On 2 February 2022, HMRC updated its Cryptoassets Manual to include a new DeFi section setting out, for the first time, HMRC’s view on the taxation of cryptoassets used in decentralised finance or ‘DeFi’ transactions. HMRC appears to be one of the first tax authorities to issue such detailed guidance on DeFi, and this update will be welcomed by those who are seeking further clarification on HMRC’s views in this area.
But the new guidance looks likely to disrupt the DeFi market in ways that crypto investors and users may see as disadvantageous. Indeed, Crypto UK, an industry body, has attacked the guidance as an ‘unnecessary burden’ and ‘inconsistent’ with the approach of other UK government bodies. Here we give an overview of the new guidance as it pertains to individuals.
What is DeFi?
DeFi is a type of financial technology based on a similar distributed ledger technology (‘DLT’) as which underpins cryptocurrencies. It provides a means for financial services to be carried out without the involvement of the traditional gatekeepers of the financial world.
The DeFi section of HMRC’s guidance is concerned with ‘lending’ and ‘staking’ of tokens. Broadly, lending in this context involves the owner of a cryptoasset transferring it to a borrower or DeFi lending platform as a loan. Staking in this context is where a person (known as a ‘liquidity provider’) transfers the control of tokens to a DeFi lending platform, at which point the platform transfers control of one or more different tokens to the liquidity provider. This meaning of ‘staking’ is not to be confused with ‘proof of stake’ staking, in which the owner of the cryptoasset locks the asset up as a way of contributing towards the functioning of the blockchain network (and earns rewards for doing so).
There are numerous applications of DeFi technology and ways in which users engage with it but the new guidance limits itself to describing certain types of transaction and setting out some general principles.
The new DeFi section covers a number of important tax questions. What kind of taxable events, if any, occur when cryptoassets are lent, borrowed or used as collateral? How does HMRC plan to tax the returns earned by lenders for lending or staking? We look at these in overview below.
The rules below can be expected to apply to an individual in any year in which he or she is UK tax resident, but individuals with an international nexus should consider taking specific advice as their position may be more complicated. Please refer to our article on the location of cryptoassets here for more information).
DeFi returns – income or gains?
Whether the return from lending or staking is characterised as income or gain is clearly an important question for the lender, with income tax rates reaching up to 45% compared with 20% for capital gains tax.
HMRC rules out the possibility that any return earned can be interest for tax purposes, but as expected HMRC’s basis for taxation of the return requires the return to be characterised as either an income (revenue) receipt or a capital receipt. To do this, the guidance asks us to consider whether the return is:
- earned by the lender for the provision of a service to the borrower or DeFi platform (in which case it is likely to be income), or
- realised from the capital growth of the asset owned by the lender (in which case it is likely to be a capital).
This ties into a key question in tax terms, which is whether the activity generating the return is a trade or not. Relevant factors are whether the amount of the return is known in advance, whether it is paid periodically or as a lump sum and whether the lending is for a fixed or indefinite period and short or long term. The amount chargeable to tax is the sterling value of the tokens at the date of receipt.
Naturally, all this means that whether a particular DeFi transaction will result in an income or capital return to the lender will be very fact sensitive and require in-depth analysis if the conclusion is on the margin. However, it would not be surprising if, as DeFi transactions/activities gain traction, HMRC take a greater interest in them as a potential trading activity.
While it is possible that the activity of lending tokens can itself amount to a trade (leading to a charge to income tax on any profits from that trade), HMRC states that individuals will only be carrying on a trade involving the making of DeFi loans in exceptional circumstances, although each case will turn on its own facts.
Disposals for capital gains tax purposes – unwelcome news
The new guidance also covers how cryptoassets are taxed when they are lent, borrowed or used as collateral.
The key issue is whether a transfer by a lender or borrower of cryptoassets counts as a ‘disposal’ for capital gains tax purposes. If there is a disposal (see further below), a 10% or 20% tax charge will be levied on any gain realised by the holder (ie on the positive difference, if any, between the holder’s pooled acquisition cost for the cryptoassets and the value at the time of the disposal).
HMRC identifies several points at which a disposal may occur, including:
- when an individual lends cryptoassets to a borrower;
- when an individual transfers cryptoassets to a DeFi platform in return for other tokens received from the DeFi platform; and
- when an individual locks up his or her cryptoassets as collateral for a loan.
Is there a disposal?
Whether the transfer of the cryptoasset is a disposal is fact dependent and turns on whether the recipient of the tokens has the ability to deal with them as he wants or is restricted from doing so. The same applies to a borrower who provides tokens as collateral for a loan.
However, as would be expected, whether there is a disposal will require an analysis that is sensitive to the facts of each case, particularly the terms on which the recipient receives the tokens.
High and dry
If a DeFi transaction does trigger a disposal under the new guidance, this could very quickly lead to liquidity issues for some users by creating a ‘dry’ tax charge – where the taxpayer does not actually receive any cash to pay the tax liability. Worse still, it might lead to a charge to tax in circumstances in which the taxpayer has not beneficially received any value at all.
For example, if Alice lends 10 tokens to Bob with a market value of £10 per token, firstly she must calculate the difference between the tokens’ base cost and the market value at the time of the loan, and pay capital gains tax on any gain. If, when Bob repays Alice, the market value of the tokens is £15 per token, Bob must pay capital gains tax on his gain of £50, even though on the face of it he does not personally benefit from the increase in value of the tokens he borrowed. The position is more nuanced where tokens are transferred by the borrower to a DeFi platform to provide collateral for his/her loan.
Borrowers in particular therefore need to be very careful about how they engage with DeFi services, to avoid an unexpected dry tax charge, particularly given the volatility of cryptoassets.
In addition, it may be necessary for some individuals to sell some of their cryptoassets in order to pay the liability, which would itself potentially be another chargeable event.
Why does it matter?
It is worth highlighting at this point that HMRC guidance is not law; rather, the guidance sets out HMRC’s interpretation of the law. The absence of case law and legislation does open the door to taxpayers adopting alternative interpretations and positions, but in turn this could pave the way for litigation between HMRC and taxpayers.
In the meantime, taxpayers should not ignore this guidance. HMRC has not stated explicitly whether the guidance applies retrospectively, and without any such reassurance, taxpayers who have used DeFi services in prior tax years will need to consider carefully whether they need to amend their tax returns. Given that DeFi is a relatively recent phenomenon, in most cases this may only require amendments to one or possibly two years’ tax returns.
How we can help
The recent publication of the DeFi update to the Manual highlights once again how quickly this area of taxation is evolving. Crypto investors who have filed on what HMRC may now view is an incorrect basis or who are seeking to regularise their tax position in light of the developing guidance should seek legal advice.