Decentralised Finance – HMRC’s new consultation on Lending and Staking

As new forms of cryptoassets and related services continue to evolve, so too does the Government’s approach to the taxation of them. HMRC’s formal consultation proposing to introduce legislation to disregard transactions for relevant tax purposes that arise through the lending or staking of cryptoassets, in line with the economic substance of the activity, is a welcome step in the right direction. In addition, the potential introduction of a new miscellaneous income charge specifically for cryptoassets should provide some certainty to taxpayers when completing their tax returns.

In July 2022, the Government issued a Call for Evidence on the tax treatment of Decentralised Finance (DeFi) transactions involving the loaning and staking of cryptoassets, including:  

• Lending services, which allow users to deposit their tokens and receive a financial return in exchange; and
• Staking, whereby cryptoasset owners (liquidity providers), in exchange for a financial return, can provide their tokens to a platform to pool with those of other users, allowing the platform to provide other DeFi services with the pooled tokens.

The Call for Evidence followed the publication of HMRC’s updated guidance in February 2022, setting out their position that cryptoassets are (generally) chargeable capital gains assets, but as cryptoassets do not customarily meet the definition of a security (other than security tokens), the statutory disregard available for repos of securities and stock loans is not available in relation to loaning and staking of cryptoassets.

Unsurprisingly, nearly all respondents agreed that treating lending and staking as a disposal fails to acknowledge that these products are intended to mimic a lending relationship and results in significant reporting and compliance burdens.

Having reviewed responses, HMRC are consulting on the feasibility of an equivalent repo and stock lending regime for cryptoassets in recognition that this:

• Better reflects the true economic reality of the DeFi transaction;
• Should impose a lower administrative burden than the other options previously proposed in the Call for Evidence;
• Provides more flexibility to address future requirements; and
• Is tailored to the DeFi market, minimising any unintended consequences of attempting to combine TradFi (Traditional Finance) and DeFi legislation in this area.

However, lenders who sell their rights in the lent or staked cryptoassets, by (for example) selling a liquidity token issued by the platform which represents the lent or staked tokens, will be considered to have disposed of the underlying lent or staked tokens and be subject to capital gains tax. Similarly, where an NFT (non-fungible token) is issued by a platform to represent the lent or staked token and the NFT is ‘fractionalised’, and then a part of the fractionalised NFT is sold, this would be regarded as a part disposal of the lent or staked token.

In order to further reduce administrative burdens, HMRC have put forward a proposal to treat all DeFi returns as being revenue in nature and charged to a new cryptoasset miscellaneous income category (thereby avoiding the current need to consider whether the return is of a revenue or capital nature). However, for some individuals this may turn what was a capital receipt into miscellaneous income resulting in an increase in their marginal tax rate, potentially up to 40/45 percent. Some individuals may therefore consider undertaking their future DeFi transactions through a company to benefit from lower corporate tax rates.

Although the focus of the consultation is on DeFi lending and staking, the proposals are also intended to apply to CeFi (Centralised Finance), the lending and staking of cryptoassets through an intermediary.

These rules are to apply when all relevant conditions are fulfilled post the commencement date. At present the consultation does not reference any transitional provisions, so those who have already triggered disposals, and potentially gains, will not be able to access any relief.

For example, it is typical in lending and staking transactions to transfer a pair of tokens to a platform and for the same types of tokens to be returned but in different amounts and/or proportions, and/or for a pre-agreed stablecoin to be returned instead, as this gives participants greater flexibility. HMRC’s position (as set out in the consultation) is that there has been an economic conversion and that the conditions set out for the proposed lending exemption would not be satisfied. However, HMRC are keen to gather industry views on this, including whether this is a fair outcome for such transactions.

It is also unclear currently how the new cryptoasset miscellaneous income category may interact with existing rules on, for example, loss relief.

The consultation is open for responses until 22 June 2023.

For further information please contact:

• Susanne Dixon
• Jonathan Peall