CRYPTO60000: ‘DeFi’nitive guidance from HMRC?

Regardless of what you may think personally about cryptocurrency and whether it is here to stay, clients from all areas in the personal and corporate worlds are getting involved. When dealing with the annual tax returns, it is now quite common for a client to mention that ‘I hold some crypto and may have had some gains in the year.’ In the most simplistic of cases, clients would be trading crypto tokens through a recognised exchange (such as Coinbase or Kraken), a relatively simple affair. More recently, even those at the less tech-savvy end of the spectrum are venturing into the ‘DeFi’ space, and this term is one that many advisers do not yet fully understand. To advise properly, one needs to keep up with both HMRC’s iterations of its Cryptoassets Manual and broadly abreast of developments in the crypto space.

It’s worth noting that there is really nothing new or ground-breaking in the update to the manual and we haven’t yet seen any specific legislation that defines cryptoassets in their own right. HMRC is applying rules found within TCGA 1992, ITA 2007 and CTA 2009 to a new space and asset; it is perhaps most useful to see how HMRC has interpreted the application of the current legislation to this new area.

What is DeFi and staking?

The term ‘DeFi’ is short for decentralised finance. The providers of DeFi are known as DeFi protocols. You can’t go too far wrong if you think of it as peer-to-peer lending in cryptocurrency which uses blockchain technology to put together the lenders and borrowers, rather than a central organisation.

Loans are requested by borrowers through a decentralised application (‘dApp’), which then uses an algorithm to link them with lenders. If the terms of the lender are agreed to, then the borrower will be able to borrow the required amounts. The blockchain is used to record the transaction.

Before we get into tax, it’s important to understand the mechanics of a DeFi transaction. Increasingly, DeFi protocols are encouraging crypto holders to deposit their cryptocurrency with them as part of a lending pool (known as ‘staking’). In return, the protocol provides a return to the lender. The pool then lends to borrowers on a collateralised basis: the borrower must deposit an amount of crypto with the exchange and may only be able to borrow a percentage of the crypto value. If the borrower defaults, the collateral is liquidated by the protocol to cover any principal borrowed and interest accrued.

DeFi is still in its infancy, with new arrangements and ideas being created regularly. The market is totally unregulated: it can be difficult to find out who created the dApp and who is lending or borrowing through it. But it looks as if it’s a technology that’s here to stay.

It’s worth noting that the term ‘staking’ can also be used to describe the return received when a cryptocurrency (such as Ethereum) is held with an exchange as a ‘proof of stake’ in order to assist with the validation of transactions on the blockchain. The tax treatment of the return described as ‘staking income’ is constant among both uses of the word.

Trading versus income

When determining the possible tax implications of undertaking a DeFi transaction, HMRC notes that the context in which the transaction is undertaken needs to be considered.

The implication of this is more severe for individuals. If the transaction is part of a trade, income tax will take priority over capital gains tax and be applied to the profits of the trade: not only will higher rates of tax be applied but NICs will also need to be considered.

For corporates, the rate of tax will be the same whether profits are subject to corporation tax under CTA 2009 s 35 or to corporation tax under CTA 2009 s 2. The key difference is that, if losses are made on a transaction, the way capital losses can be used is much less flexible than if a trading loss had been incurred.

Staking and the return

In its guidance, HMRC contends that a chargeable event occurs when the beneficial interest in a crypto is transferred from one person to another (i.e. from an individual to a DeFi protocol). In CRYPTO61620, HMRC argues that the beneficial interest is likely to have transferred where ‘the recipient of the tokens has the ability to deal with the tokens received as they want’ (i.e. there are no restrictions on how the DeFi protocol can use the tokens once they are held).

It is normally the case that the protocol can onward lend the assets, generating a return it can then pay to the lender. This means that a chargeable gain will normally occur when a cryptocurrency is deposited with a DeFi protocol.

The return on the staked asset can be either income or capital for tax purposes, depending on how the DeFi protocol structures the transaction. There are two scenarios we typically come across in practice:

Scenario 1: Crypto A is exchanged for crypto B which gives the holder a share of the total pool of tokens held by the DeFi protocol: this provides a capital return to the crypto lender.

Scenario 2: Crypto A is exchanged for crypto C which gives the holder a right to crypto A in the future and a regularly paid return during the period in which crypto C is held (this provides an income return to the crypto lender).

In scenario 1, the exchange of crypto A to crypto B is a taxable event. The gain is calculated in the same manner as the gain on shares in a company would be calculated. The only difference is that the proceeds, or ‘capital sum’, will be the money’s worth of the crypto A at the date of disposal (TCGA 1992 s 22(3)). The rules for determining the base cost of crypto A are the same as those applied to shares, namely:

• the same day rules under TCGA 1992 s 105(1);
• for individuals, the 30-day rule under TCGA 1992 s 106A(5), (5A);
• for corporates, the 10-day rules under TCGA 1992 s 107(3); and
• the ‘pool’ rules under TCGA 1992 s 104.

The subsequent disposal, representing the change in value of the pool, is also an event taxable under the gains rules.

