Why I did not pay taxes on Staking Rewards and why it makes sense.

So just recently I got my tax receipt from the german government and it says I don’t have to pay taxes on my staking rewards from Cosmos in 2019. This is very surprising, since in Germany you have to pay taxes on staking rewards, usually up to 42%.

For me Cosmos was the first investment in a Proof-of-Stake coin with its ICO in 2017, before that I was not convinced by the earlier candidates, like Peercoin and others, but I was mining Bitcoin in the early days and getting into Ethereum, once it had proven it works with Frontier. I have to be honest, when the Ethereum ICO was announced, I just thought “yeah sure buddy, you gonna build this, at your age, in a few years, this is ridiculous” and just closed bitcointalk.org, lol. But once it was working, I could not believe it, amazing. So from all of this I was already aware, that taxes have to be paid and even if crypto makes it very easy not to pay taxes and to avoid them, here comes financial advice: Pay your taxes. In Germany school and university are for free and I greatly profited from this, so it is all fair to pay taxes now. Just look at it as a big lottery. You get some nice stuff for free, some people will succeed and get a lot of money and then you should pay your taxes. If you lose the lottery, then you don’t have to pay as many taxes back as what was given to you and that makes life at least a little bit fairer, since we cannot influence this lottery much. We can only try and be lucky.

OK, but wait, this article is about not paying taxes? Yes, I will get to this point. So when I started to stake my Cosmos’ Atoms, I already expected I’d have to pay taxes, since the earlier advocates of PoS already made it through the german tax system, even though there are technical differences, like having a Masternode and not being able to delegate only. How these differences play out for the taxation is another complex matter, but we will focus on the important stuff here.

Ok wait again, you are only talking about Germany, for me as a shitcoiner from somewhere else, this doesn’t matter? Well, I found out over the years that many countries are very similar and the same principles apply. There are 2 reasons for this. A) The principles are copied from other countries. So if a country has an effective way of taxing stocks and capital gains, other countries copy the concept. B) The principes often make a lot of sense and many alternatives lead to problematic outcomes. So if you are familiar with your tax system it is very likely you will recognize the concepts presented here.

Having this stuff in my mind, sometimes I thought about how taxing of staking rewards works. In essence you get some rewards for each block and these rewards have a value. This is your income. You have to pay taxes on this income. So if you get 1000 Atoms and these are $10 worth, you have to pay taxes on $10.000. Now let’s think about what these rewards consist of. There are the fees, which users pay if they do transactions and there are inflationary rewards. In 2019 the inflationary rewards easily make up 99% of the rewards given. So these inflationary rewards have the main purpose to punish people who are not staking by inflating the amount of Atoms in the system. So if you stake, your account grows with inflation, but if you don’t stake your account loses value because of inflation. So if Cosmos was designed differently, for example by penalizing non-staking accounts and just subtract 5% coins per year (smoothed over all blocks) from these, then you would not have to pay taxes. You only have to pay taxes on the remaining fees, which make up 1% or less. But then if you have some atoms being removed by non-stakers punishment, these are losses in the sense of taxes, so you can subtract these from your gains and pay less taxes (on the gains from fees for example). This means that 2 different systems which achieve the same thing and don’t differ in how they economically work (they differ how they account, though) would be totally different when taxed.

This lead me to the thought that something doesn’t make sense here. And then I found out that share splits for stocks are not taxed. And if we think about it, it would not make any sense to tax this. A share split turns your 10 Berkshire Hathaway shares valued at $2500 into 100 valued at $250. The value of your account does not change. And therefore nothing should be taxed. With inflationary staking rewards you have a share split every block. You get some extra Atoms, without any value added, the price should fall accordingly, it is just smoothed out over the year.

