In early February, HMRC published a new chapter in its crypto-asset handbook dealing with decentralized finance (“DeFi”). DeFi is an umbrella term encompassing a range of products comparable to traditional financial services. DeFi platforms can provide services such as decentralized exchanges, savings, loans, and derivatives, using distributed ledger technology.
The HMRC guidelines focus on taxing “lending” and “staking” services that are entered into between unconnected lenders and borrowers via a DeFi platform.
“Lending” in this context occurs when one person transfers crypto tokens to another person. The transfer results in the recipient (a “borrower”) gaining control of the tokens. The “lender” acquires the right to demand the transfer, in return, of a fixed quantity of tokens to satisfy the “loan” at some time in the future.
Staking occurs when someone transfers control of tokens to a DeFi lending platform. The transferor, also known as the “liquidity provider”, receives in return one or more different tokens from the DeFi lending platform. Tokens that have been transferred to the DeFi lending platform by the liquidity provider may be transferred by the platform to third party “borrowers”. This “borrower” is required, at a later date, to provide a return to the DeFi lending platform, some or all of which is passed on to the liquidity provider.
These arrangements may seem to have some familiar characteristics of secured lending transactions outside of the crypto-asset industry. The elements of the agreements are familiar to observers of peer-to-peer financing agreements or securities lending transactions. However, given the unique form of crypto-assets which, in the opinion of HMRC, do not constitute ‘money’ or ‘currency’, the treatment of the rate of return on ‘loan’ and ‘ game” does not constitute an “interest” for the United Kingdom. tax purposes.
As a result, HMRC follows a different approach to the taxation of loan and staking of crypto-assets compared to how, for example, loan relationships or deemed loan relationships might be taxed in the UK. The provisions of UK tax law relating to the taxation of loan relationships (and deemed loan relationships) therefore do not apply to crypto-assets.
How any DeFi returns are taxed when received by the lender and liquidity provider will depend, for both income and corporate tax purposes, on whether the activity amounts to a transaction and whether any return produced is in the nature of an inflow of capital or receipt of revenue.
Trade or invest?
The HMRC guidance indicates that the relevant considerations to be taken into account in determining whether a transaction is in progress involving the provision of DeFi loans would be similar to those taken in determining whether there is a transaction in shares, securities and securities. other financial products. This leads tax practitioners to the familiar, yet complicated, case law analysis used to determine whether a trade is being conducted (or not) or if, alternatively, the activity that generates the return falls outside the scope of any trade. There is little case law specific to crypto-assets in the UK; Generally speaking, only the deliberate and organized lending and staking of crypto-assets is likely to constitute a trade.
If a transaction is made, the crypto-assets can be held as trading shares. Where no trade is being conducted or the activity falls outside the scope of trading, lending or DeFi staking (both involving crypto-asset transfers) may be disposal of a fixed asset, subject to capital gains tax for individuals and corporation tax on taxable capital gains for corporations.
DeFi return: income or capital inflow?
Any DeFi return is taxed in accordance with whether the receipt is capital or tax in nature. A return of a capital nature would be subject to tax on the taxable gain realized. Where the return is in the nature of income, the return may be taxed as trading income if (exceptionally) the activities are sufficiently deliberate and organised, or (more likely) could be taxed under the miscellaneous income provisions (in Sections 979-981, in Part 10 of the Corporations Tax Act 2009).
HMRC notes in its guidance that the nature of the return received by the lender or liquidity provider will depend on how the transaction is structured. Token lending or staking via DeFi is recognized as a rapidly evolving field. It is perhaps unsurprising that HMRC has established ‘guiding principles’ to help determine the nature of the activities undertaken, coupled with several examples, rather than setting out hard and fast rules.
A key distinguishing question is posed by HMRC as to whether the return obtained by the lender or the liquidity provider results from providing a service to the borrower of a DeFi lending platform. This could identify the return as tax-related. On the other hand, if the return was realized from the growth of an asset held by the lender or liquidity provider, the treatment might be more consistent with a return on capital.
Complicating factors are listed in the HMRC guidelines as the different DeFi operating models, including whether the yield to be received by the lender/liquidity provider is known at the time the deal is entered into (suggesting a re-entry income), as opposed to a more speculative return (suggesting, according to HMRC, a capital inflow). The length of the term of the lending or staking agreement, any periodicity of interim payments, and the link between any returns and the token surrender are all identified as additional factors to consider. HMRC confirms that this list is not exhaustive and that no single factor is decisive.
Examples and questions
HMRC’s guidance includes a number of concrete examples covering the handling of disposals of crypto assets when loans are made, loan satisfaction and the tax position when a borrower’s collateral is enforced or liquidated. Following the examples and implementing the legal provisions regarding DeFi in a tax context will likely lead to additional questions regarding compliance and interpretation. This is perhaps all the more so as the British case law governing the identification of a trade and the nature of the receipts of capital and income is far from new. It will be interesting to see how well the case law is framed in terms of fruits and trees (Ryall vs. Hoare quoted by HMRC in its advice) when it comes to tax issues related to crypto-assets and DeFi platforms.