The logic applied in scenario 1 can be extrapolated to another emerging DeFi trend where cryptocurrency pairs are added to a liquidity pool, in exchange for a single token native to the liquidity pool. This is something we are seeing in practice, and HMRC has provided a good example of this type of transaction in CRYPTO61674. The key point is that the value of the single token needs to be apportioned on a just and reasonable basis between the two cryptos, acting as the GBP proceeds for the disposal of the two cryptos.

The exchange of cryptos in scenario 2 leads to the same tax consequences as those in scenario 1: a gain will arise on the exchange of one crypto for another. The difference is that the return will be paid on a regular basis to the holder of crypto C, rather than added to the pool and increasing the value of the crypto C as seen in scenario 1.

The return paid to the holder of crypto C is akin to interest, however CRYPTO601110 asserts that HMRC does not view the return as interest. The main impact of this is that the tax-free interest allowance for individuals under ITA 2007 s 7 and s 7A cannot be utilised against staking income. HMRC asserts that the staking return received should be taxed under the ‘sweep up’ provisions (ITTOIA 2005 ss 687–689 for individuals and CTA 2009 ss 979–981 for corporates).

Loans made outside of DeFi dApps

Peer-to-peer crypto loans are becoming a popular way of earning a higher return than those afforded via DeFi protocols, and they are probably most interesting from a tax perspective. Crypto is transferred for a future right to receive the principal crypto back and a return. The return can be fixed and known, or variable and unknown.

In both scenarios, HMRC views the transaction as a disposal for the lender because the beneficial interest in the crypto is being transferred from the lender to the borrower. The key point here is that there is no consideration given at the time of the disposal; there is instead a right to receive consideration after the time of the disposal. The rules in TCGA 1992 s 48 must therefore be applied.

Known future amounts

Where the future receivable is known, the consideration will be the number of tokens to be received, recognised at their GBP value at the time the loan is made. It is important that the principal and the return elements of the amounts to be received are split out: only the principal element will feature in the capital gains calculation. The base cost of the crypto being transferred will be calculated as those applied to shares (outlined above).

The return element is not included in the gain calculation: it will be taxable when it is received (for individuals) or on an accruals basis over the term of the loan (for corporates). This exclusion therefore stops any double taxation which could otherwise occur on the return element: being subject to tax under the gains rules and also under the income tax or corporation tax rules, as outlined in TCGA 1992 s 37.

Unknown future amounts

Where part of the future element is unknown (i.e. the return or both the principal and return), that element of the future receivable requires a value to be attributed to it for the purpose of calculating the gain arising on the change in beneficial ownership. The unknown element is valued as the amount which would be paid by an unconnected third party and is known as the ‘Marren v Ingles right’. The case of Marren v Ingles [1980] STC 500 established the right as a ‘chose in action’ and therefore a chargeable asset.

If the return of principal is known, the total proceeds used to calculate the gain will be the GBP value of the principal at the date of the loan, plus the value of the Marren v Ingles right attributable to the return. The base cost of the crypto being transferred will be calculated in accordance with the rules for shares (as explained above).

In both cases, when the return element is received, another chargeable event occurs under TCGA 1992 s 22(a): the Marren v Ingles right is disposed of in exchange for a known amount of crypto.

It may be that the market value of the Marren v Ingles right was higher than the value of the crypto eventually received: this would result in a capital loss. Where this occurs, it may be possible for individuals to offset this loss against the gain made in the initial transaction: an election would be required under TCGA 1992 s 279A for this treatment to be applied.

Borrowing from a DeFi protocol with collateral

Increasingly, we are seeing clients look to leverage their crypto holdings by borrowing from a DeFi protocol, using their crypto holdings as collateral. In transferring the collateral to the DeFi protocol, the borrower will normally give the DeFi protocol the power to liquidate their position, should the loan to value ratio fall below a certain amount. This is explored in CRYPTO62640.

There is a risk that an unexpected capital gain could occur when the collateral is transferred from the borrower’s wallet to the DeFi protocol. If the DeFi protocol can use the collateral as they wish during the period they hold the collateral, there will be a change in beneficial ownership and therefore a chargeable event. In this case, the proceeds for the disposal will be the market value of the crypto put up as collateral at the date the transaction was entered into.

If the DeFi protocol holds the collateral on trust, there has not been a change in beneficial ownership of the collateral and no chargeable event will arise.

In the instance where the DeFi protocol is required to liquidate a portion of the collateral, there are two possible tax implications:

• If the initial transfer of collateral resulted in a chargeable event, no further chargeable events will occur.
• If the initial transfer of collateral did not result in a chargeable event, the liquidation will lead to a chargeable event where the proceeds received in the disposal will be the value realised for the crypto sold by the DeFi protocol: this is taxable on the borrower.

Where does this leave us?

To recap then, advisers should read through the updated guidance; use HMRC’s examples in CRYPTO601670 onwards; understand the transaction fully before advising on the tax treatment; consider if clients’ previous tax returns have been appropriately filed; and look into software which can assist in analysing crypto transactions.