congressman Bill Foster, and Congressman Tom Emmer, to Commissioner Rettig of the U.S. IRS—formally requesting the issuance of better guidance for taxpayers participating in staking.
The letter, which laid out the differences between Proof of Work (PoW) mining, as on the Bitcoin blockchain, and PoS staking, argued that while participants should indeed be taxed on staking rewards, there needed to be careful consideration not to overstate participant’s actual gains from staking or delegation.
Similarly, the letter argues that instead of taxing staking rewards as income, it would be far more relevant to use the same taxation system as producing crops, minerals, and livestock—in other words, taxing staking rewards when they are sold. This is a type of taxation known as ‘taxpayer-created’ or ‘taxpayer-discovered’ property, and it is much clearer and fairer for staking participants from a regulatory perspective.
The letter concluded that through careful consideration of taxation for PoS participants, the U.S. could become a leader in driving blockchain technology forward, with ‘American ingenuity’ leading the PoS ecosystem forward.
A clearer regulatory landscape?
Naturally, these developments are currently relevant only to U.S. market participants. However, as the world’s leading financial market and economic leader, many countries look to the U.S. for guidance on how to implement similar taxation scenarios in their jurisdictions.
As a result, pushing these issues to the highest levels of U.S. governance and decision making is crucial in bringing widespread recognition of staking and delegation as an emerging technology worldwide, and the Cardano Foundation is proud of the role it has played in this development through our expert opinion and guidance.
Naturally, legislative and regulatory procedures take time. This letter is just the first step out of many, but it is an enormous milestone and it is evidence that top lawmakers and Congressmen are taking our industry seriously. Lobbying, drafting legislation, reviewing existing taxation structures, voting and approval, and finally, implementation is a lengthy process, potentially spanning many years and involving multiple stakeholders.
Nevertheless, this does not dissuade the Cardano Foundation from its goals. As a Foundation, it is our duty to think many years ahead and envisage the blockchain ecosystems of the future. This will require patience as regulatory infrastructure is built, but it will expedite the adoption of the entire industry in time—assisting us in delivering blockchain infrastructure that serves both the many and the few.
If you would like to find out more about staking and delegation on Cardano, read our article ‘Staking and delegating for beginners—A step-by-step guide’, or visit our staking portal on Cardano.org.