Borrowers Beware – HMRC’s New DeFi Guidance – Technology

On 2 February 2022, HMRC updated its Cryptoassets
Manual to include a new DeFi section setting out, for the first
time, HMRC’s view on the taxation of cryptoassets used in
decentralised finance or ‘DeFi’
transactions. HMRC appears to be one of the first tax
authorities to issue such detailed guidance on DeFi, and this
update will be welcomed by those who are seeking further
clarification on HMRC’s views in this area.

But the new guidance looks likely to disrupt the DeFi market in
ways that crypto investors and users may see as disadvantageous.
Indeed, Crypto UK, an industry body, has attacked the guidance as
an ‘unnecessary burden’ and ‘inconsistent’ with the
approach of other UK government bodies. Here we give an overview of
the new guidance as it pertains to individuals.

What is DeFi?

DeFi is a type of financial technology based on a similar
distributed ledger technology (‘DLT’) as which underpins
cryptocurrencies. It provides a means for financial services to be
carried out without the involvement of the traditional gatekeepers
of the financial world.

The DeFi section of HMRC’s guidance is concerned with
‘lending’ and ‘staking’ of tokens. Broadly, lending
in this context involves the owner of a cryptoasset transferring it
to a borrower or DeFi lending platform as a loan. Staking in this
context is where a person (known as a ‘liquidity provider’)
transfers the control of tokens to a DeFi lending platform, at
which point the platform transfers control of one or more different
tokens to the liquidity provider. This meaning of ‘staking’
is not to be confused with ‘proof of stake’ staking, in
which the owner of the cryptoasset locks the asset up as a way of
contributing towards the functioning of the blockchain network (and
earns rewards for doing so).

There are numerous applications of DeFi technology and ways in
which users engage with it but the new guidance limits itself to
describing certain types of transaction and setting out some
general principles.

Taxing DeFi

The new DeFi section covers a number of important tax questions.
What kind of taxable events, if any, occur when cryptoassets are
lent, borrowed or used as collateral? How does HMRC plan
to tax the returns earned by lenders for lending or staking? We
look at these in overview below.

The rules below can be expected to apply to an individual in any
year in which he or she is UK tax resident, but individuals with an
international nexus should consider taking specific advice as their
position may be more complicated. Please refer to our article on
the location of cryptoassets here for more information).

DeFi returns – income or gains?

Whether the return from lending or staking is characterised as
income or gain is clearly an important question for the lender,
with income tax rates reaching up to 45% compared with 20% for
capital gains tax.

HMRC rules out the possibility that any return earned can
be interest for tax purposes, but as expected HMRC’s basis
for taxation of the return requires the return to be characterised
as either an income (revenue) receipt or a capital receipt. To do
this, the guidance asks us to consider whether the return is:

• earned by the lender for the provision of a service to the
  borrower or DeFi platform (in which case it is likely to be
  income), or




• realised from the capital growth of the asset owned by the
  lender (in which case it is likely to be a capital).
  
  This ties into a key question in tax terms, which is whether the
  activity generating the return is a trade or not. Relevant factors
  are whether the amount of the return is known in advance, whether
  it is paid periodically or as a lump sum and whether the lending is
  for a fixed or indefinite period and short or long term. The amount
  chargeable to tax is the sterling value of the tokens at the date
  of receipt.

Naturally, all this means that whether a particular DeFi
transaction will result in an income or capital return to the
lender will be very fact sensitive and require in-depth analysis if
the conclusion is on the margin. However, it would not be
surprising if, as DeFi transactions/activities gain
traction, HMRC take a greater interest in them as a
potential trading activity.

While it is possible that the activity of lending tokens can
itself amount to a trade (leading to a charge to income tax on any
profits from that trade), HMRC states that individuals
will only be carrying on a trade involving the making of DeFi loans
in exceptional circumstances, although each case will turn on its
own facts.

Disposals for capital gains tax purposes – unwelcome
news

The new guidance also covers how cryptoassets are taxed when
they are lent, borrowed or used as collateral.

The key issue is whether a transfer by a lender or borrower of
cryptoassets counts as a ‘disposal’ for capital gains tax
purposes. If there is a disposal (see further below), a 10% or 20%
tax charge will be levied on any gain realised by the holder (ie on
the positive difference, if any, between the holder’s pooled
acquisition cost for the cryptoassets and the value at the time of
the disposal).

HMRC identifies several points at which a disposal may
occur, including:

• when an individual lends cryptoassets to a borrower;




• when an individual transfers cryptoassets to a DeFi platform in
  return for other tokens received from the DeFi platform; and




• when an individual locks up his or her cryptoassets as
  collateral for a loan.

Is there a disposal?

Whether the transfer of the cryptoasset is a disposal is fact
dependent and turns on whether the recipient of the tokens has the
ability to deal with them as he wants or is restricted from doing
so. The same applies to a borrower who provides tokens as
collateral for a loan.

However, as would be expected, whether there is a disposal will
require an analysis that is sensitive to the facts of each case,
particularly the terms on which the recipient receives the
tokens.

High and dry

If a DeFi transaction does trigger a disposal under the new
guidance, this could very quickly lead to liquidity issues for some
users by creating a ‘dry’ tax charge – where the
taxpayer does not actually receive any cash to pay the tax
liability. Worse still, it might lead to a charge to tax in
circumstances in which the taxpayer has not beneficially received
any value at all.

For example, if Alice lends 10 tokens to Bob with a market value
of £10 per token, firstly she must calculate the difference
between the tokens’ base cost and the market value at the time
of the loan, and pay capital gains tax on any gain. If, when Bob
repays Alice, the market value of the tokens is £15 per
token, Bob must pay capital gains tax on his gain of £50,
even though on the face of it he does not personally benefit from
the increase in value of the tokens he borrowed. The position is
more nuanced where tokens are transferred by the borrower to a DeFi
platform to provide collateral for his/her loan.

Borrowers in particular therefore need to be very careful about
how they engage with DeFi services, to avoid an unexpected dry tax
charge, particularly given the volatility of cryptoassets.

In addition, it may be necessary for some individuals to sell
some of their cryptoassets in order to pay the liability, which
would itself potentially be another chargeable event.

Why does it matter?

It is worth highlighting at this point
that HMRC guidance is not law; rather, the guidance sets
out HMRC’s interpretation of the law. The absence of case
law and legislation does open the door to taxpayers adopting
alternative interpretations and positions, but in turn this could
pave the way for litigation between HMRC and
taxpayers.

In the meantime, taxpayers should not ignore this
guidance. HMRC has not stated explicitly whether the
guidance applies retrospectively, and without any such reassurance,
taxpayers who have used DeFi services in prior tax years will need
to consider carefully whether they need to amend their tax returns.
Given that DeFi is a relatively recent phenomenon, in most cases
this may only require amendments to one or possibly two years’
tax returns.

How we can help

The recent publication of the DeFi update to the Manual
highlights once again how quickly this area of taxation is
evolving. Crypto investors who have filed on
what HMRC may now view is an incorrect basis or who are
seeking to regularise their tax position in light of the developing
guidance should seek legal advice.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.