HMRC updates crypto guidance on DeFi and tax. But will the approach taken stand the test of time?

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.

If you would like to discuss this piece, then do please contact us at enquiries@humphreys.law.

Please refer to Blockchain & crypto with regard to our capabilities in this evolving area. Other Insight pieces that we have written on crypto and blockchain include:

End of ‘dot.coin’ and blockchain 101

#Block 2: the blockchain methodology

Digging digital nuggets out of the dirt: proof of work and incentivisation in a blockchain

New HMRC guidance on the taxation of cryptoassets

Cryptoasset and stablecoin regulation: HM Treasury launches consultation and call for evidence

Crypto news: Bank of England looking at its own crypto currency and HMRC publish crypto tax manual

All the thoughts and commentary that HLaw publishes on this website, including those set out above, are subject to the terms and conditions of use of this website.  None of the above constitutes legal advice. Much of the above will no doubt fall out of date and conflict with future law and practice one day. None of the above should be relied upon.  Always seek your own independent professional advice.

Humphreys Law