Share this content
A heap of abstract stylized digital coins
istock_whitehoune_AW

HMRC calls for evidence on taxation of DeFi transactions

by

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.

3rd Aug 2022
Share this content

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.

Cryptoassets manual

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.

Summary

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.

 

Replies (5)

Please login or register to join the discussion.

avatar
By JustAnotherUser
03rd Aug 2022 12:08

Before they call for evidence on Defi, the global and local need for classification is needed, not an easy ask.

coin, token, currency, asset, commodity, securities...

SEC chairman "Cryptocurrencies like bitcoin are not securities (they are commodities)"...This includes cryptocurrencies such as Bitcoin, Ether, and Litecoin..."

Not much is truly decentralised, what is it that needs to be decentral... the token, the DeFi aspect, a DOA? What if DeFi is the name but its not actually decentralised?

"The UK Treasury in April announced plans to make the country a global crypto hub" - ok just go with option C please and apply a simple flat rate fee....

Some other countries views... maybe we should band together into some kind of European union on these type of affairs?
https://koinly.io/blog/crypto-tax-free-countries/

#brexitmeansbrexit
#itsjustabunchoftulips

Thanks (0)
Replying to JustAnotherUser:
avatar
By Hugo Fair
03rd Aug 2022 23:10

Is any of the above available in English?

I know you're hip to the crypto daddio ... but some of us don't even understand your last two lines (the ones starting with a hash symbol)!

I might be interested (no promises) if I could understand what's being said.

Thanks (2)
Replying to Hugo Fair:
avatar
By JustAnotherUser
04th Aug 2022 09:35

Its a suggestion of some form of standardisation... the first hashtag is that any European standardisation would be silly for the UK to be a part of.

The issue is...
Lets say the SEC in the states classifies a token/coin.....etc etc as a security (loosely) "investors kicking in money with the intention of profiting from the efforts of the organization’s leadership"

But bitcoin is classified differently as truly decentralised with no leadership or organisation.

Lets say a firm creates a token then turns it into a DAO, (decentralized autonomous organization) separate to the organisation, but still an organisation, just owned by its members....is this now treated separately?

The issue governing bodies will have is that every body will and is treating all these things differently, and the web 3 movement will easily adapt and change way faster than any legislation, legislation that will only hurt the small investors, anyone with substantial money in the game will just move their operations for better tax purposes.... easy examples in the states is the moves to Puerto Rico.

If the UK wants to be a hub, make the tax treatments simple and attractive and competitive with others. If they don't do this, the complex nature of crypto tax will still capture some extra tax from the average Joe, but the big boys will leave and HMRC gets nothing.

The second hashtag is for the users who contribute nothing other than screaming that this entire space is just tulip mania, a pyramid scheme and a pointless scam

Thanks (0)
avatar
By JustAnotherUser
05th Aug 2022 09:16

Interesting side note, the law commission recently published a 549 page document on digital assets / consultation paper for provisional law reform proposals.

This is good news and will help classify these things in law and is much bigger news as it could set precedent on how HMRC treat these things.

One of the main topics is that existing property laws can’t sufficiently accommodate digital assets.

Property law in England recognises two types of personal property: “Things in possession” and “Things in action” for property like company shares that can “only be claimed or enforced through legal action.”.... They are proposing the creation of a new category called “data objects”. ... will there be a new data objects Tax in the future?

Thanks (1)
Replying to JustAnotherUser:
avatar
By Hugo Fair
05th Aug 2022 21:16

Interesting (or terrifying) indeed!

Do you suppose they have the slightest idea what the term "data objects" means (and has meant for over 20 years) in the realms of IT/Computing?

They have a transient existence (and can be created/deleted by automated trigger actions - so not just without human intervention but without human knowledge).
This may turn out to be appropriate in attempting to tie down a digital economy, but sounds to me like trying to capture quicksilver in the 4th dimension via as yet undeveloped quantum 'measurements'!

Thanks (1)