Writing for Taxation magazine, BKL cryptocurrency tax expert Sam Inkersole explains HMRC’s current approach and guidance for cryptoassets and decentralised finance (DeFi).
- More understanding is needed of decentralised finance.
- HMRC has updated its cryptoassets guidance to define decentralised finance, including terms like lending and staking.
- HMRC launched a consultation in July on the taxation of cryptoasset loans.
DeFi’ning a new approach
On 5 July 2022, HMRC released Individuals holding cryptoassets: uptake and understanding. According to this report, 10% of UK adults hold or have held a cryptoasset. This may be surprising to those who dismiss cryptocurrencies and other digital assets as a fad, but with an estimated $30bn invested into the global crypto industry in 2021 (according to KPMG’s Pulse of Fintech H2’21 report from January 2022), crypto in some form is here to stay. This is further supported by Google, Microsoft, PayPal and Goldman Sachs (to name a few) backing projects in the crypto space. As Andrew Hubbard said in these pages in March, cryptocurrency has ‘moved well into the mainstream’ (‘Overcoming adversity’, 31 March 2022, page 14).
One area of rapid innovation has been decentralised finance or DeFi for short. The term describes peer-to-peer finance, such as: collateralised and uncollateralised borrowing; individual and pooled lending; insurance products; saving to earn interest; providing liquidity to a pool to stabilise a crypto’s value. If you have come across a proposal in the real world, then there will already, or soon, be a version of it in the crypto sphere which operates according to a pre-programmed smart contract, taking out the requirement for individuals to sit in transactions.
This article will explore the importance of DeFi and why we should start building an understanding of the underlying activities and the tax implications.
HMRC’s current DeFi guidance
In February 2022, HMRC updated its Cryptoassets Manual to cover DeFi transactions (CRYPTO60000) in which it outlined what it understood by the terms lending and staking including the tax implications for the lender and borrower.
The general principle HMRC has applied to crypto taxation is that when a crypto holder exchanges their crypto for another crypto or back to conventional currency (known as fiat), a taxable event has occurred. The crypto holder has lost their beneficial interest in the original crypto for a beneficial interest in another asset.
So long as this activity does not amount to a trade, the profit made on the gain will be subject to tax under the capital gains rules. In CRYPTO20250, HMRC notes that: ‘Only in exceptional circumstances would HMRC expect individuals to buy and sell exchange tokens [cryptocurrency intended to be used as a means of payment, such as Bitcoin] with such frequency, level of organisation and sophistication that the activity amounts to a financial trade in itself. If the taxpayer’s activity is considered to be trading then income tax will take priority over capital gains tax and will apply to profits (or losses).’
This general principle of a change in beneficial ownership followed through to HMRC’s DeFi guidance. The two examples below (Arabella and Bertie) show how different legs of a vanilla DeFi lending/borrowing transaction occurs.
Example 1: Arabella
Arabella contributes TokenA to a DeFi platform’s lending pool, in exchange for a return on their principal at 10% per year. Arabella receives a non-tradeable TokenA1 in exchange for adding her TokenA holding to the pool. The DeFi platform can onwards lend TokenA or undertake other activities whilst the cryptoasset is in the pool. Twelve months later, Arabella exchanges the TokenA1 crypto for her initial principal amount of TokenA.
The initial exchange leaves Arabella in the position of giving up her beneficial interest in TokenA until such a point she chooses to redeem her TokenA1 holding for the TokenA cryptoasset. This transaction has been undertaken by Arabella in order for her to obtain a return on her cryptoasset, rather than Arabella carrying on a trade of adding cryptoassets to liquidity pools. As outlined in HMRC guidance (CRYPTO61600), adding her TokenA holding to the lending pool will create a taxable event for Arabella, on which CGT will arise (on the difference between the original purchase price of the TokenA holding, subject to the TCGA 1992, s 104 pooling rules, and the market value of the TokenA holding at the date it is added to the lending pool). Given that Token1A is a non-tradeable token, this would be a dry tax charge: a tax charge which arises where no cash or liquid consideration is received in a disposal. This is something which HMRC is looking to address in its call for evidence which is touched on later in this article.