So I explained this to my tax lawyer/adviser and he said: “Yes, sure it makes no sense to pay taxes on something that just changes accounting. It should be possible to explain this to the authorities and they should follow”. So then I had to explain how in reality it is all a bit more complicated:
There are inflationary rewards and fees. The gains from the latter should be taxed. And inflationary rewards are not that easy, because not everyone gets them. This means the inflationary reward is only like a share split if everyone stakes. If some do not stake, which is always the case, then you get an economic advantage over them, because your account inflates by 10% and the whole network only inflates by 7%. This means that 7% should not be taxed but 3% should be. On top come fees, which also should be taxed. This makes it a bit more complicated. Luckily there is an easy way of calculating the actual gains:

virtual_gainz = sum of claim_rewards
real_gainz = advantageous_inflation+fees

The virtual gains are pretty easy to calculate, since this is what you can see in your transactions. Advantageous_inflation is the part of inflation that gives you proportionally more than what the network actually increases. The real gains are unfortunately not so easy to read out somewhere, but let’s try to have more equations for more clarity:

sum of claim_rewards = fees + advantageous_inflation + even_inflation
=>sum of claim_rewards — even_inflation = fees + advantageous_inflation

Ok, this is pretty nice, because on the right side of the last equation is the expression we already have for the real_gainz, which gives us a resulting equation:

real_gainz = sum of claim_rewards — even_inflation

Now we have arrived at a very helpful equation and this is a very special moment for me, because this is the first time my Physics PhD and years of handling complex equations like these have helped me in real life!
Why is this equation so helpful? Because the even_inflation is very easy to calculate. If there is 240m Atoms at the beginning of the year and there are 256,8m Atoms at the end, then there was 7% global inflation. These numbers are publicly available, basically they can be derived from the market cap and the price, just by dividing and these numbers are very available for every day and even for the hour and minute.

So how does the exact calculation look like?
You have 100 Atoms. In the fiscal year you collected rewards of 3 and 5 Atoms. The network has inflated by 7% in this year. This means you lose to even_inflation 7 Atoms (100*0.07 if you want to follow this calculation closely). This gives you real_gainz of 1 Atom (3+5–7, just go through it slowly). So if the price of the atom at the collect rewards point in time was $10, then you have to pay taxes on these $10. Easy we understand this. It gets a bit more complicated though if there are different valuations at the collect reward times (which is extremely likely). So with our example, let’s assume in the time span over which the 3 Atoms were collected the network increased by 4% and for the 5 Atoms it was 3%. Prices were $20 and $10 respectively. So now for the first collect we have claim_rewards of $60 and loss to inflation $80, for the second collect we have claim_rewards of $50 and loss to inflation of $30. Now for the whole year we have made -$20 in the first interval and +$20 in the second. This means for the whole year we have made no real gainz and don’t have to pay taxes. This is the scenario why I don’t have to pay taxes for staking rewards in 2019. At the beginning the price of Atom was a bit higher and I did not stake immediately, so I lost out on inflation, later in that year I made more from staking rewards than what I lost to global inflation, but it’s mostly eaten up by the first months, mostly because the price was also higher in this time span.

I think at this point it is pretty clear, how it works and even if you stake all through a year, it benefits you, because there is always something that should be subtracted from your vitual_gainz. I also hope it was understandable why it makes sense, since taxing should not be based on accounting but rather on real value added. Especially since the former allows for all kind of tax evasion shenanigans and we don’t want that for a functioning society.

Expected to be frequently asked questions:

Does this apply to all Proof-of-Stake staking rewards?
No. Take for example Terra, which is also based on the Cosmos technology, therefore one would expect it to be taxes in the very same way. Surprisingly this is completely different, because Terra does not do inflation. On Terra the rewards come from fees of blockchain transactions and users of the real world payment applications built on top of Terra. You have to look closely what the rewards consist of. Another important question is if this is actually running a business, which changes a lot of the taxation. In Germany for example mining PoW coins is a business, you automatically do it as a business and not as a private person. The same applies to running a validator (or Masternode), but does not apply to delegation, which usally belongs to your private asset management.

Does this include losses from slashing as well?
No, slashed Atoms are directly removed from your staked Atoms, just write down this number when you stake and then you can easily calculate your losses from slashing.