On 2 February 2022 HMRC released new guidance titled Decentralised Finance: Lending and Staking. Don’t be misled by the title and the terminology used throughout the guidance, HMRC make it clear that it is intended to cover all lending and staking scenarios; regardless of whether or not it was via a decentralised or centralised platform. HMRC explain at CRYPTO1000 that it is the facts of the situation, rather than the terminology, which is determinative of the tax position.

The timing of this guidance from HMRC was particularly unhelpful, given that taxpayers, their accountants and software providers were still working all hours to get tax returns filed by 28th February. Now we have taken the time to digest and unpack the guidance, we are sharing our thoughts on it with you. We have also updated our Cryptocurrency Tax Guide for UK Individuals with comprehensive analysis of the substantially different tax position resulting from this guidance on crypto tax.

On the face of the HMRC guidance, the revised tax position presents significant capital gains tax implications for investors choosing to generate a yield from their cryptoassets, whilst holding on to them for long term gains. However, this will only apply when there is a transfer of beneficial ownership to another party at the point of entering the yield generating activity. If there has been no transfer of beneficial ownership when locking your tokens away, there may be no change to the crypto capital gain tax position of the crypto tokens locked away.

How to decide if there is a transfer of beneficial ownership?

HMRC explains at CRYPTO61620 that considering whether the lender/liquidity provider actually transfers their beneficial ownership of the crypto tokens will require an examination of the contract/terms and conditions. This will need to be done for each type of lending/staking activity that the taxpayer is involved in.

Where the recipient of the crypto tokens has the ability to deal with the tokens received as they want, HMRC say at CRYPTO61620 that this will be a strong indicator that the recipient has acquired the beneficial ownership of those crypto tokens. Conversely if the recipient is specifically restricted from dealing with the crypto tokens received, HMRC believe this will be a strong indicator that the recipient does not have beneficial ownership of the crypto tokens received.

It will be the responsibility of the taxpayer to decide whether or not beneficial ownership has transferred, yet this is a complex legal matter with very little in the way of supporting guidance and examples from HMRC. It is recommended that professional legal and tax advice is sought regarding your specific circumstances.

See further guidance on whether or not there may be a change in beneficial ownership in our Cryptocurrency Tax Guide for UK Individuals.

How has CGT position changed?

Where there is a transfer of beneficial ownership of the crypto tokens locked away, this could mean a large capital gains tax bill at the point of entering and exiting the yield generating activities which are set out below:

• At the time of lending out and receiving repayment of your crypto tokens
• At the time of staking and un-staking your crypto tokens
• At the time of entering and exiting a liquidity pool
• At the time of depositing, withdrawing or the liquidation of crypto collateral against a loan you have taken out

It is important to understand that the new guidance for crypto tax on yield generating activities does not create additional tax bills. It merely accelerates the capital gains tax that would have been ultimately payable upon disposing of the crypto (ie cashing out for fiat, exchanging the crypto for token, using it to buy something or gifting it). Instead, capital gains tax is potentially front-loaded to the point of entering the yield generating activity, it is re-assessed for capital gains tax at the point of exit and the balance is payable at the time of ultimate disposal.

See further guidance on how to work out your tax position for yield generating activities in our updated Cryptocurrency Tax Guide for UK Individuals.

Are rewards taxable as income or capital?

HMRC have also indicated in this latest guidance that cryptoasset reward tokens received for yield generating activities (such as staking and lending) will not always be income in nature. So we cannot automatically assume they will be taxed as miscellaneous income.

You may think that a 20% CGT (capital gains tax) rate on your crypto rewards is much better than income tax at say 40%, but it’s not that rosy. The problem is that capital rewards are subject to CGT at the point of entering the yield generating activity, and then re-assessed for CGT upon receipt of the reward (usually on exit). Paying CGT on the estimated future reward upon locking up your crypto tokens in a staking protocol is very unattractive – especially where it is long-term for say 5 -10 years.

Example 1C in our updated guide, shows the tax position for staking with a capital reward, where there has also been a transfer of beneficial ownership of the tokens staked.

HMRC guidance at CRYPTO61214 helps determine whether the reward received by the lender/liquidity provider should be treated as income or capital. This will depend on how the transaction is structured. As there are many different structures that are ever-evolving, HMRC has set out some guiding principles in CRYPTO61214.

The tax treatment of the crypto reward is determined by whether it is an income or capital reward. It is irrelevant whether or not beneficial ownership of the principal tokens has been transferred upon entering the yield generating activities. Therefore, even where beneficial ownership has not been transferred, it is necessary to work out if the crypto reward is income or capital.

See further guidance in our guide on how to decide if the crypto reward is income or capital. We have included a summary of the indicators that HMRC have produced.