The return is income in nature and is taxable under the sweep up provisions in ITTOIA 2005, s 687 to s 689. HMRC notes in CRYPTO61212 that it does not regard the return to be interest for tax purposes, which has the effect of not enabling the personal savings allowance in ITA 2007, s 12 to be used against the returns received on the provision on the cryptoassets to the lending pool.
The final exchange from TokenA1 to TokenA would again be a taxable event, subject to CGT. The base cost of TokenA1 would be the market value of TokenA at the date it was originally added to the lending pool. Again, this is a dry tax charge: if the value of TokenA had increased in the period it was in the lending pool, then additional tax would be due. Where there is a fall in value of TokenA during the period and the final exchange happened in the same tax year then it would be possible to net the previous capital gain against this capital loss. The issue arises where a capital gain was made in the period in which the initial exchange occurred and then a capital loss is incurred in the next period when the final exchange occurs: under the capital gains rules it is not possible for this capital loss to be carried back into the previous period, resulting in the possibility of a trapped loss.
Example 2: Bertie
Bertie applies to a DeFi platform for a collateralised loan: he wants to put up 100 TokenB as collateral and borrow TokenC at a 70% loan to value. The DeFi platform holds TokenB on trust for Bertie and does not have the right to do anything with it, except liquidate it if the loan to value ratio falls below a set level. Six months later, Bertie’s loan to value drops below that required by the DeFi platform and part of his collateral is automatically liquidated. After this, Bertie repays the remaining loan balance and the remainder of the collateral is returned to him.
On the transfer of the collateral to obtain the loan, the DeFi platform is specifically restricted from entering into other transactions with the collateral. In CRYPTO61640, HMRC outlines this as a strong indication that the DeFi platform has not acquired the beneficial ownership of the collateral. As such, Bertie has not made a disposal by transferring the collateral to the DeFi platform to hold on trust.
The liquidation event, where the loan-to-value ratio falls below the predetermined amount and the collateral is liquidated by the DeFi platform automatically, will result in a disposal which is treated under the rules outlined in TCGA 1992, s 26(2). To calculate the capital gain/loss on the liquidation, the portion of the loan forgiven (or treated as repaid) under the liquidation event will be treated as the proceeds for the TokenC which are liquidated; and the base cost will be the amount paid by Bertie to acquire the original TokenC holding, subject to the TCGA 1992, s 104 pooling rules.
The repayment of the loan by Bertie, and subsequent return of the remaining collateral by the DeFi platform to Bertie, will not be a taxable event. The transaction here is the return of assets to Bertie, over which he retained beneficial ownership throughout the period.
HMRC call for evidence
Between July and August 2022, HMRC consulted on the taxation of cryptoasset loans and ‘staking’ within the context of decentralised finance. This has a particular interest in ascertaining whether administrative burdens and costs could be reduced for taxpayers engaging in this activity, and whether the tax treatment can be better aligned with the underlying economics of the transactions involved.
The consultation put forward three different proposals:
- Option 1: Legislate to bring DeFi lending and staking within the repo and stock lending rules by defining cryptoassets as ‘securities’.
- Option 2: Legislate to create separate rules for DeFi lending and staking, along the lines of those applicable to repos and stock lending.
- Option 3: Apply a ‘no loss no gain’ treatment to DeFi loans and staking, deferring the tax liability until the assets are economically disposed of.
There are pros and cons for each of the options: the idea of tax professionals needing to explain complex repo and stock lending rules to clients, who do not necessarily understand the fairly simple principles currently laid out in guidance, is not a prospect which many of us would relish. In addition, none of the proposals cut down on the administrative burden of compiling trading data from multiple exchanges and categorising it (normally using a third-party piece of software on which all parties place some sort of reliance).
It is my view that new legislation, starting with a blank piece of paper, is required to give certainty of tax treatments attributable of the array of cryptoassets available to the general public. This would need to be hand in hand with regulation of the cryptoasset space.
This consultation is a step forward and underpins my initial assertion that understanding cryptoassets, and the tax treatments applied to them, is crucial for all tax advisers. The cryptoassets on offer to the public may change drastically over the coming months and years, but one thing we can be sure of is that the technology behind cryptoassets is here to stay.
This article was first published in Issue 4860 of Taxation magazine and is available here on the Taxation website.
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