In early February, HMRC published a new chapter in its Cryptoassets Manual dealing with decentralised finance (“DeFi”). DeFi is an umbrella term encompassing a range of products which are comparable with traditional financial services. DeFi platforms can provide services such as decentralised exchanges, saving, lending and derivatives, using distributed ledger technology.
HMRC’s guidance focuses on the taxation of “lending” and “staking” services which are entered into between unconnected lenders and borrowers through a DeFi platform.
“Lending” in this context occurs when a person transfers crypto-tokens to another person. The transfer results in the recipient (a “borrower”) taking control of the tokens. The “lender” acquires a right to demand the transfer, in return, of a determined quantity of tokens to satisfy the “loan” at some point in the future.
“Staking” occurs when a person transfers control of tokens to a DeFi lending platform. The transferor, also known as a “liquidity provider,” receives one or more different tokens from the DeFi lending platform in return. The tokens which have been transferred to the DeFi lending platform by the liquidity provider can be transferred by the platform to third party “borrowers.” That “borrower” is required, at a future date, to provide a return to the DeFi lending platform, all or part of which is passed on to the liquidity provider.
These arrangements might appear to have certain familiar hallmarks of collateralized lending transactions outside the cryptoasset sector. Elements of the arrangements are familiar to observers of peer-to-peer financing arrangements, or stock lending transactions. However, given the unique form of cryptoassets as, in the view of HMRC, not constituting “money” or “currency,” the treatment of the rate of return on the “lending” and “staking” does not constitute “interest” for UK tax purposes.
Accordingly, HMRC follow a different approach to the taxation of lending and staking of cryptoassets to the way in which, for example, loan relationships or deemed loan relationships might be taxed in the UK. The provisions in UK tax legislation for taxing loan relationships (and deemed loan relationships) therefore do not apply to cryptoassets.
How any DeFi return is taxed when arising to the lender and liquidity provider will depend, for both income tax and corporation tax purposes, on whether the activity amounts to a trade, and whether any return produced has the nature of being a capital receipt or a revenue receipt.
Trading or investing?
The HMRC guidance states that the relevant considerations to be made when determining whether a trade is being carried on involving the making of DeFi loans would be similar to those made when considering whether there is a trade in shares, securities and other financial products. This leads tax practitioners to the familiar, but complicated, case law analysis being used to determine whether a trade is being carried on (or not) or whether, alternatively, the activity which generates the return falls outside the scope of any trade. There is little cryptoasset-specific case law in the UK; as a general observation, only deliberate and organized cryptoasset lending and staking is likely to constitute a trade.
If a trade is carried on, the cryptoassets may be held as trading stock. Where no trade is being carried on, or the activity falls outside of the scope of trading, the making of a DeFi loan or staking (both involving transfers of cryptoassets) may be the disposal of a capital asset, subject to capital gains tax for individuals and corporation tax on chargeable gains for companies.
DeFi return: an income or capital receipt?
Any DeFi return is taxed in accordance with the receipt being of a capital nature or revenue nature. A return of a capital nature would be subject to tax on the chargeable gain realized. Where the return has a revenue nature, the return might be taxed as trading income if (exceptionally) the activities are deliberate and organized enough, or (more likely) could be taxed within the scope of the miscellaneous income provisions (in sections 979-981, within Part 10 of the Corporation Tax Act 2009).
HMRC note in their guidance that the nature of the return received by the lender or liquidity provider will depend on how the transaction is structured. The lending or staking of tokens through DeFi is acknowledged to be a rapidly evolving area. Perhaps unsurprisingly, HMRC set out “guiding principles” to assist with determination of the nature of the activities being undertaken, coupled with several examples, instead of laying out rules which are set in stone.
A key distinguishing question is stated by HMRC to be whether the return earned by the lender or liquidity provider has resulted from the provision of a service to the borrower of a DeFi lending platform. This might identify the return as being of a revenue nature. By contrast, if the return was realised from the growth of an asset owned by the lender or liquidity provider, the treatment might be more compatible with a capital return.
Complicating factors are listed in the HMRC guidance as being the various DeFi operating models, including whether the return to be received by the lender/liquidity provider is known at the time the agreement is made (being suggestive of a revenue receipt), as opposed to a more speculative return (being suggestive, in HMRC’s view, of a capital receipt). The length of the period of the lending or staking arrangement, any periodical nature of interim payments and the linking of any return to the disposal of the tokens are all identified as additional factors to be taken into account. HMRC confirm that this list is not exhaustive, and that no single factor is determinative.
Examples and questions
The HMRC guidance includes a number of worked examples covering the treatment of cryptoasset disposals 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 arrangements regarding DeFi in a tax context, is likely to lead to additional questions around compliance and interpretation. This is perhaps particularly so given the fact that the UK case law which governs the identification of a trade, and the nature of capital and income receipts, is far from new. It will be interesting to see how well case law couched in terms of fruits and trees (Ryall v Hoare , cited by HMRC in their guidance) fares when dealing with taxation questions arising from cryptoassets and DeFi platforms.