Hard forks and soft forks.

In recent years, many hard forks and soft forks of the bitcoin blockchain have emerged. Some well-known examples of hard forks are Bitcoin Cash, Bitcoin Diamond and Bitcoin Private. Another example of a Bitcoin hard fork is Litecoin. In addition to hard forks, soft forks exist. What are hard forks and soft forks? And how does the Dutch tax authorities treat hard forks?

What is a fork?

Very briefly, a fork is an update to a blockchain. But that doesn't cover it. It is more than a "simple" update of the blockchain. A fork is a branching of the blockchain. A blockchain with one set of transactions branches off into a second set of transactions. You can think of this as a highway splitting into two roads. This is what actually happens during a fork in a blockchain.

The road being traveled is split into two different roads. The original road continues its path while the new road goes to a different destination. In the blockchain world, an entirely new crypto is then created at the branching point (hard forks). There is also soft forks. In soft forks, there is a path that changes the price. No second path is created. That is the elementary difference. In hard forks, a new crypto arises at the branching whereas in soft forks it does not. In the soft forks, the path merely changes course while the hard fork creates an entirely second path.

Each crypto has its own blockchain. On this blockchain, all kinds of things are determined. For example, rules on how to mine, block size, transaction rules, consensus mechanism, etc. All these rules and processes are also called the blockchain protocol. These rules and processes determine how the crypto should function.

Difference between hard forks and soft forks

Soft Fork

A soft fork only occurs when something is changed in the rules of the blockchain protocol itself. In a soft fork, a particular rule in the blockchain protocol itself is made 'stricter' or is modified. Notice well here that the change occurs within the existing blockchain protocol. A good example is Bitcoin. With bitcoin, the rule in the beginning was that there was no limit on the size of the MBs of a block. So a block could be infinitely large MBs. The developers found this too flexible and wanted to make the rule stricter. To change this rule, a soft fork was needed because the change must be made in the blockchain protocol itself.

The developers forked the maximum size of a block to about 1 MB. Fortunately, this rule fit into the existing rules, as one rule was to allow block sizes of 1 MB or smaller. This created no conflict with miners, nodes, wallets and the blockchain network. No one had to update their hardware or software, nor did new cryptos need to be created.

Hard Fork
A hard fork is the exact opposite of a soft fork. In a hard fork, the rules within a protocol are not made stricter, but rather relaxed. If the rule is that a block can only be up to 1 MB and then suddenly it can be infinite MB, then everything must be updated.

A more lenient code (1MB to infinite MB) causes two blockchains to actually be created. A blockchain with the older strict code (1MB) and a new blockchain with a smoother code (infinite MB). Then the network is asked which blockchain they want to support. Miners are asked if they want to update their software and start mining new crypto or they can continue mining the old coins.

A well-known example of a hard fork is Bitcoin cash. The inventors of this crypto felt that the block size of bitcoin should definitely be at least 8MB instead of 1MB. They could not solve this in a soft fork. In fact, we go from strict to flexible. A new path must be created. This meant that the bitcoin blockchain split off into a new blockchain. This created a new crypto, bitcoin cash.

Why should the blockchain fork?

Why should we fork the blockchain? There are roughly two reasons to fork, or update the blockchain:

• New functionalities: every technology starts with a certain idea and this idea needs to be tested. This idea is often conceived to improve the blockchain itself. By making updates and adding new features each time, forking needs to be done.
• Security: there are still many security risks associated with cryptos. Hacks of crypto is not something that happens infrequently. Security issues therefore need to be resolved. The security of crypto can be improved by updating the blockchain and making it more secure.

These are the most important reasons to fork, but there are more other reasons to fork.

