Taxation of decentralised finance: call for evidence

The government has published a Call for Evidence on the tax treatment of decentralised finance (DeFi) transactions involving the loaning and staking of cryptoassets. In particular, the government is concerned to address the tax charge that can arise where lending or staking of cryptoassets leads to a transfer of beneficial ownership in circumstances where, economically, investors do not consider that such a transfer has taken place.

The purpose of the call for evidence is to obtain more evidence about how the tax treatment impacts DeFi activities and to inform the government’s options for reducing the administrative complexity for taxpayers arising from the application of current tax law. The government invites views from a wide range of stakeholders, particularly firms and investors engaged in relevant cryptoasset transactions.

This call for evidence only concerns the tax treatment for investors participating in DeFi lending and staking. Other DeFi activities are not in scope. Also out of scope is the tax treatment of transactions entered into by an individual or entity as part of a trade, such as running a platform.

Background

In April 2022, as part of the government’s broader response to the regulation of cryptoassets and stablecoin and the use of distributed ledger technology in financial markets, the government announced that it would review how DeFI loans and staking is taxed. DeFi lending and staking encompasses a range of activities that reward users who deposit cryptoasset tokens into a pool or lend them to other individuals or platforms to earn passive income returns often described as interest.

This followed the publication of HMRC guidance in its Cryptoasset Manual setting out HMRC’s view on the taxation of cryptoassets used in or DeFi transactions. The guidance covers a number of important tax questions concerned with DeFI transactions, including HMRC’s view on the nature of returns from these activities and when taxable events occur where cryptoassets are lent or staked.

In particular, HMRC’s guidance indicates that the lending or staking of cryptoassets to a DeFi platform in return for other tokens received from the DeFi platform will generally give rise to a disposal for tax purposes where the lender/transferor if the lender/transferor has transferred beneficial interest in their tokens. The same analysis would apply to a borrower who provides tokens as collateral for a loan. This analysis is, of course, fact specific and will depend on particular terms of any arrangement as well as factors including the nature of smart contracts deployed and the underlying technology of the tokens lent/staked. However, this analysis attracted criticism as it potentially leads to a tax charge in circumstances where the lender/transferor does not receive any return at the time of the disposal (a so-called dry tax charge). For further information, see our recent Insights article discussing HMRC’s DeFi Guidance.

The government will use the information received from the Call for Evidence to decide what changes, if any, are needed to reduce administrative burdens and costs for taxpayers engaged in this activity, and whether the tax treatment can be better aligned with the underlying economics of the transactions involved.

Call for Evidence

The document notes that the tax outcome for participants in DeFi activities is determined by the facts and circumstances, rather than the terminology used. It is therefore necessary to establish the legal substance of each transaction before applying the relevant tax law. However,
DeFi is an evolving area and, particularly in novel situations, it may be necessary to conduct an extensive factual analysis to determine the correct tax position, including, in particular, whether there has been a transfer of beneficial ownership.

In general, a transaction involving the lending or staking of tokens has three main elements that need to be considered for tax:

• the lending of tokens or making the tokens available for staking
• the return from the lending or staking activity
• the repayment of the DeFi loan or the withdrawal of stake.

Under the current law, the tax treatment of the lending/staking of cryptoassets and the repayment/withdrawal will depend on whether there is a transfer of beneficial ownership. If there is, then there will be a disposal for capital gains tax (or corporation tax) purposes with a potential tax charge (which, as noted above, may be a “dry” tax charge. Moreover, the need to determine and record the market value of assets at each step in the transaction may also give rise to a disproportionate administrative burden.

The return from the lending and staking activity may give rise to an income or capital receipt, which will determine its tax treatment. The document recognises that this may also be a difficult question.

