HMRC Updates Crypto Guidance on DeFi and Taxes But will the chosen approach stand the test of time? – Fintech

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

While taxpayers operating in the DeFi space have welcomed the fact that HMRC has clarified its intended position regarding DeFi arrangements, the new guidance has received a mixed response on substance. Some crypto trading organizations such as Crypto UK see this as an unnecessary and illogical burden on investors, 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 trade borders and is evolving too quickly for regulations to keep up is undoubtedly a source of trouble for crypto investors and HMRC. Until lawmakers establish a separate tax regime for crypto, HMRC is tasked with trying to fit new concepts into a set of existing rules designed for “conventional” assets.

It is difficult to predict how long this state of affairs will last. The UK government is aiming to turn the UK into a “global hub for cryptoassets,” according to the Treasury Department’s April 4, 2022 announcement (available HERE), which sets out a set of measures to achieve this and outlines the UK’s forward-looking approach to cryptoassets. These include proposed new regulations to facilitate the use of stablecoins as a means of payment (which HM Treasury has been advising on for some time – see ours 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 regime could encourage further development of the UK cryptoasset market, acknowledging issues surrounding the current tax treatment of DeFi lending and staking. Perhaps this will eventually lead to the introduction of bespoke rules for crypto and DeFi?

What is DeFi?

DeFi is an emerging financial technology based on blockchain technology that allows participants to trade, borrow and lend crypto assets without going through a central intermediary. It thus reduces the need for traditional financial institutions/banks while aiming for lower costs and more transparency.

DeFi lending and borrowing has proven to be particularly attractive to investors due to the high returns it offers. “Lending” in this context is typically a process in which the crypto investor (lender) transfers control of the tokens to a borrower, thereby giving the lender the right to demand an equivalent amount of tokens from the borrower in the future for the loan to use.

Similarly, “staking” (in this context) involves a process whereby the crypto investor (also known as “liquidity provider”) transfers control of tokens to a DeFi platform in exchange for rewards, typically paid out in tokens . This is a form of passive income, similar (but notably not the same) as interest on loans.

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

Tax Treatment of DeFi Earnings: Income or Capital Gains?

HMRC has clearly stated that periodic proceeds from staking or lending in DeFi arrangements are not treated as interest, despite the commercial similarity of these arrangements to a traditional fiat currency loan. HMRC bases this position on the fact that cryptoassets are not real currency (and there are other tax authorities like the IRS that are currently taking a similar approach).

Based on this, the question arises as to whether DeFi returns are classified as income or capital gains. This distinction is important given the different income tax and capital gains tax rules (including rates). Essentially, it boils down to a question of fact: does the return equal an income or an investment return?

The new HMRC guidance sets out a number of factors to consider (based on established general principles), recognizing that DeFi is a constantly evolving space, making it impossible to set out every circumstance in which a lender /Liquidity providers earn a return on their activities and the nature of that return.

One such factor is whether the yields are fixed (e.g. a 5% agreed upon yield paid monthly for a fixed term) as opposed to unknown and speculative yields. The former scenario would indicate an income return, the latter an investment return. Another consideration is whether returns come from a service provided by the investor or whether they represent capital growth on an investment.

Accordingly, DeFi investors need to conduct a detailed analysis of the DeFi arrangements in question to determine what types of returns they receive.

A change in token ownership may be considered a “disposal” for capital gains tax purposes

One of the main points of the updated guidance is that DeFi arrangements can result in unintended “disposals” for capital gains tax (“CGT‘) purposes, depending on how they are structured. A disposal typically occurs when a specific item has been transferred in such a way that beneficial ownership of that item changes.

Sale by the lender/investor

When a crypto investor lends crypto assets to a borrower in a typical DeFi “lending arrangement,” such an arrangement may result in beneficial ownership of the crypto assets in question shifting from the lender to the borrower, creating a taxable disposal on the part of the borrower lender is triggered. This can also occur in a typical “staking” arrangement, where beneficial ownership of crypto assets passes from the investor to a DeFi platform. In either case, divestment results in CGT (subject to any available exceptions or reliefs).

disposal of the borrower

Borrowers in DeFi arrangements are often asked to provide crypto assets as collateral (similar to collateral on a traditional bank loan). Since the borrower typically does not have access to these crypto assets for the duration of the loan agreement, this can also be treated as a taxable disposal, triggering a CGT fee.

Another concern for borrowers is that if the borrower repays the principal by returning the previously borrowed tokens, a second sale is likely to occur, as beneficial ownership of such tokens reverts to the lender. If the value of the tokens has increased during the lending period, the borrower will face a CGT bill even though they have not realized any actual profit. Given the volatility of cryptoassets, this could create significant CGT liabilities.

looking ahead

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

HMRC, in its new guidance, acknowledges (egHERE) that the current guidance is not comprehensive as crypto is a “constantly evolving field.” And since there is no single standardized DeFi model, different DeFi arrangements could potentially be subject to very different tax treatments. It will also take time for the new guidance to be rolled out and tested by the courts. Considering the speed of development, it may well be that the current guidance is out of date by the time case law is available.

As of today, DeFi investors and borrowers must contend with the increased tax (and compliance) burdens that result from requiring certain DeFi arrangements for crypto asset lending and staking to be treated as divestitures. But given the UK government‘s determination to make the UK a more attractive place for crypto, including HM Treasury’s acknowledgment of the issues surrounding tax legislation and DeFi, this may not be the end of the matter.

Originally published April 14, 2022

The content of this article is intended to provide a general guide to the topic. In relation to your specific circumstances, you should seek advice from a specialist.

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