Proposed Changes to DeFi Crypto Tax Rules

Yesterday HMRC issued a consultation on the taxation of DeFi activity in cryptoassets (such as staking and lending). This applies equally to similar activity done through an intermediary (ie CeFi such as via Binance or Coinbase). Although the consultation is aimed an individuals, HMRC will consider bringing the same rule changes in for companies engaged in DeFi activity as well.

HMRC has taken on board representation made by stakeholders such as ourselves in their ‘Call for Evidence’ on the topic last summer. They are proposing to introduce a new regime to better align the tax position of DeFi activity with the underlying economic substance, whilst reducing the administrative burden on users.

We welcome the majority of the proposals in the consultation; but they do not go far enough. We will be lobbying for the new rules to cover liquidity pool activity, we will be challenging the blanket taxing of rewards as income and will be arguing for the rules to be applied retrospectively. It will take years to get the proposed new legislation and taxpayers need more clarity and certainty on the tax position of their DeFi activity in the meantime.

What is the current tax position and why the need for an overhaul?

HMRC published controversial DeFi guidance in their Cryptoasset Manual in February 2022, which indicated that DeFi type crypto activity (such as staking, lending, liquidity pools and collateralised loans) potentially triggers a CGT disposals of the crypto tokens locked away.

HMRC claim that if beneficial ownership of the tokens locked away is passed to another party, then there is a CGT disposal at the time of locking them up and later upon withdrawing the tokens. This is in addition to taxing the reward.

A big problem with this is where there is a capital gain (value at time of locking the tokens up vs acquisition cost), the CGT charge may be due for payment while the tokens are still locked away. Even the CGT due on exit may cause problems if the tokens removed remain illiquid in crypto.

In addition to the tax burden, determining whether or not there is a change of beneficial ownership is a complex legal decision and there is a huge administrative burden tracking these transactions from a tax perspective.

Proposed changes – CGT disposals

HMRC accept that their current guidance (based on the law as it stands) does not reflect the economic reality of the DeFi activity. In the proposals, they are seeking to bring in new laws to remove these CGT disposals arising from DeFi activity where the economic interest in the tokens is retained throughout. Instead there will only be a CGT disposal when the crypto tokens are economically disposed of in a non DeFi transaction (such as a sale for fiat, a swap/exchange for another crypto token, used as payment for good/services, or a gift).

The relief from CGT is intended to cover the DeFi transactions where the user retains the economic interest in the tokens locked away. HMRC think this is the case where the user has a legal right to receive the same quantity of cryptoassets back at some point in the future and to benefit in full from changes in the value of the token over the term of the lending or staking. So there may be some DeFi activity that is excluded from the new rules.

In particular HMRC are implying that liquidity pool activity will be excluded from the CGT relief, which is disappointing to say the least. They think the user does not retain the full economic interest over the tokens added to the pool, because it is foreseeable at the beginning of the transaction that different proportions of tokens will be withdrawn from the pool.

Liquidity pools are integral to DeFi and represent a large part of the activity undertaken by UK taxpayers. It is essential that they are included in the proposed legislation for tax clarity and we will be making representations to this effect. There are practical difficulties to be overcome, but addressing this issue is crucial to ensure that individuals do not inadvertently create CGT disposals when entering and exiting liquidity pool positions.

Below is HMRC’s summary of the application of new proposed rules that are proposed to apply when economic interest in the tokens is retained during a DeFi transaction:

• the transaction will be disregarded from CGT for both the lender and the borrower.
• any sale of rights related to the lent or staked tokens is seen as a disposal of the tokens to which those rights relate.
• any DeFi return which accrued on the tokens prior to the sale of such rights is taxable on the lender at the time the rights are disposed of.
• the buyer of rights to lent or staked tokens is treated as acquiring the lent or staked tokens.
• the lender will be treated as having disposed of the staked or lent tokens if the borrower is not able to return the borrowed tokens. This will occur at the point in time the borrower loses the ability to return them.

Proposed changes – Tax on the DeFi Rewards

HMRC are controversially proposing to treat all DeFi returns/rewards as being revenue (income) in nature and charged to a new miscellaneous income charge specific for cryptoasset transactions. The income would be the market value of the tokens at the date of receipt.

The current HMRC guidance says you need to examine the nature of the reward to determine if it is revenue (income) or capital in nature and then tax is accordingly.

HMRC are suggesting that this will reduce the administrative burden for users, however this simplicity will come at a great cost to some taxpayers given the large difference in income tax and CGT rates.

Upon examination of the facts, we have found many rewards to be capital in nature and this would be a big blow for these taxpayers. It is not just the extra tax that is the issue. The biggest problem with taxing rewards as income, based on the value at the date of receipt, is the inability to offset capital losses when the tokens later fall in value by the time they are sold.

It is clear that treating all rewards as income is not a fair outcome for this highly volatile asset class. Instead, treating rewards as capital would better reflect the economic reality of the activity, as you will be taxed on the value at the time of disposal of the reward.  Re-evaluating the tax position of staking and lending crypto rewards is necessary for the UK to become a crypto hub and align taxes with the economic substance of the transaction, as well as reducing the burdens of hedging for market volatility.

Conclusion

This long awaited HMRC consultation on DeFi lending and staking is a significant step towards creating a level playing field for crypto activity (when compared with traditional investments such as shares).

It is essential that stakeholders provide feedback to shape the final legislation, and we encourage participants to include concrete examples for context.

A u-turn on the timing of implementation is needed, to ensure all DeFi transactions entered into before the new law is introduced are covered by the new rules.

We will be challenging the proposed blanket approach of taxing all rewards as income, as it causes one of the biggest pain points in crypto taxes when the value of the tokens at the date of taxing the income subsequently falls.