The UK government has recently initiated a consultation on the taxation of decentralised finance (DeFi) activities involving the lending and staking of cryptoassets. The aim is to clarify tax guidelines and eliminate tax disposals related to these activities, aligning taxation with the economic substance of the transactions.
Why the government is planning to legislate:
HMRC's current guidance on Decentralised Lending and Staking (issued Feb 22) highlights the complexities surrounding beneficial ownership in cryptoasset lending and staking. Determining beneficial ownership can be challenging, but HMRC's guidance suggests that transferring assets to a liquidity pool or staking service would likely trigger a tax disposal. This is because they expect there to be a change in beneficial ownership when control of the assets is transferred to a third-party contract or service. In contrast, tax disposals for similar activity with stocks, shares, and securities are already eliminated by existing REPO legislation.
What is the government proposing?
Following HMRC’s DeFi lending and staking consultation Aug 2022 the government proposes new legislation eliminating tax disposals when entering and exiting DeFi lending and staking positions. The new legislation is expected to be aligned with current REPO rules, which provide the same elimination of tax disposals for other asset classes like stocks and shares.
Recap's perspective on the consultation:
Recap praises HMRC's progressive cryptoasset tax policy, which removes dry tax charges for many taxpayers. Despite this, we recommend adopting a retrospective legislative approach to address historical transactions and support early DeFi participants and innovators. Although the proposals seek to reduce administrative burdens, taxpayers must still contend with carve-outs and eligibility.
For the UK to truly excel as a thriving cryptoasset hub, further simplification of compliance burdens for crypto users is necessary. We propose that all lending and staking activities be considered capital in nature, enabling investors to compound earnings and defer tax until a non-DeFi disposal takes place. This approach would remove many from self-assessment requirements, align tax with economic substance, and allow crypto investors to accumulate wealth without facing unfair income tax charges determined at the time of receipt, while still exposed to market volatility until tax is due.
Exploring the full range of DeFi transactions:
To ensure comprehensive and effective legislation, it is crucial to examine the entire spectrum of DeFi transactions. This would include bridging and wrapped assets into the proposed changes, as they are currently being ignored. This will provide tax clarity and foster industry growth and development. However, determining the eligibility of transactions executed on decentralised protocols will always be complex, suggesting that the legislation should adopt a broad approach to be effective.
Addressing the complexity of crypto accounting:
The government are claiming the proposed changes will reduce the tax administration burden, but we are not sure how effective this will be. As a result of the proposed legislative changes, taxpayers will be required to update their accounts and make a determination of which of their activities are affected by the changes. With many crypto evangelists having transactions in the hundreds of thousands, deciding and applying the carve-out reliefs will be very painful. This is, of course, where Recap can help; we already apply automatic tax classifications for lots of Defi contracts, such as Uniswap and other LP protocols. The challenge is always what transaction metadata is available, and what was the intent of the transaction to make an automatic tax determination (note: that you are free to override). Correlating returns against the principal to determine the rewards earnt can be challenging, especially for users with thousands of transactions, multiple staking terms and limited transactional metadata.
Integrating liquidity pools into legislation
Liquidity pools are integral to DeFi, and their inclusion in the proposed legislation is essential for tax clarity. However, incorporating liquidity pool transactions may present challenges due to the difference in assets returned from lending or staking positions. Addressing this issue is crucial to ensure that individuals do not inadvertently create tax disposals when entering and exiting LP positions.
Revenue vs capital in-nature rewards
It is contentious that the proposals suggest all rewards are taxed as income when received. Although it would seem to be a simplification, it retains the big issue faced by taxpayers of being taxed on the income at value when received, despite the value dropping by the time they sell/swap the token. A capital loss made on disposing of the token received as income cannot reduce the income tax bill. In addition to this, De-Fi rewards which are genuinely capital in nature, will suffer higher tax rates as a result of the proposed change. Recap supports clearer legislation to simplify the determination. However, we argue that treating all rewards as income is not a fair outcome for this highly volatile asset class. Recap’s preferred approach is to treat all DeFi lending and staking transactions as capital in nature, as it aligns more with the economic reality. By taxing rewards as capital, tax is deferred until the rewards are disposed of in a non-DeFi transaction. Taxpayers would not need to file self-assessments year on year, only when they dispose of the reward assets. It would also remove the need for those currently earning staking rewards from having to hedge currency risk.
In conclusion, the UK government's consultation on DeFi lending and staking represents a significant step towards establishing a level playing field in the cryptoasset space, aligning with existing repo legislation for traditional assets like stocks and shares. Recap encourages stakeholders to provide feedback and concrete examples to help shape the final legislation, including considering all DeFi lending and staking activities as capital in nature, which aligns more with the economic reality.
Adopting a retrospective approach will ensure clarity and certainty for taxpayers engaged in DeFi activities before the introduction of new legislation, supporting the sector's innovators. It is essential that the consultation examines decentralised activities, such as bridging and wrapping, to ensure that as many DeFi activities as possible fall within the scope of the new legislation, ultimately fostering industry growth and development.