Proof of Stake Alliance publishes white papers on legal aspects of liquidity staking

The Proof of Stake Alliance (POSA), a nonprofit industry alliance, has published two white papers examining on the status of deposit tokens in United States securities and tax law on Feb. 21. The papers were authored by representatives of over 10 industry groups.

Liquid staking is the practice on blockchains using a proof-of-stake consensus mechanism of issuing transferrable receipt tokens to show ownership of staked crypto assets or rewards accrued for staking. The tokens are often referred to as liquid staking derivatives, which is a term the POSA objected to as being inaccurate, recommending that they be called liquid staking tokens instead. Liquid staking has seen a surge of interest since the Ethereum Merge.

Neither the U.S. Treasury nor the Internal Revenue Service have issued guidance on liquid staking, the POSA noted in “U.S. Federal Income Tax Analysis of Liquid Staking,” but it should be subject to capital gains tax rules under general principles. The paper said:

“Receipt Tokens evidence ownership of intangible commodities in the digital world in a substantially identical manner that warehouse receipts, bills of lading, dock warrants and other documents of title evidence title to tangible commodities in the physical world.”

In line with capital gains taxation, the argument continued, “a liquid staking arrangement will be a taxable event only if there is a sale or other disposition of cryptoassets in exchange for property that differs materially in kind or extent,” which is standardly referred to as “realization” of an asset.

That reasoning is supported with an argument that a liquid staking protocol (smart contract) should not be considered a separate entity, as it lacks a second party that shares in the profits. “If a Liquid Staker does not have a taxable event as discussed above, the Liquid Staker must then grapple with the taxation of its continuing ownership of the staked cryptoassets,” it concludes.

In “U.S. Federal Securities and Commodity Law Analysis of Staking Receipt Tokens,” the POSA said that determining whether or not a receipt token is an investment contract is a gating issue.

1/ Excited to see the launch of the @team_Posa Liquid Staking White Papers. 18 months ago our goal was to bring together the leaders in the staking space to tackle some of the biggest unknown regulatory and tax issues that could hamper liquid staking adoption. https://t.co/O77MpMPF3i

— Evan Weiss (@evweiss1) February 21, 2023

It argued that liquid staking is not an investment contract, and therefore not a security, using a case-based analysis of the well-known Howey test. Then it examined all four prongs of the Howey test and concluded that the tokens generally do not meet any of them.

Related: Expect the SEC to use its Kraken playbook against staking protocols

The paper also considers the Reves test, from a 1990 Supreme Court ruling that determined when an instrument constituted a “note” based on its “family resemblance” to an investment contract. The SEC and federal courts have found some crypto assets to be notes. Further, the paper argued a receipt token is not a swap under the Commodity Exchange Act.

A receipt token serves security purposes, allowing the holder to transfer ownership of staked funds between wallets in the event of a compromised key, and commercial purposes, similarly to warehouse receipts, the paper concludes.

The papers were intended to offer “a framework for meaningful legislative codification or elucidation,” according to an accompanying statement. They also were meant to provide a basis for self-regulatory standards.