HMRC has expanded its in-house crypto-asset handbook released in March last year to include guidance on “decentralized finance” (or DeFi) as well as various real-world examples.
The guidelines explain that DeFi is an umbrella term covering products similar to traditional financial services via distributed ledger technology and analyze the form of transactions and the tax treatment of the parties to them, namely the “borrower”, the “liquidity provider” and the DeFi lending platform. The new guidelines apply to two types of transactions:
- one person (lender) transfers control of tokens to another person (borrower). At the time this transfer takes place, the lender acquires the right to require the borrower to transfer to the lender control of an equivalent amount of tokens at some point in the future to satisfy the loan.
- a person (liquidity provider) transfers control of tokens to a DeFi lending platform. (staking or providing liquidity). At the time the transfer takes place, the DeFi lending platform transfers control of one or more different tokens to the liquidity provider.
While the guidelines seek to analyze transactions and their tax treatment with reference to familiar (albeit sometimes uncertain) tax treatment, there has been some backlash within the crypto community expressing dismay at certain aspects of the guidelines. , including the implication that returns will have to make in respect of capital gains (including, potentially, in relation to past transactions) due to HMRC’s view that tokens are assets for purposes capital gains and DeFi activity involving, in some cases, the transfer of beneficial ownership of tokens.
Noting that token lending/staking via DeFi is an ever-evolving field, the new guidelines define the following five common lending types:
- The lender provides tokens directly to the borrower
- Lending provider provides liquidity to DeFi lending platform: Liquidity provider does not receive tokens from DeFi lending platform
- The liquidity provider provides liquidity to the DeFi lending platform. The liquidity provider receives tokens from the DeFi lending platform at a fixed ratio for each token lent
- The liquidity provider provides liquidity to the DeFi lending platform. The liquidity provider receives tokens from the DeFi lending platform to represent its share in the liquidity pool
- The liquidity provider provides liquidity to the DeFi lending platform. The liquidity provider receives a non-fungible token from the DeFi lending platform that records the terms of the loan
Income or capital receipt
The guidance explains that the taxation of the return of the lender or liquidity provider will depend on its nature of capital (for example, in the case of disposal of a fixed asset) or income (for example, derived from a service) which can will depend on how the transaction is structured.
To determine whether a receipt is income or capital in nature, HMRC refers to familiar factors such as whether a return is fixed or known, whether there is an asset disposal and whether there is a recurring payment or punctual. In some cases, a lender/liquidity provider will not be rewarded by the borrower/DeFi platform for providing their services, but rather seek to profit from their activities through growth in the value of a capital.
No interest and no loan relationship
As stated elsewhere in the existing guidelines, HMRC does not consider exchange tokens to be currency or cash, which means that:
- although a return in the nature of income from a DeFi loan may be analogous to interest, it is not actually interest and the legal provisions applicable to interest will not apply to it. (see CRYPTO61214/61110); and
- HMRC does not expect the lending/staking of tokens by a company to constitute a lending relationship. (see CRYPTO41100).
Income tax/corporate income tax
The guidelines express the view that a lender/liquidity provider’s return on DeFi loans could be taxed as profits from a transaction, but this is likely only to be the case in exceptional circumstances (see CRYPTO20250) and that in checking whether a transaction exists, HMRC would consider factors similar to those it applies to transactions in shares, securities and other financial products (see BIM568000). Some examples are: the accuracy with which the activity is carried on and whether it is carried out in a commercial manner, the money-making strategy and any business plan, the acumen and experience of the taxpayer, the number and frequency of transactions and the record keeping.
If there is no crypto trading or the assets are held as investments outside of any trading, HMRC is of the view that income from DeFi lending or holding would be taxable as a result. under the miscellaneous income provisions of part 5 ITTOIA 2005 / section 979 CTA 2009 (the ‘sweep’ provision charge). HMRC’s view of the case law relating to these provisions is that a reward would be payable under them”if it has the character of income and results from an agreement between the two parties according to which the beneficiary will remunerate the service provider for his services, for example if there is consideration. It doesn’t matter that a formal written contract does not exist.” (see CRYPTO61212).
It does not matter if the amount to be paid by the borrower/DeFi lending platform is unknown, for example because the rate of return fluctuates or the borrowing term is indefinite. The amount to be charged against income tax would be the cash value of the receipt, which is the sterling value of the tokens received by the lender.
Capital gains tax/corporation tax on taxable gains
HMRC considers that there will be an assignment for appreciation purposes if the lender/liquidity provider effectively transfers its beneficial ownership of the tokens to the borrower/DeFi lending platform. Whether there has been a transfer of a beneficial interest should be determined by analyzing the contract and other circumstances, for example the ability of the recipient to freely manage the tokens is a key factor (see CRYPTO61620).
The legal disregard of what would otherwise be a disposal/acquisition for capital gains purposes for repurchase agreements and stock lending (Sections 263A and 263B TCGA 1992) is not reflected for crypto-assets and HMRC points out in its guidance that the existing provisions will generally not apply as tokens generally do not meet the definition of “securities” in these sections (see CRYPTO61610).
The guidelines go on to discuss and provide concrete examples of the calculation of capital gains that would arise in scenarios with different types of consideration for the disposal – deferred consideration, ascertainable or indeterminable consideration, as well as illustrating the exclusion of amounts charged to tax. as income.
The advice also covers the position of the borrower; the cost of acquiring a borrower will be equal to the value of his obligation to transfer a quantity of tokens to the lender in the future. (see CRYPTO61630). The borrower will make an assignment when it has satisfied the loan (assuming this involves a transfer of beneficial ownership).
The guidance also notes that capital gains disposals could be triggered by:
- posting of collateral by a buyer if the DeFi lending platform acquires beneficial ownership of the tokens;
- the borrower satisfies the loan by transferring beneficial ownership of the tokens to the lender; and
- the liquidity provider withdrawing its staked tokens from a DeFi platform’s liquidity pool.
Of course, not all disposals will trigger a taxable capital gain (especially given the exclusion of amounts charged to income tax) but a calculation will be necessary.
Take away key
The new HMRC guidance raises several questions due to the inconsistency with the approach taken by other authorities and regulators. Taxpayers are urged to consider the potential impact of these new guidelines on their investments, particularly with respect to reporting requirements and tax compliance obligations.