The call for evidence sets out four principles to be used to review the current tax treatment of DeFi lending and staking:

• Tax neutrality between economically equivalent activities: the tax system should not distort the market by unintentionally incentivising participants to favour one activity or asset over another which is economically similar. As such, holders of cryptoassets should obtain broadly similar tax outcomes to holders of other financial assets (eg shares) when lending or borrowing their respective assets.
• The tax system ought to reflect the economic substance of the activity in question: the tax system can treat DeFi loans and staking as disposals for CGT purposes. However, many users consider that when they lend or stake their tokens, they retain ownership and will recover those same assets in due course. They therefore question whether they should be regarded as disposing of the assets and realising a chargeable gain or loss. Under the current rules, DeFi users could be liable for a dry tax charge. This leads some stakeholders to question whether the tax treatment is consistent with the economic substance of the transaction.
• An efficient tax system that is perceived as fair and predictable: to achieve this, there must be clarity in law.
• Minimising the administrative burden required to comply with tax rules: complex tax computations may deter individuals from engaging in DeFi, or limit participation to those who can afford professional advice.

Policy options for reform

The document notes that the UK has introduced specific tax legislation in other areas where the application of general taxation principles could give rise to tax outcomes that do not follow the economic reality of the transaction, such as the repo and stock lending regimes which apply to transfers of securities. These, or similar rules, could address some of the issues that have been highlighted about the application of tax rules for the DeFi market.

Repos are financing transactions that are structured to involve the sale of securities combined with an obligation to repurchase the same or similar securities at a pre-determined price. Because they are structured as a sale, there is a disposal of beneficial ownership. This is similar to the disposal of beneficial ownership that may arise in the staking or lending of cryptoassets. The repo regime, however, prevents a CGT charge by following the underlying economic substance of the transaction and treating the sale and repurchase as if it were a loan.

It has been proposed that cryptoassets should be included in the repo and/or stock lending rules by defining cryptoassets as ‘securities’ (Option 1). Doing so would exclude from CGT DeFi transactions that meet the specific statutory rules in the Repo and/or Stock Lending legislation. The government is, therefore, interested to understand if this option is seen as a suitable solution by DeFi market participants and, if not, the perceived deficiencies of such an approach.

In particular, the document highlights the requirement (for both the Repo and the Stock Lending regimes) that transactions are between ‘persons’ and whether this may be problematic for certain DeFi platforms. Views are also sought on whether, considering the evolving nature of the market, this option would successfully simplify the taxation of all or most current and future DeFi models, or whether it would result in barriers to the development of the DeFi market.

A second option (Option 2) for reform involves legislating to create separate rules for DeFi lending and staking activities which follow the principles applicable to repos and stock lending. These rules would remove from the scope of CGT some lending and staking activities. Option 2 will be considered if the evidence gathered shows that Option 1 would have detrimental effects on the development of the DeFi market, would not be sufficient to cover the variety of DeFi models that exist, or would create further issues for participants.

In addition to options 1 and 2, the government is interested to get views from DeFi stakeholders on whether a ‘no gain no loss’ treatment for DeFi loans and staking is seen as a viable approach (Option 3). Under Option 3, the transfer of cryptoassets for lending and staking would be seen as a ‘no gain no loss’ transaction, by treating the disposal value as matching the acquisition cost. A CGT gain or loss would arise under Option 3 when cryptoassets are disposed of in a non-lending or staking transaction.

In addition, the government is interested to consider other options that are in line with the principles and objectives set out above. Suggestions of further options would therefore be welcome.

Comment

The Call for Evidence is open for responses until 31 August 2022, which should be submitted to financialproductsbai@hmrc.gov.uk. We will be contributing to the call for evidence and would be happy to share particular feedback on behalf of clients and contacts.

Whilst the Call for Evidence does not, at this stage guarantee that changes will be made, there certainly appears to be a willingness on the part of government to address the issues that have been raised in this context with appropriate rules to remove the potential for a dry tax charge. As such, affected businesses and investors should certainly consider engaging with the Call for Evidence and it is to be hoped that the government will address this issue at an early stage following the Call for Evidence.

The government has also recently launched a consultation on expanding the investment manager exemption to include cryptoassets. Further details can be found in our separate Insights article.