HMRC Updates Crypto Guidance On DeFi And Tax. But Will The Approach Taken Stand The Test Of Time? – Fin Tech


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On 2 February 2022, HMRC released a long-awaited update to its
Cryptoassets Manual on the tax treatment of ‘Decentralised
Finance’ (‘DeFi’), an
increasingly popular crypto investment space. The update (which can
be found 
HERE) seeks to clarify the UK tax treatment of certain DeFi
arrangements for the first time – HMRC is among the first tax
authorities to attempt to do this – and investors and
borrowers involved with DeFi and subject to UK taxation need to
take note.

While taxpayers operating within the DeFi space have welcomed
the fact that HMRC has clarified the position it intends to take
with regard to DeFi arrangements, the new guidance has received a
mixed response in terms of substance.  Some crypto trade
bodies, such as Crypto UK, regard it as an unnecessary and
illogical burden on investors that is at odds with the approach
taken by other government bodies such as the Financial Conduct
Authority and HM Treasury.

The need to apply existing UK tax rules to a new area that
challenges commercial boundaries and is developing too fast for the
rules to keep up, is no doubt a source of difficulties for crypto
investors as well as HMRC.  Until the legislator establishes a
separate tax regime for crypto, HMRC has the task of trying to
shoehorn novel concepts into a set of existing rules conceived for
‘conventional’ assets.

How long this state of affairs will continue is hard to
predict.  The UK government is keen to turn the UK into a
“global cryptoassets hub”, as per the Treasury
announcement on 4th April 2022 (available 
HERE), which sets out a range of measures to achieve this and
display the UK’s forward-looking approach towards
cryptoassets. These include proposed new regulations to facilitate
the use of stablecoins as a form of payment (on which HM Treasury
had been consulting for some time – see our 
Insight piece from January 2021) and plans for the Royal
Mint to launch a non-fungible token
(‘NFT‘). And, significantly, the
Treasury has promised a review of how the UK tax system could
encourage further development of the cryptoasset market in the UK,
acknowledging issues surrounding the current tax treatment of DeFi
loans and staking.  Perhaps this will eventually result in
bespoke rules being introduced for crypto and DeFi?

What is DeFi?

DeFi is an emerging financial technology based on blockchain
technology, which allows participants to trade, borrow and lend
cryptoassets without going through a centralised intermediary. It
thus reduces the need for traditional financial institutions/banks,
while also aiming towards lower costs and increased
transparency.

DeFi lending and borrowing has proven to be particularly
attractive to investors due to high yields. In this context,
‘lending’ is typically a process whereby the crypto
investor (lender) transfers control of the tokens to a borrower,
and in doing so the lender obtains a right to demand that the
borrower transfers an equivalent quantity of tokens in the future
to satisfy the loan.

Similarly, ‘staking’ (in this context) involves a
process whereby the crypto investor (otherwise referred to as the
‘liquidity provider’) transfers control of tokens to a
DeFi platform and is in turn provided with rewards, usually paid
out as tokens. This is a form of passive income similar (but
importantly, not the same) to loan interest.

Taxation of DeFi arrangements – key points
from the new HMRC guidance

Tax treatment for DeFi returns: income or capital
gains?

HMRC has clearly stated that periodic returns from staking or
lending in DeFi arrangements will not be treated as interest,
despite the commercial similarity of these arrangements to a
traditional loan in fiat currency. HMRC justifies this position by
stating that cryptoassets are not real currency (and there are
other tax authorities, such as the IRS, that currently take a
similar approach).

On that basis, the question is whether DeFi returns are
classified as income or capital gains. This distinction is
significant given the difference in income tax and capital gains
tax rules (including rates).  Essentially, it turns on a
question of fact: does the return resemble an income receipt or a
capital receipt?

The new HMRC guidance sets out a number of factors to consider
(based on established general principles) while acknowledging that
DeFi is a constantly evolving area, which makes it impossible to
set out all the circumstances in which a lender/liquidity provider
earns a return from their activities and the nature of that
return.

One such factor is whether returns are fixed (for example, an
agreed return at 5% to be paid monthly for a set term), as opposed
to unknown and speculative. The former scenario would be indicative
of an income return, the latter of a capital receipt.  Another
consideration is whether returns derive from the provision of a
service on the part of the investor, or whether they represent
capital growth of an investment.

Accordingly, DeFi investors will need to carry out a detailed
analysis of the DeFi arrangements in question in order to ascertain
what types of returns they receive.

Change in token ownership may be considered a
‘disposal’ for capital gains tax purposes

One of the most significant points to note from the updated
guidance is that DeFi arrangements may give rise to unintentional
‘disposals’ for capital gains tax
(‘CGT‘) purposes, depending on the way
in which they are structured. A disposal typically occurs where a
given item has been transferred such that there is a change in the
beneficial ownership of that item.

Disposal on the part of the lender/investor

Where a crypto investor lends cryptoassets to a borrower in a
typical DeFi ‘lending’ arrangement, such arrangement
may result in the beneficial ownership of the relevant cryptoassets
to pass from the lender to the borrower, thereby triggering a
taxable disposal on the part of the lender. This may also occur in
a typical ‘staking’ arrangement where beneficial
ownership of cryptoassets passes from the investor to a DeFi
platform. In both cases, the disposal will give rise to CGT
(subject to any available exemptions or reliefs).

Disposal on the part of the borrower

Borrowers in DeFi arrangements are commonly asked to provide
cryptoassets as collateral (not unlike collateral with a
traditional bank loan). As the borrower will typically not have
access to those cryptoassets for the period of the lending
arrangement, this may also be treated as a taxable disposal, thus
triggering a CGT charge.

A further issue for borrowers is that a second disposal is
likely to take place when the borrower repays the principal amount
by returning the tokens previously borrowed, as the beneficial
ownership of such tokens will once again revert to the lender. If
the value of the tokens has risen over the loan period, the
borrower will face a CGT bill despite having realised no actual
gain. Given the volatility of cryptoassets, significant CGT
liabilities could thereby arise.

Looking ahead

To avoid unexpected (and unwelcome) tax consequences, investors
and participants in the DeFi space should make themselves familiar
with the latest update to the HMRC Cryptoassets Manual.  But
some uncertainties remain.

HMRC admits in its new guidance (e.g.
 HERE) that, as crypto is a ‘constantly evolving
area’, the current guidance is not comprehensive. And since
there is no single standardised DeFi model, different DeFi
arrangements could potentially be subject to very different tax
treatments. It will also take some time for the new guidance to bed
in and be tested by the courts.  Looking at the speed of
development, the current guidance may well be out of date by the
time any case law starts coming through.

As things stand, DeFi investors and borrowers will have to
contend with the increased tax (and compliance) burdens that result
from having to treat certain DeFi arrangements for lending and
staking cryptoassets as disposals.  But given the UK
government’s determination to make the UK a more attractive
place for crypto, including HM Treasury’s acknowledgement of
the issues surrounding the tax code and DeFi, this may not be the
end of the matter.

Originally Published 14 April 2022

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.


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