There are few topics within the taxation of cryptoassets that are as confusing as how Decentralised Finance (DeFi) is taxed. However, there is change on the horizon with a HMRC consultation proposing new legislation to reduce the tax burden on investors.
In what is a positive step for the cryptoasset industry in the UK, last week HMRC released the long awaited consultation document (condoc) proposing new legislation to simplify the taxation of certain DeFi activity and reduce the administration. HMRC will be one of the first, if not the first, tax administration to design and implement specific rules for the taxation of DeFi transactions. While the condoc focuses on individuals, HMRC states that it is aware there are similar issues for corporates and may introduce similar rules for them.
By way of a quick refresher; broadly, DeFi lending and staking is where an individual will provide a token, say a bitcoin, to a lender (platform) for which they will receive a return (sometimes inaccurately called interest). The platform will then use that token as part of their lending business.
It can be helpful to liken this to the activity of a bank. A person will deposit money, in practice lending money to the bank, for which they will be paid interest. The bank will then use it for economic activity such as lending to others at a higher rate than the interest paid to the depositor. DeFi lending is similar, except there is no money, no bank protections and myriad ways in which it can be done.
A further difference is that it is retail investors that are the main source of liquidity for DeFi platforms. When an individual lends cryptoassets to the platform this usually results in a change of beneficial owner of the cryptoasset, which is a disposal for tax purposes. Whereas, if the individual had lent stocks or shares, there are specific tax rules that switch off the transfer of beneficial ownership.
The condoc states it will “disregard from CGT any disposal of beneficial ownership that may happen when cryptoassets are staked or lent.” Further, by doing so the transactions will better reflect the “economic substance” of the transactions. This move certainly removes one of the main tax concerns when tokens are lent to platforms.
HMRC are also considering treating all returns on such DeFi transactions to be treated as revenue in nature and subject to miscellaneous income. Whilst this simplifies tax treatment (since in some cases returns can currently be treated as capital in nature) this may lead to more tax to pay for many individuals.
However, in our view, the suggested amendments may not lead to the hoped for reduction of administration. As mentioned above, DeFi lending requires individuals to provide the necessary liquidity. Under the proposals, if an individual gets their original collateral back there will be no tax liability, but this isn’t how most individuals interact with DeFi platforms so there will still be friction and record keeping needed.
This is a positive step for the cryptoasset industry in the UK and will provide clarity and certainty for the sector. But is it the right step? As always the devil will be in the detail when the legislation is finalised.