High stakes – KPMG response to crypto lending and staking consultation

HMRC may have staked a position on the taxation of decentralised finance transactions – but are there more questions than answers?

More questions than answers?

HMRC’s recently closed consultation on the taxation of decentralised finance (DeFi) involving the lending and staking of cryptoassets was welcomed by an industry which has long been asking for certainty on tax matters. It set out HMRC’s proposals to introduce legislation to disregard such transactions for relevant tax purposes (in line with the economic substance of the activity) and to introduce a new miscellaneous income charge specifically for cryptoassets. However, as we explained in our response to HMRC, any proposed regime needs to consider other ongoing policy work, be administratively practicable and – given that this is the stated policy intent – actually exempt economic lending and staking transactions.

Further to our article on the background to the consultation, we raised the following points in our consultation response, for further consideration by HMRC.

Policies and the macro environment

  • HMRC recognise that any exemption should minimise unintended consequences of attempting to combine DeFi legislation with existing securities lending/repo exemptions. Nevertheless, the proposed exemption closely follows the conditions of the TradFi (Traditional Finance) exemptions. Given the marked differences in both users and transactions however, the focus should be on equity, not equality, so that in some cases it might be more appropriate to have a wider exemption in order to achieve greater fairness of outcome;
  • The Financial Conduct Authority (FCA) Crypto Policy Team is considering whether cryptoasset lending should be a separate regulated activity, and just after the HMRC consultation closed the Law Commission published its recommendations for reform of the law to accommodate cryptoassets. It is important that the tax laws remain flexible in order to address emerging legal and regulatory positions; and
  • Any proposed regime must remain fit for purpose, particularly where the speed of innovation is as fast as it is in relation to DeFi. It is not clear how HMRC intend to assess any impact of the proposed rules, especially once they begin to receive information under the OECD Cryptoasset Reporting Framework.

Practical application and potential issues

  • The scope of the proposed exemption comes short of covering most DeFi lending models where the same assets or ratios are not returned, including in relation to popular liquidity pools supporting ETH/USDT and ETH/USDC exchanges – a large part of the market;
  • Questions remain on the tax consequences of lending wrapped assets (where the original asset is wrapped into a digital vault and a newly minted token is created to transact on other platforms e.g. wrap BTC to stake it on to Ethereum) or whether yield optimisers that operate through a chain of smart contract interactions are (or should be) in scope of the proposed exemption; and  
  • Industry has raised concerns in relation to over-collateralised borrowing and the tax treatment of borrowers where the obligation is to return the tokens less liquidated collateral (rather than returning the borrowed tokens) which would not fall within the scope of the proposed exemption. 

Practicable for taxpayers

  • Many unrepresented taxpayers will be investing in cryptoassets and both the proposed exemption and any nil gain/nil loss treatment could be difficult for them to apply. It might therefore be appropriate to treat certain categories of taxpayers differently (as is done in some countries) or to give taxpayers a choice. For example, there does not appear to be a policy rationale for why a taxpayer may not elect to apply nil gain/nil loss treatment where they have a limited number of DeFi transactions;
  • The proposal to treat the DeFi return as a new miscellaneous income charge is suggested as an approach allowing taxpayers to avoid considering the income vs capital rules. However, for financial traders the returns from DeFi lending transactions are genuine trading income and there does not seem to be a policy rationale for why this should not continue to be the case;
  • It is also not clear how a new income category would interact with existing rules on loss utilization; and
  • For individuals, the new income category may result in an increase in their marginal tax rate of up to 40/45 percent instead of a capital gains tax charge. 

The stakes are high

The UK Government has repeatedly stated its ambition to place the UK’s financial services sector at the forefront of cryptoasset technology and innovation. Certainty around tax treatment of cryptoassets should help bolster the UK’s standing in the world amongst cryptoasset firms and investors, however, it is important to note the limited scope of this consultation.

As well as the open questions in relation to DeFi mentioned above, questions remain on important points such as the situs of cryptoassets which has an impact for capital gains tax and inheritance tax, and on source for income tax purposes. Further, failure to align how transactions are viewed for corporation tax and VAT purposes could also cause issues. The industry still needs further guidance on these issues.

Please contact the authors, or your usual KPMG in the UK contact, if you have questions or concerns regarding the tax treatment of cryptoassets.