HMRC calls for evidence on taxation of DeFi transactionsby
The government is seeking views on whether its current approach to decentralised finance results in unnecessary administrative burdens. Helen Thornley examines what is at stake in the consultation process.
When HMRC published its guidance on decentralised finance (DeFi) transactions in February 2022 it proved unpopular. Following a statement in April from the government outlining that they want the UK to be a global hub for cryptoassets, HMRC has now published a call for evidence to ask if there are alternatives to their current position.
DeFi is the cryptoasset equivalent of traditional financial services activities. Individuals and businesses can lend or borrow, put their cryptoassets up as collateral or transact in cryptoasset derivatives. Deals are based on smart contracts – contracts expressed in computer code that will execute automatically when the agreed terms and conditions are met.
While it is possible for an individual to lend out their cryptoassets on a peer-to-peer basis, the majority of transactions occur on platforms or exchanges, which provide a form of marketplace. Like traditional financial services, lenders can expect some kind of reward for making their tokens available but, unlike the traditional approach, there are no middlemen or intermediaries such as banks to determine who can lend or borrow.
HMRC provided an update to their cryptoassets manual specifically covering DeFi transactions in February 2022. The key to this is HMRC’s view that the tax treatment of DeFi transactions depends on whether beneficial ownership of the underlying tokens changes at any point. If the person borrowing the token can do as they wish with it for the duration of the loan, then HMRC’s view is there are two potential capital gains tax (CGT) disposals for the lender – one on the initial loan of a token (when the lender will be issued with some sort of liquidity token in exchange) and a second when the lender gets their original tokens back and disposes of the interim liquidity token. On top of that, any interim returns during the loan that might look like interest are taxable as income.
This approach is unpopular for a number of reasons. Firstly, there is the significant administrative burden of carrying out multiple CGT computations (not always straightforward) and secondly, there is a “dry” tax charge created when the loan starts before any profits have been made. A number of those active in the DeFi space have argued that this approach is inconsistent with the economic substance of the transaction, and that what is really happening is a financing exercise, in which the lender “borrows” cash for a period by selling tokens and then agrees to repurchase them at a later date – a “repo” transaction. Similarly, securities can be borrowed for short periods of time in stock lending arrangements. Such transactions with shares are taxed under special rules as loans and not as disposals subject to CGT.
Unnecessary administrative burdens
HMRC is seeking views on whether the current approach results in unnecessary administrative burdens. This call for evidence is an open stage 1 consultation and is focused on DeFi lending and staking where those involved are not trading. Lending includes the loan of cryptoassets either directly (peer-to-peer) or indirectly via a platform. Staking involves providing tokens to a platform, which are then pooled with tokens from other users in a liquidity pool that the platform can use to provide other DeFi services.
Other forms of transactions or trading activities related to DeFi are out of scope. The call for evidence also confirms that HMRC is holding to the position that an individual engaging in DeFi transactions and holding crypto is unlikely to be trading and therefore will be largely subject to CGT on any gains/losses.
Crux of the consultation
In addition to some questions focused on getting more background information on the DeFi market in the UK, the crux of the consultation is whether different options for the taxation of DeFi lending or staking would be an improvement. The consultation sets out three options:
1. Allow DeFi transactions to be brought within the repo and stock lending rules by defining cryptoassets as securities
2. Create separate, specific tax rules for DeFi lending/staking along the lines of repo and stock lending
3. Apply a “no gain no loss” treatment to DeFi loans and staking, so that any tax liability is deferred until the assets are disposed of in a non-DeFi transaction (for example cashed in for fiat currency or for other cryptoassets).
The consultation also invites respondents to make other suggestions. Interested parties have until 31 August to respond.
The ATT will be responding to the consultation and is currently seeking members’ views.
While the first option appears to be the simplest and would remove some of the administrative burden, the second option would get the same result and help set a useful precedent resulting in the creation of legislation specifically targeted at cryptoassets. As yet, we are having to wrestle this distinct class of assets into existing legislation. Having specific cryptoasset legislation may be better in the longer term. The third option would start to introduce the idea of taxing cryptoassets differently as a discrete class, which again might be a more manageable approach in the future.
Whatever approach is taken, the main practical issue with establishing the tax position when dealing with cryptoassets is often the sheer volume of transactions. Any solution needs to be something that can be automated easily so the various software providers that are emerging to help people calculate the gains and losses on these assets are able to apply the rules easily – and that it is possible to audit how the resulting gains or losses have been established.
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Helen Thornley has a focus on personal and capital taxes. Initially training as an accountant before moving to tax, she worked in practice until her appointment as a technical officer in 2017. She also has an interest in the history of tax.