Legal Updates

On February 3, 2022, a United States District Court issued an order (the “Order”) setting a bench trial for a novel case – Jarrett v. United States of America – involving the proper characterization of rewards derived from staking cryptocurrency for tax purposes. Notably, the plaintiffs rejected an offer to settle from the Internal Revenue Service in advance of the Order being issued, signaling that the plaintiffs want their day in court.

What Is Staking and What Are Staking Rewards?

Consensus protocols for blockchain networks are mechanisms designed to ensure the integrity of the blockchain by preventing illegitimate transactions from being recorded. Proof-of-stake (“POS”) is a type of consensus protocol used to validate transactions and create new blocks on blockchains. POS protocols are usually contrasted with their highly energy-intensive counterparts, proof-of-work protocols, which require significant computing power to solve complex algorithmic puzzles.

Generally speaking, token holders in POS protocols are able to offer their tokens as collateral (or “stake” their tokens) for the chance to validate blocks. Token holders who stake their tokens and validate blocks are sometimes referred to as “validators.” POS protocols incentivize staking by rewarding validators with newly created tokens.

What Is this Case About?

The Jarrett case deals with Joshua Jarrett, a man from Tennessee who staked his Tezos tokens (“XTZ”) on the Tezos blockchain in 2019. In connection with his staking and validation efforts, Mr. Jarrett was rewarded in XTZ.

According to the complaint (the “Complaint”) filed by Mr. Jarrett and his spouse (the “taxpayers”), the taxpayers reported income in a 2019 tax return in connection with the staking rewards received by Mr. Jarrett. The Complaint states that the taxpayers later requested a refund of the tax paid on the staking rewards, along with an increase in tax credits that resulted from the reduction of the taxpayers’ income.

In the Complaint, the taxpayers asserted that the United States of America “seeks to use the federal income tax law to do something unprecedented, which is tax creative activity rather than income.” More specifically, the taxpayers argued that:

Like a baker who bakes a cake using ingredients and an oven, or a writer who writes a book using Microsoft Word and a computer, Mr. Jarrett created property. Like the baker or the writer, Mr. Jarrett will realize taxable income when he first sells or exchanges the new property he created, but the federal income tax law does not permit the taxation of the Jarretts simply because Mr. Jarrett created new property.

Essentially, the taxpayers are arguing that U.S. federal income tax law does not apply to tax staking rewards at the time they are received. Rather, it is the taxpayers’ position that such rewards may only be taxed on a later disposition.

What Are the Takeaways from this Case?

The Jarrett case is one to watch because it is the first of its kind (in the U.S. or Canada) to deal with the taxation of staking rewards. As the technology surrounding blockchain evolves, the taxation of the many different facets of cryptocurrency will need to evolve as well. Canada will be watching closely to see how the U.S. courts deal with staking rewards.

If you have any questions regarding this legal update or the taxation of cryptocurrency in Canada, please contact Colin Romano at cromano@wildlaw.ca or any other member of our Tax practice group.

This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.

If you would like further information regarding the issues discussed in this update or if you wish to discuss any aspect of this commentary, please feel free to contact us.