HMRC continues to update its guidance on the taxation of cryptoassets. The latest guidance addresses increasingly important issues associated with Decentralised Finance or “DeFi” including the tax implications arising when tokens are lent, borrowed and used as collateral and how any returns from these transactions are taxed.
What are DeFi transactions?
DeFi is an umbrella term for products similar to traditional financial services provided through Distributed Ledger Technology, the technology underpinning cryptoassets, which aims to facilitate transactions between unconnected lenders and borrowers.
DeFi transactions may involve “lending” or “staking” of cryptoassets.
Lending involves a person (the “lender”) transferring control of tokens to another a person (the “borrower”) and acquiring a right to demand that the borrower satisfies the loan in future by transferring to the lender control of an equivalent quantity of tokens.
Staking involves a person (the “liquidity provider”) transferring control of tokens to a lending platform which transfers control or one or more different tokens to the liquidity provider. The DeFi lending platform may then transfer control of tokens to borrowers who must provide a return to the platform in excess of the tokens borrowed.
DeFi returns: income or gains?
Since HMRC does not consider cryptoassets to be currency or money, it does not consider that returns from DeFi transactions can be interest for tax purposes.
To characterise a return as income or gains, HMRC’s guidance provides a list of factors it may consider including:
- whether the return is known at the outset. For example, an agreed annual return of 5% per annum would indicate a revenue receipt, while if the return was unknown and speculative it would indicate a capital receipt.
- if the return is realised through the disposal of a capital asset, that would indicate a capital receipt;
- whether the return is paid periodically throughout the period of staking or lending, or whether it is paid on repayment of the principal, with the former more likely to be capital, and the latter more likely to be income.
Therefore, depending on whether the returns are income or capital in nature, they may be subject to income tax or capital gains tax, and whether a particular transaction results in an income tax or capital gains tax liability, will depend on the specific facts.
Disposals for capital gains tax
HMRC’s guidance identifies a number of DeFi related instances where a disposal may occur for capital gains tax purposes including:
- when an individual loans tokens to a borrower;
- when an individual transfers tokens to a DeFi platform in return for other tokens received from that platform; and
- when an individual locks up his or her cryptoassets as collateral for a loan.
Whether a transfer amounts to a disposal will be fact dependent, turning on whether the recipient of the token has the ability to deal with them as he or she wants. The same applies to a borrower who provides tokens to a lender as collateral for a DeFi loan.
Implications
If a DeFi related transfer does result in a disposal, it may mean that the lender or liquidity provider is subject to capital gains tax even before having earned any return on the DeFi investment. Potential lenders or liquidity providers should therefore take care to understand the potential implications of any significant DeFi transaction before entering into it.
HMRC’s views on DeFi, and cryptoassets more generally, are guidance and are not underpinned by specific legislation or case law on the treatment of cryptoassets for taxation purposes. It may therefore be that alternative positions might be taken, but any taxpayer deciding to take an alternative interpretation should consider an appropriate disclosure in the relevant self-assessment tax return and expect an HMRC enquiry to follow.
Taxpayers with historic cryptoasset transactions, including DeFi transactions, should consider their positions carefully and whether the need to amend their returns to make an appropriate disclosure to HMRC.
If you would like to discuss the tax implications of cryptoassets for you or your clients, please contact us.