HMRC have released the outcome of their consultation on 'The taxation of decentralised finance (DeFi) involving the lending and staking of cryptoassets'. HMRC are considering deferring gains on certain DeFi lending and staking transactions until an economic disposal of the cryptoasset is made.
Following the publication of guidance in 2022, in which HMRC set out their interpretation of how the law applies to cryptoasset loans and liquidity pool arrangements, concern was raised that there may be situations where the tax treatments lead to disproportionate administrative burdens.
The government then released a Call for evidence in July 2022, looking for opinions on potential options for the taxation of crypto loans and liquidity pools.
Three options were put forward to be considered:
- Option 1: Bring cryptoasset loans and liquidity pools into line with the repo and stock lending regimes by defining cryptoassets as securities for the purposes of those rules.
- Option 2: Create separate rules for cryptoasset loans and liquidity pools that follow the principles applicable to repos and stock lending. This would remove some lending and staking transactions from the scope of Capital Gains Tax (CGT).
- Option 3: Introduce new rules based on the 'no gain, no loss' (NGNL) principle, where the disposal value is treated as matching the acquisition cost, effectively deferring the tax liability until tokens are economically disposed of.
Respondents favoured both option 2 and option 3 in equal measures; however, option 3 was considered by many to be administratively burdensome.
Following on from this, a further consultation was issued in April 2023. New rules were proposed that would disregard, for CGT purposes, any disposal of beneficial ownership that may occur during cryptoasset loans or liquidity pool arrangements. Instead, a CGT liability would arise when the cryptoassets are economically disposed of.
Opinions were also sought on the tax treatment of rewards from cryptoassets from such arrangements.
Respondents unanimously supported HMRC's review of the current rules. Key themes were:
- A need for new regulations to make compliance more straightforward.
- Flexibility to adapt when new arrangements emerge.
- Simplifying compliance in the sector and bringing greater tax certainty.
The government highlighted that the cryptoassets market is still evolving and the right balance is required between fostering innovation and growth, and protecting the integrity of the tax system.
Proposed scope of the potential rules
The proposed new rules were welcomed by respondents, and it was felt that this was a step in the right direction by HMRC.
- There was discussion around which transactions would be caught by the new rules, with many pointing out that further clarification is needed regarding the scope of the new rules.
- Many respondents considered that the specific conditions of the new rules would be too narrow and only affect a small fraction of the market.
- In contrast, some respondents thought the scope was wide but did note that consideration would need to be given to the fact that the market continues to evolve with new models and platforms continuing to emerge.
Unintended consequences and potential for abuse
Around a third of respondents highlighted their concerns for unintended consequences arising from applying a repo-like principle.
Many supported the NGNL principle as it would be better suited to achieving the policy intention. Reasons being:
- Administrative burden.
- A repo-like approach means users would still need to track the liquidity token and/or rights in relation to such transactions.
- NGNL is a more familiar principle.
- NGNL would be a more suitable approach for liquidity pool models with repo-like principles, leading to disproportionate administrative burdens and uncertainty of tax treatment.
Rights
Over half of the respondents believed that the legal nature of the lender's right is dependent on particular facts and would require review on a case-by-case basis, particularly where a platform is involved, as it would depend on the platform's terms and conditions.
- Some comments pointed out that terms and conditions applied to certain arrangements are not always clear and can also change over time.
- In contrast, a quarter of the respondents consider the right of the lender would normally be of a legal nature, but cited legal complications around enforceability as an issue.
- There were a few respondents who believed, generally, there would be no legal right for participants.
Reward
Some responses favoured simplifying the operation of the tax treatment of returns; however, most respondents were not in favour of a direct change to treat all returns as revenue.
It was thought that this approach:
- May lead to unintended consequences.
- Ignored the long-established principle of distinction between capital and revenue.
- May result in returns being taxed at a higher rate than capital gains, leading to overall higher tax liabilities.
- Could encourage artificial tax avoidance structures.
- Could bring non-residents into the scope of UK tax.
Around a fifth of the respondents said they would be content with returns being treated as revenue so long as provisions were made to ease the position, such as:
- Allowing capital losses to be offset against revenue.
- Changing the tax point for recognising such return income to be when the return crystallises to fiat currency.
Single token arrangements
Many respondents highlighted that the examples given in the consultation had been over-simplified to demonstrate basic principles and did not fully reflect the scope of the market.
Multi-token arrangements
Almost all respondents who laid out their thinking on how to tax this type of arrangement proposed a treatment based on the NGNL principle.
It was advocated that depositing into and redemption from liquidity pools should be treated as NGNL dispositions.
General comments
Respondents highlighted:
- Consideration should be given to applying the new rules retrospectively to earlier periods by way of an election.
- Some respondents required clarity on definitions and emphasised the importance of having clear definitions.
- Some sought clarification on how the new rules would interact with other tax rules, such as Corporation Tax.
Impact of the proposed new rules
The responses were mixed on how effective the new rules would be in reducing administrative burdens and costs for DeFi users.
- A third of respondents believed the new rules would reduce the administrative burden.
- Another third believe adopting the repo-like principle will increase the administrative burden. Many are adding that these rules are already not well understood.
- The final third gave no direct answer but highlighted that taxpayers would be expected to continue to require professional advice, which incurs costs.
Next steps
HMRC have continued to engage with stakeholders and adopted a possible new approach. This is outlined with examples here. They will continue to assess the merits of this approach and the case for making legislative changes.
Useful guides on this topic
How are Bitcoin, cryptocurrencies or cryptoassets taxed in the UK?
How do you tax Bitcoin? Are cryptocurrency or cryptoasset gains or profits taxable? Can you obtain tax relief if you make losses on Bitcoin? Gains on transactions in cryptoassets are potentially taxable in the same way as other investments.
How are Cryptoassets taxed in the UK? At a glance (Freeview)
How do you tax Bitcoin? Are cryptocurrency or cryptoasset gains or profits taxable? Can you obtain tax relief if you make losses on Bitcoin?
External link
HMRC: The taxation of decentralised finance (Defi), involving the lending and staking of cryptoassets