What happens after a hard fork?
So after a hard fork, two different blockchains are created. So how is it determined which blockchain belongs to which crypto? Three situations can arise:

• One blockchain becomes dominant
  If a hard fork happens that takes a completely new path that everyone in the network supports, then the entire community will fully support the crypto, the new protocol and the new blockchain. This means that the old blockchain will no longer be supported and will die a quiet death. 
• Both blockchains are used and accepted. But one is clearly more dominant.
  It happens that the old blockchain and the new blockchain are accepted and supported by a large group. Bitcoin and the Bitcoin cash is an example of this. A large portion of bitcoin supporters felt that the solution of bitcoin cash was better than the solution offered by the classic bitcoin. Currently, classic bitcoin has the most supporters. Since the two blockchains have a significant following, the two crypto just may survive well. However, classic bitcoin is still the most dominant.
• Both blockchains are accepted
  It can also happen that the network is almost completely divided by two. In this way, both blockchains continue to coexist without one being more dominant than the other. An interesting case was with the bitcoin hard fork Segwit 2X. The bitcoin network was precisely divided into two camps. On one side were the miners and on the other side were the developers. If this split were to continue, this fork would have caused both camps to sacrifice so much quality that no matter which blockchain became more dominant, the damage would be too great. Therefore, the decision was ultimately made not to "fork" and to continue developing the same crypto together.

Free money after a hard fork?

So "free money" is created in a hard fork when a new path/crypto is created. Bitcoin cash was created by a hard fork of classic bitcoin and bitcoin cash has the same history as bitcoin. Having the same history means that exactly the same amount of bitcoin cash was created as bitcoin was created. Also, classic bitcoin and bitcoin cash have exactly the same transactions. Everyone who has obtained bitcoin will now also receive the same amount of bitcoin cash. This means if you own 2 bitcoin, after the fork you also own 2 bitcoin cash again. When bitcoin cash was just created, it had a value of approximately $555. If you owned 2 bitcoins at the time, you just got 1110 dollars for free after the fork. Of course, this is very crazy and doesn't make sense. The crypto market is still a very immature market. 

If we look at the stock market, you don't just get free money when you split a stock. This is because the price or value of those same shares then also goes through half. So that doesn't happen with a fork. If you own 10 bitcoin, a fork will also give you 10 bitcoin cash. This still happens with a hard fork. So this is a good opportunity to literally make free money. But note that it does not always happen that after a hard fork there is money to be made. Sometimes the value of the newly created coin can be 0 or much lower than the classic crypto. But often the value of the newly created crypto will be higher than the hard fork. So this is a good way to take advantage of this.

A hard fork and the Dutch tax consequences

In a recently published WOB request, the Dutch tax authorities addressed 2 questions:
1. Are crypto coins created from a fork (the created crypto coins) an asset in box 3?

Yes, if there is a hard fork where there is sufficient support for both the original and the resulting crypto currency, a new crypto currency is created with an own value. This created crypto currency is linked to the private key and is tradable independently of the original crypto currency. Like the original crypto currency, the created crypto currency is an asset in Box 3.

Like the original crypto currency, the resulting crypto currency is digital money (this should be distinguished from scriptural or cash money). According to the State Secretary of Finance, crypto currency should be included in the tax return as follows:

"Crypto currencies must be stated in the income tax return according to their fair value on the reference date  (1 January of every year) of a calendar year. This means that the applicable exchange rate on the reference date must be used. There are various exchange rates for crypto currencies. Now that there is no legal requirement as to which exchange rate should be used, the exchange rate on the reference date of the used exchange platform is the most obvious exchange rate."

2. If yes, is this also the case if the taxpayer does not claim the newly created crypto?

Yes, the created crypto currency is linked to the private key and is therefore in the possession of the taxpayer. If the taxpayer has to follow a procedure/act to use the created crypto tokens (or make them visible in the wallet), this does not mean that there is no possession of the newy created crypto.

Similarly, the fact that the taxpayer refrains from using the created crypto currency due to risks does not mean that there is no possession. The possession is the crypto currency on the blockchain linked to the private key (and thus an asset that has to be stated in the income tax return).