Dude, Where Is My ETH?! A Guide to Bridged Ethereum on Layer 2s

TL;DR for UK Taxpayers: Bridging ETH to Layer 2 networks and back to Layer 1 is most likely a taxable event, potentially triggering Capital Gains Tax. DeCrypto.tax treats all bridging as taxable events by default unless a user specifies otherwise.

After the Dencun Upgrade Ethereum’s Layer 2 (L2) solutions have become essential for scaling the network, reducing transaction costs, and improving speed. This guide provides a comprehensive overview of Ethereum on L2s, covering key topics including what ETH on L2s is, the difference between wrapped and native ETH, naming conventions, and tax implications of bridging or using ETH on different blockchains.

1. What Are ETH on Layers 2?

Layer 2 solutions are networks built on top of Ethereum (Layer 1) to process transactions off-chain while leveraging Ethereum’s security. These solutions address Ethereum’s scalability issues by offering faster transaction speeds and lower fees. Examples of L2s include Arbitrum, Optimism, and zkSync.

ETH on L2s refers to Ethereum that has been transferred from the main Ethereum blockchain (L1) to an L2 network. This process involves:

• Locking ETH in a smart contract on Ethereum’s mainnet.
• Minting an equivalent amount of ETH on the L2 network.

This bridged ETH is used for gas fees, DeFi interactions, and other transactions within the L2 ecosystem.

Examples of Layer 2 Networks:

Arbitrum: ARETH

Arbitrum, uses ARETH to denote ETH bridged to its network. This nomenclature serves to:

• Prevent User Errors: Distinct tickers reduce risks of cross-chain misdirected transactions.
• Clarify Network Context: ARETH explicitly signals the asset resides on Arbitrum, ensuring users select the correct network for deposits or withdrawals.
• Technical Implementation: ARETH is an ERC-20 token on Arbitrum, backed 1:1 by ETH locked in Arbitrum’s Ethereum bridge contract. Trust Wallet and exchanges like Binance adopt this naming to align with user expectations.

Optimism: ETHOP and Native ETH

Optimism’s approach to ETH representation has evolved:

• ETHOP (Optimistic Ethereum): Early implementations labeled bridged ETH as ETHOP to distinguish it from Layer 1 ETH. This was common in wallets like Atomic Wallet, which treated ETHOP as a wrapped ERC-20 token.
• Post-Bedrock Upgrade: The 2023 Bedrock upgrade integrated ETH as a native asset on Optimism, eliminating the need for ERC-20 wrapping. ETH now functions natively, with gas fees paid directly in ETH. Despite this, some interfaces retain ETHOP for legacy compatibility.

zkSync Era: ETH

zkSync, a ZK-Rollup, treats ETH as its native gas token without rebranding:

• Direct Usage: ETH bridged to zkSync remains denominated as ETH, leveraging zkSync’s EVM compatibility. Users interact with ETH natively for transactions and smart contracts.
• Bridging Mechanism: When ETH is bridged from Ethereum, zkSync mints an equivalent amount on its network via a lock-and-mint model. This avoids ticker changes but requires users to distinguish between L1 and L2 ETH via contract addresses.

Starknet: ETH

Starknet, a ZK-Rollup using zk-STARKs, retains ETH as its primary transactional currency:

• Native Integration: ETH is used for gas fees and smart contract interactions without modification. Bridged ETH is stored in Starknet’s L1 contract and mirrored on L2 via the StarkGate bridge.
• No Ticker Differentiation: Unlike Arbitrum, Starknet does not rebrand ETH, relying on network context (e.g., wallet settings) to distinguish L1/L2 assets.

Base: ETH

Coinbase’s Base, an Optimism-powered L2, adopts Ethereum’s native ETH:

• Seamless Compatibility: Base uses ETH for gas fees and transactions, ensuring direct interoperability with Ethereum dApps. No secondary ticker is employed, simplifying user experience.
• Bridging Simplicity: ETH bridged to Base retains its original ticker, with Coinbase emphasizing accessibility for mainstream users.

Polygon (MATIC): WETH and MATIC ETH

While not covered extensively in the provided sources, Polygon—a sidechain/commit-chain hybrid—commonly represents ETH as:

• WETH (Wrapped ETH): ETH bridged to Polygon is wrapped as WETH (ERC-20) for compatibility with DeFi protocols.
• MATIC ETH: Some wallets label Polygon-based ETH with the network prefix (e.g., “ETH (Polygon)”).

ENSv2 and Cross-Chain Naming

The Ethereum Name Service’s migration to L2s introduces subdomains (e.g., .base.eth) but does not alter ETH’s representation. Instead, ENSv2 focuses on human-readable addresses across chains, abstracting complexities of L1/L2 ETH distinctions.

2. Key Trends and Challenges

Naming Conventions

• Preventative Labeling: Wallets like Trust Wallet and Atomic Wallet use network-specific tickers (ARETH, ETHOP) to reduce user errors.
• Native Integration: Newer L2s (Base, zkSync) avoid rebranding ETH, relying on network context for clarity.

