Taxation of DeFi lending and staking: consultation

The government has published a consultation document as part of Tax Administration and Maintenance Day 2023 proposing to introduce legislation to disregard transactions for relevant tax purposes that arise through the lending or staking of relevant cryptoassets. The intention is that the taxation of lending or staking of cryptoassets should broadly follow the tax regime for repo and stock lending transactions.

In addition, the government intends to introduce rules to provide that all returns from cryptoasset lending and staking transactions are treated as revenue returns to be taxed under a new miscellaneous income head.

The consultation is open for responses until 22 June 2023.

Background

In 2022, the government issued a Call for Evidence on the tax treatment of decentralised finance (DeFi) transactions involving the loaning and staking of cryptoassets. In particular, the government was responding to concerns around 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. For more details of the Call for Evidence, see our article here.

This followed the publication of HMRC guidance in its Cryptoasset Manual setting out HMRC's view on the taxation of cryptoassets used in 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). It also requires a relevant taxpayer to analyse the extent to which a particular DeFi transaction would result in a disposal of beneficial ownership, which is not straightforward.  For further information, see our Insights article discussing HMRC's DeFI Guidance.

Consultation

Following consideration of the responses to the Call for Evidence, the government is now putting forward proposals to introduce legislation to disregard from CGT (or corporation tax on chargeable gains) the transactions that would otherwise occur when cryptoassets are lent or staked. The purpose of the consultation is to seek views on this proposal and a final decision will be taken on whether to proceed with the legislative changes after the consultation has concluded.

The consultation discusses the responses to the Call for Evidence, noting that most participants proposed implementation of the last two options in the Call for Evidence, namely:

Option 2: Create separate rules for DeFi lending and staking activities mirroring the principles applicable to repos and stock lending; or

Option 3: Treating the transfer of cryptoassets for lending and staking as a 'no gain no loss' transaction, by treating the disposal value as matching the acquisition cost.

The government has opted for an approach reflecting its proposed Option 2 rather than Option 3. In discussing the drawbacks of Option 3, the government recognised that 'no gain, no loss' treatment would require a disposal to apply, and as a corollary, could lead to administrative and technical difficulties determining the disposal of beneficial ownership (as was noted in our response to the Call for Evidence). 

The DeFi transactions intended to be covered are broadly those where participants retain the economic interest in the lent or staked tokens over the duration of the transaction even though there is a transfer of legal or beneficial ownership. This happens when participants transfer a cryptoasset to a different party (the borrower) for a period of time with a legal right to receive the same quantity of cryptoasset back at some point in the future. Participants retain the economic interest in the lent or staked tokens if they benefit in full from changes in the value of the token over the lending or staking term. These transactions often take place through a platform where cryptoasset owners (liquidity providers) provide their tokens to a platform to pool with those of other users (a liquidity pool). This provision of liquidity to a platform is known as 'staking' and allows the platform to perform other DeFi services with the pooled tokens.

There are situations when, during the term of the stake or loan, participants can sell their rights in the staked tokens to another party. These rights are often represented by a liquidity token issued by a platform. The new rules will regard the disposal of the right to the staked or lent tokens as a disposal of the related tokens. CGT will apply as if the user has sold the staked or lent tokens at the time that right is disposed of.

The staking or lending of liquidity tokens or of other tokens representative of rights in staked or lent tokens will not be seen as a disposal.

The buyer of rights of staked or lent tokens will be regarded under these proposals as having acquired the lent or staked tokens. This means that there will be no CGT consequences when those rights are exercised and the staked or lent tokens are withdrawn. For example, there will be no CGT when the buyer of a liquidity token uses it to withdraw cryptoassets that were originally staked by another user.

Although the focus of the consultation is on DeFi lending and staking, the proposed tax framework is also intended to apply to the lending and staking of cryptoassets which is done through an intermediary (referred to as Centralised Finance or CeFi).

Proposed rules

Based on the principles outlined in the consultation, a transaction is intended to be disregarded if it contains the following elements:

a) there is an initial transfer of cryptoassets from one party (the lender) to another party (the borrower) and/or there is a transfer of cryptoassets through the use of a smart contract

b) the borrower has an obligation to return to the lender the borrowed tokens and/or the smart contract allows the lender to withdraw the tokens

c) the tokens can be returned at the instigation of the lender, at the request of the borrower, or automatically at the end of a pre-determined period

d) the lender has the right to withdraw at least the same quantity of the same type of tokens that were originally lent or staked.

In such circumstances, the transaction will be disregarded from CGT for both the lender and the borrower. However, any actual sale of rights related to lent or staked tokens will be seen as a disposal of the cryptoassets to which those rights relate and the buyer will be treated as acquiring the lent or staked cryptoassets.

In addition, the lender will be treated as having disposed of the staked or lent tokens if the borrower is not able to return them. The consideration will be the amount received from the borrower as compensation for the tokens that cannot be returned.

Taxation of the DeFi return

HMRC's guidance (CRYPTO61214) currently indicates that a DeFi return may either be treated as miscellaneous income or a capital gain depending on the nature of the return. Since this can be a complex question, the consultation puts forward the suggestion that the new rules should treat all DeFi returns as being revenue in nature and charged to a new miscellaneous income charge specific to cryptoasset transactions.

Commencement

If the proposals are taken forward, it is intended that they would apply to transactions where the first lending or staking occurs after the commencement date. DeFi transactions that have started before the commencement date would remain taxable under the existing rules.

Comments

The consultation is open for responses until 22 June 2023 and responses should be sent to financialproductsbai@hmrc.gov.uk.

The proposal to introduce bespoke UK legislation tailored to the distinct nature of the crypoasset market, rather than simply seeking to bring the transactions within the scope of existing provisions (such as the stock lending and repo rules) is to be welcomed. It should provide an opportunity for the government to provide a regime that caters specifically for cryptoasset staking and lending and that can be adapted for future developments without affecting other areas of the tax code.

As noted in our response to the Call for Evidence, the rules will need to be refined to ensure that certain novel and multilateral transactions do not inadvertently fall outside the scope of the proposed regime. The increasing sophistication and deployment of smart contracts have created a variety of structured transactions which will need addressing in response to the consultation, although it is positive to see that the position of arrangements involving smart contracts has already been anticipated in the proposed relieving provision.

We will, in due course, prepare a response with our comments on the consultation and would be happy to share particular feedback on behalf of clients and contacts as part of our response.