On 27 April 2023, HM Revenue & Customs (HMRC) released a second consultation regarding the taxation of transactions in the Decentralised Finance (DeFi) market. In short, HMRC proposes to legislate to ensure that the use of cryptoassets in certain DeFi transactions would no longer give rise to a taxable disposal, but instead would trigger taxation only when the assets are economically disposed of in a non-DeFi transaction.
This is a significant step for HMRC and the UK government in recognizing the growing importance of the DeFi market. Providing clear guidance on the taxation of DeFi transactions is viewed as important to maintaining the UK’s position as a leading financial centre and fintech innovator.
Background
Cryptoasset holders in search of returns have several choices. In perhaps its simplest form, holders can lend their cryptoassets on a centralised finance (CeFi) platform. These are operated by private financial intermediaries that oversee and control their customers’ transactions.
Alternatively, cryptoholders can lend or otherwise make their tokens available on the DeFi market, which uses blockchain technology to provide the same or similar financial services, but without the need for a traditional financial intermediary. Generally, this occurs through a smart contract which, based on a codified set of rules, executes transactions on a blockchain when certain parameters are met. In return for connecting a digital wallet to a DeFi app and depositing cryptoassets, the owner of these assets can earn a DeFi return.
In the consultation paper, HMRC proposes to address the tax treatment of two flavours of DeFi transactions, which they refer to as “lending” and “staking” of cryptoassets. In a lending transaction, a holder of a cryptoasset transfers the asset to another person in exchange for an economic return that might be described as “interest,” although the tax characterization of this return as interest may not be entirely clear under current law. A staking transaction, as described in the consultation paper, is one in which a holder of a cryptoasset deposits tokens on a liquidity pool platform and earns a financial return, typically at a fixed rate or based on a share of the amounts earned by the liquidity pool. The transaction that HMRC refers to as “staking” should not be confused with the consensus mechanism used in proof-of-stake blockchains and the financial return to validators on such blockchains. HMRC’s use of the term staking arguably could be used to describe the returns that holders of cryptoassets earn from delegating tokens to validators on a proof-of-stake blockchain, although it is not clear if this was intended. Our discussion below adopts HMRC’s use the term staking in liquidity provider transactions.
The Tax Problem
The tax treatment of the lending or staking of tokens depends on whether beneficial interest in those tokens is transferred. Where it does involve a transfer of beneficial interest, the user would be treated as disposing of their tokens and would be taxable on any capital gain that arises, even if there is no realised gain as such. In addition, if at the end of the DeFi transaction the lender or liquidity provider surrenders a token representing their right to receive certain assets back, they may again be treated as disposing of an asset, giving rise to another dry tax charge. On top of this, there is uncertainty regarding the proper tax treatment of the DeFi return, which may be income or capital in nature depending on how the transaction has been designed. Ultimately, the tax consequences will depend on how the transaction or smart contract operates, which creates significant complexity for users.
HMRC recognizes that the tax system ought to reflect the economic substance of the activity in question. As a result, HMRC ran a call for evidence between 5 July and 31 August 2022, in which they asked respondents to provide details on how the current tax treatment affects users and thoughts on HMRC’s initial proposals for tackling these problems, and HMRC has now published its proposed route forward.
HMRC’s Policy Approach
Having listened to respondents’ answers, HMRC plans to introduce separate rules for DeFi transactions to remove the lending and staking activities in question from the scope of capital gains tax (CGT). The potential disposal of beneficial ownership of tokens in a DeFi transaction would be disregarded for tax purposes and instead a chargeable disposal would only arise when the tokens are subsequently disposed of in a non-DeFi transaction.
DeFi transactions should only be within the scope of these rules where participants retain an economic interest in the lent or staked tokens throughout the transaction despite transferring legal or beneficial ownership. Specifically, HMRC proposes the scope to be limited to transactions where (i) there is a transfer of cryptoassets between two parties and/or through the use of a smart contract; (ii) the borrowing party has an obligation to return the borrowed tokens to the lender and/or a smart contract allows the lender to withdraw the tokens; (iii) the tokens can be returned upon request of either the lender or the borrower, or automatically at the end of a pre-determined term; and (iv) the lender has the right to withdraw at least the same quantity of the same type of tokens that were originally lent or staked.
The final condition effectively limits the scope of the proposed rule to staking, or liquidity provider, transactions involving the lending of a single type of token in exchange for a financial return, such as single-token lending transactions on platforms like Aave and Compound. Providing liquidity to a decentralised exchange like Uniswap typically involves the deposit of more than one type of token, in which case the mix of tokens returned to the liquidity provider is not guaranteed to be the same as the mix of tokens that were deposited in the liquidity pool at the outset of the transaction (for a high-level illustration of this, see Understanding returns). HMRC acknowledges in the consultation paper that many staking transactions involving more than one token likely will not satisfy the final condition of the test, and invites comments on how this might be addressed.
The intended result of HMRC’s proposed rule would be that the initial lending of cryptoassets or making them available to a liquidity provider would be a disregarded transaction for CGT. Any tokens received in the transaction to represent the holder’s rights to redeem those assets would be treated as the holding of the original tokens.
If the lender or liquidity provider sees through the duration of the loan/contract, the return of the lent or staked tokens should also generally be disregarded for CGT. If, however, a lender or liquidity provider sells any rights representing the lent or staked tokens, this will be treated as a disposal of the underlying tokens to which those rights relate. Equivalently, any buyer of such rights would be treated as buying the underlying tokens that have been lent or staked, and thus any exchange in connection with the return of the underlying tokens to the buyer at the conclusion of the smart contract should also be disregarded. If the borrower is not able to return the lent or staked tokens, the lender will be treated as having disposed of them for CGT purposes.
To reduce the administrative burden of determining how to treat a DeFi return, HMRC has stated that the return will be revenue in nature and taxed as miscellaneous income under a new charge specific to cryptoassets, assessed at its market value at the time it is received. If the lender/liquidity provider sells their tokens with an outstanding DeFi return, any amount which accrued on the tokens prior to the sale of such rights would be taxable in the hands of the lender at the time the rights are disposed of and taxable as income not a capital gain.
HMRC also states that the intention is extend these rules to apply to identical CeFi transactions.
Where Next?
HMRC will be consulting on these new rules until 22 June 2023, and has posed a series of questions on which it has invited public comment. HMRC has not set out a timeline for introducing the legislation but it is not implausible that they would seek to introduce draft legislation in an upcoming budget with a view to legislating in 2024.
Legislation that provides simplicity, less tax friction, and a lower compliance burden should make the UK increasingly attractive to the DeFi market. That said, HMRC will need to design rules that are flexible to future innovation in the market if it wants the UK to remain a powerhouse for the financial services industry in a post-Brexit world. Watch this space.