Examples:

• Arbitrum: Trust Wallet labels bridged ETH as ARETH, clearly distinguishing it from mainnet ETH.
• Optimism: Early implementations used ETHOP, but after the Bedrock upgrade, Optimism now uses native ETH.
• Polygon: Uses WETH (Wrapped Ether) as an ERC-20 token for compatibility with its ecosystem.
• zkSync: Retains the name ETH since it treats bridged Ethereum as a native asset.

Technical Considerations

• Custodial Requirements • Wrapped ETH: Requires reserve-backed smart contracts or centralized custodians (e.g., Arbitrum’s ARETH). • Native ETH: Operates without reserves, as L2 validators batch transactions to Ethereum, inheriting its security.
• Smart Contract Compatibility • Wrapped ETH: ERC-20 compliance ensures compatibility with DEXs like Uniswap but necessitates wrapping/unwrapping fees. • Native ETH: Functions identically to L1 ETH, enabling direct use in protocols like CoW Swap without ERC-20 conversion.
• Gas Fee Structures • Wrapped ETH: Gas fees are paid in the wrapped token (e.g., ARETH), which may require users to maintain separate balances. • Native ETH: Gas fees use ETH directly, simplifying onboarding for Ethereum-native users

Ecosystem Impact

• DeFi Interoperability: Uniform naming (e.g., ETH on Base) simplifies cross-chain liquidity provision.
• Exchange Listings: Platforms like Binance list L2-specific ETH variants (ARETH, ETHOP) to align with wallet terminology.

Here is the summary of differences between wrapped tokens and native assets:

3. Tax Implications of Bridging ETH to Layer 2s

The rapid adoption of Layer 2 (L2) blockchains like Arbitrum, Optimism, and zkSync has introduced complexities in cryptocurrency taxation, particularly regarding the conversion of Ethereum (ETH) from Layer 1 (L1) to Layer 2 networks. In the UK, HM Revenue & Customs (HMRC) treats crypto assets as taxable property, subjecting gains and income to Capital Gains Tax (CGT) or Income Tax depending on transaction specifics. The overview of general rules and approaches to crypto taxation is given in this guide.

3.1. HMRC’s Treatment of Bridging Transactions

Current HMRC guidance lacks explicit rules for L2 bridging but provides analogies:
Conservative Interpretation:

• Bridging ETH to L2 constitutes a crypto-to-crypto exchange, triggering CGT on gains.
• Example: Converting 1 ETH (acquired at £2,000) to ARETH when ETH’s price is £3,000 results in a £1,000 taxable gain.

Aggressive Interpretation:

• Argues bridging is a non-taxable transfer between wallets under the same ownership.
• Relies on the premise that L2 ETH retains identical economic value and ownership.

HMRC’s Likely Position:

• Bridging resembles a “swap” facilitated by smart contracts, meeting the criteria for a disposal.
• The 2022 Ethereum Merge precedent (non-taxable soft fork) does not apply, as L2 conversions involve distinct ledgers and are not treated as ‘one-way’ transfers under CRYPTO22110.

3.2. How DeCrypto.tax treats bridging transactions:

• Until HMRC offers clearer guidance on the tax treatment of bridging, DeCrypto.tax will adopt a conservative approach—treating bridging transactions as taxable events for both wrapped and native tokens.
• However, users always have the option to take a more aggressive stance by manually editing bridging transactions to classify them as de facto internal transfers, which would not trigger capital gains tax. We recommend consulting a professional tax advisor beforehand.

3.3. Tax Calculation Scenarios

Scenario 1: Bridging with Stable Value

• Action: Bridge 1 ETH (cost basis: £2,500) to Arbitrum when ETH = £2,500.
• Tax Outcome: £0 gain/loss. No CGT owed, but transaction must be reported if proceeds exceed £49,200.

Scenario 2: Bridging with Appreciation

• Action: Bridge 1 ETH (cost basis: £2,000) to Optimism when ETH = £3,000.
• Tax Outcome: £1,000 gain. Subject to CGT at 18%–24% (2024–2025 rates).

Scenario 3: Bridging Fees

• Cost Basis of ETH: £2,000 per ETH.
• Current Market Price of ETH: £3,000 per ETH.
• Amount of ETH Used for Bridging Fees: 0.005 ETH.

Taxable Gain Calculation:

1. Disposal Value: The value of 0.005 ETH at the current market price:
   Disposal Value = 0.005 * 3,000 = £15

2. Cost Basis for 0.005 ETH: The proportionate cost basis of 0.005 ETH:
   Cost Basis = 0.005 * 2,000 = £10

3. Taxable Gain: The difference between the disposal value and the cost basis:
   Taxable Gain = £15 - £10 = £5

3.4. Record-Keeping and Reporting Requirements

Taxpayers must document:

• Date and value of ETH acquisitions.
• Bridging transaction timestamps and ETH/GBP exchange rates.
• Transfer fees paid in crypto.

Fortunately, DeCrypto.tax takes care of all Record-Keeping for you without any hassle.

3.5. Mitigation Strategies and Risks

1. Harvest Losses: Offset bridging gains with losses from other crypto disposals.
2. Timing: Bridge during low-volatility periods to minimize gains.
3. Use Allowances: Utilize the £3,000 CGT annual exemption (2024–2025).

3.6. Comparative Analysis: Wrapped Tokens vs. Native ETH