Global Tax Alert: New guidance from HMRC on Crypto 'Decentralised Finance: Lending and Staking'
HMRC has expanded its internal manual on Cryptoassets published in March last year to include guidance on ‘decentralised finance’ (or DeFi) together with various worked examples.
The guidance explains that DeFi is an umbrella term covering products akin to traditional financial services through Distributed Ledger Technology and analyses the form of the transactions and the tax treatment of the parties to them, being the ‘borrower’, the ‘liquidity provider’ and the DeFi lending platform. The new guidance applies to two types of transaction:
- a person (lender) transfers the control of tokens to another person (borrower). At the time that transfer occurs, the lender acquires a right to demand that the borrower transfers to the lender the control of an equivalent quantity of tokens at a time in the future to satisfy the loan.
- a person (liquidity provider) transfers the control of tokens to a DeFi lending platform (staking or providing liquidity). At the time when the transfer occurs, the DeFi lending platform transfers control of one or more different tokens to the liquidity provider.
While the guidance seeks to analyse the transactions and their tax treatment by reference to familiar (if sometimes uncertain) tax treatment, there has been some reaction within the crypto community expressing dismay at certain aspects of the guidance, notably, the implication that returns will have to be made in respect of capital gains (including, potentially, in relation to past transactions) because of HMRC’s view of tokens being assets for capital gains purposes and DeFi activity involving, in some cases, the transfer of beneficial ownership of tokens.
Noting that lending/staking of tokens through DeFi is a constantly evolving area, the new guidance sets out the following five common types of loan:
- Lender provides tokens directly to borrower
- Lender provider provides liquidity to DeFi lending platform: The liquidity provider doesn’t receive tokens from the DeFi lending platform
- Liquidity provider provides liquidity to DeFi lending platform. The liquidity provider receives tokens from the DeFi lending platform at a fixed ratio for each token that is loaned
- Liquidity provider provides liquidity to DeFi lending platform. The liquidity provider receives tokens from the DeFi lending platform to represent their share in the liquidity pool
- Liquidity provider provides liquidity to DeFi lending platform. The liquidity provider receives a non-fungible token from the DeFi lending platform that records the terms of the loan
Revenue or capital receipt
The guidance explains that the taxation of the lender’s or liquidity provider’s return will depend on whether it has the nature of capital (for example where there is a disposal of a capital asset) or revenue (for example being earned from a service) which may in turn depend on how the transaction is structured.
In determining whether a receipt is revenue or capital in nature, HMRC refers to familiar factors such as whether a return is fixed or known, whether there is a disposal of asset and whether there is a recurring or one-off payment. In some cases, a lender/liquidity provider will not be rewarded by the borrower/DeFi platform for providing their services but rather will seek to benefit from their activities through the growth in value of a capital asset.
Not interest and not a loan relationship
As set out elsewhere in the existing guidance, HMRC does not consider exchange tokens to be currency or money with the consequence that:
- although a return in the nature of income from DeFi lending may be analogous to interest, it is not actually interest and the statutory provisions applying to interest will not apply to it. (see CRYPTO61214/61110); and
- HMRC does not expect that the lending/staking of tokens by a company will constitute a loan relationship. (see CRYPTO41100).
Income tax/corporation tax on income
The guidance expresses the view that a lender/liquidity provider’s return from DeFi loans could be taxed as profits of a trade but that this only is likely to be the case in exceptional circumstances (see CRYPTO20250) and that in ascertaining whether a trade exists, HMRC would look at similar factors to those which it applies to transactions in shares, securities and other financial products (see BIM568000). Examples here are: how precisely the activity is carried out and whether it is done in a commercial way, the profit-making strategy and any business plan, the taxpayer’s acumen and experience, number and frequency of transactions and record keeping.
If no crypto trade exists or the assets are held as investments outside of any trade, HMRC’s view is that a revenue return from a DeFi loan or stake would be taxable under the miscellaneous income provisions of Part 5 ITTOIA 2005/section 979 CTA 2009 (the ‘sweep up’ provisions charge). HMRC’s view of the case-law on these provisions is that a reward would be chargeable under them “if it has the character of income and results from an understanding between both parties that the recipient will remunerate the provider for their services, for example, if there is a quid pro quo. It does not 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 period is indefinite. The amount to be charged to income tax would be the money’s worth of the receipt, being the pound sterling value of the tokens received by the lender.
Capital gains tax/corporation tax on chargeable gains
HMRC considers that there will be a disposal for capital gains purposes if the lender/liquidity provider actually transfers their beneficial ownership of the tokens to the borrower/DeFi lending platform. Whether there has been a transfer of a beneficial interest is to be ascertained by analysing the contract and other circumstances, for example the ability of the recipient to deal freely with the tokens is one key factor (see CRYPTO61620).
The statutory disregard of what would otherwise be a disposal/acquisition for capital gains purposes for repos of securities and stock loans (sections 263A and 263B TCGA 1992) is not mirrored for crypto assets and HMRC points out in its guidance that the existing provisions will generally not apply since tokens will not generally meet the definition of ‘securities’ in those sections (see CRYPTO61610).
The guidance goes on to discuss, and supply worked examples, of the capital gains computation which would arise in scenarios with various types of consideration for the disposal – deferred consideration, ascertainable or unascertainable consideration, as well as illustrating the exclusion of amounts charged to tax as income.
The guidance covers the borrower’s position too; a borrower’s acquisition cost will be equal to the value of its obligation to transfer a quantity of tokens to the lender in the future. (see CRYPTO61630). The borrower will make a disposal when it satisfies the loan (assuming that this involves a transfer of beneficial ownership).
The guidance also notes that capital gains disposals could be triggered by:
- the giving of collateral by a buyer if the DeFi lending platform acquires beneficial ownership of the tokens;
- the borrower satisfying the loan by transferring beneficial ownership of tokens to the lender; and
- the liquidity provider withdrawing their staked tokens from the liquidity pool of a DeFi platform.
Of course not all disposals will trigger a chargeable gain (especially given the exclusion for amounts charged to income tax) but a calculation will be required.
HMRC’s new guidance raises several questions as a result of inconsistency with the approach taken by other authorities and regulatory bodies. Taxpayers are advised to consider the potential impact of this new guidance on their investments, in particular concerning reporting requirements and tax compliance obligations.
Find out more by contacting the authors or your usual DLA Piper relationship attorney.