Possible future changes to this HMRC guidance

There has been significant criticism about the damaging consequences of this guidance from the crypto community. Investors may not have the available funds to pay capital gains tax on a disposal triggered when entering the protocol, because their cryptoasset tokens remain locked up and cannot be sold to pay the tax bill. It has also added significant complexities and burdens for taxpayers, their accountants and the software providers in trying to comply with several additional tax points and extremely complex and subjective decisions effecting the tax position.

Crypto UK (leading trade body) has challenged this new guidance on behalf of the crypto community and has formed a working group of tax professionals and barristers with the objective of lobbying the government to create new tax legislation specifically for cryptoassets. This aims to address the many problems with the current law governing the tax position of cryptoassets; particularly yield generating activity covered by this new HMRC DeFi guidance.

It is very positive that Economic Secretary to the Treasury, John Glen, has announced in April 2022 that the government agrees that the current tax legislation will need major surgery to make it work more easily for crypto. They will be engaging with stakeholders on the changes they want to make and are looking to resolve specific issues like the treatment of DeFi loans and staking. They are also setting out new legislation to see stablecoins recognised as a valid form of payment in the UK. Although this will be regulatory rather than tax legislation, there will be an impact on the tax position if stablecoins are recognised as currency.

Therefore, with an appetite from Government to introduce changes to the tax system for crypto (DeFi in particular), we are optimistic that new rules will be sensible to help attract crypto businesses and investors to the UK.

As a result of this positive activity, the HMRC guidance published on 2 February 2022 regarding DeFi lending and staking may well change, evolve, or be entirely re-written over time, depending on the progress of any new tax legislation. Drafting and enacting new legislation can be a long-winded, time consuming process and it may be a few years before anything changing this HMRC guidance is in place.

When does the new HMRC DeFi guidance apply from?

There is a great deal of uncertainty in the crypto community as to when the changes come into effect from. HMRC’s guidance isn’t the law; it is their interpretation of the law. So if this new guidance from HMRC is a correct interpretation of the law, then it applies retrospectively to all prior transactions. This new guidance from HMRC is not a change in position, it is just them providing more clarity and guidance on the laws that were already in place.

Do I need to re-file tax returns for earlier years?

Unfortunately, if you think your prior years’ tax returns were filed incorrectly, the onus is on the taxpayer to file amended returns for 2020/21, or to make a voluntary disclosure to HMRC for earlier tax years.

How is Recap handling the new HMRC DeFi Guidance?

A bespoke approach is required for each different yield generating activity you are involved with. The terms and conditions or the way the protocol works will determine whether:

• The crypto rewards are income or capital
• Whether or not there is a transfer of beneficial ownership of the tokens locked up

Recap's default position for smart contract based yield generating activity is to treat the interaction as a change of beneficial owner and any rewards as income in nature.

Our approach detects yield-based activity by interrogating the log events of transactions to ascertain if there has been a swap of assets. Swapping one asset for another indicates that the user has lost control of the tokens they commit to a yield based contract, constituting a change of beneficial owner. Most yield-based activities generally include reward payments in separate transactions to opening or closing a yield position, which is a strong indicator that the rewards are income. If your wallet has received some rewards, they will be classified as deposits, where you manually need to reclassify the transactions and income.

A good example of our approach is Uniswap v2 liquidity pool, where the user surrenders 1 A token and 2 B tokens and receives a liquidity token representing their position in the liquidity pool. The Ethereum log events clearly show an exchange of the user's principal assets A and B for the liquidity tokens. Therefore, they are treated as a disposal of the A and B tokens at market value and an acquisition of the liquidity tokens. On redemption, the user surrenders the liquidity token to the pool, which then redeems the position of the two assets in the pool.

This methodology also works for most staking contracts where you deposit an asset A and receive a token representing a claim in return. The claimA token can then be used as a right to redeem the A principal.

For yield based activities through a centralised platform, our default approach is not to treat the activity as a change in beneficial ownership. We think it would be unreasonable to treat such transfers as a disposal and could potentially open up a pandora's box of bringing cryptocurrency exchanges into the same scope, when it is well established that depositing tokens on an exchange is not a tax disposal.

Recap provides the tools to reclassify transactions should customers object to our default positions. We expect to further refine our support for yield-based transactions that are capital in nature and build automated reconciling for all the major protocols as we get more guidance and legal clarity in the future. Our default positions do not constitute tax advice.

It is therefore not possible to apply a generic approach in the software (for example treating entering all liquidity pools as a CGT disposal) and some may be and some may not.

Need help from a tax professional?

Louise Lane heads up the Crypto Department at Wright Vigar and is happy to assist with any crypto tax or accounting advice you may need. Louise has worked closely with us for over 3 years and has written this blog and our newly updated Cryptocurrency Tax Guide for UK Individuals.