Tax treatment of crypto DeFi platforms
HMRC have made a habit of publishing their view on the taxation of cryptocurrency transactions by stealth. HMRC's updated guidance on their view of the tax treatment of crypto DeFi platforms is no exception.
There's a lot of detail covered in HMRC's manual, so we'll stick to the salient points of how they view the tax treatment of crypto DeFi platforms for individuals.
What are crypto DeFi transactions?
Decentralised Finance or DeFi for short, provides products similar to those available from financial services, albeit via Distributed Ledger Technology. Typically DeFi platforms provide services such as Decentralised exchanges, saving, lending and derivatives. Most of these services are built on Ethereum utilising smart contracts and are available to everyone.
Lending and borrowing of cryptocurrency has been possible since the inception of bitcoin. However, this was a very risky activity due to lack of regulation. As a result it was usually conducted between parties that knew each other. For example a company and its shareholder(s).
Transactions carried out on crypto DeFi platforms
There has been a rise in popularity of the use of DeFi lending platforms amongst crypto investors in recent years. This is largely as a result of the very attractive potential rate of return for returns offered to investors. Uniswap, is probably one of the most well known and popular DeFi lending platforms with in excess of $8 billion under management.
DeFi lending platforms facilitate lending between unconnected lenders and borrowers. When making a loan to a DeFi lending platform, the lender reduces their exposure to any borrower defaulting on the loan.
Instead the risk of a default is spread across all the enders participating on the DeFi lending platform. It may be further mitigated by the provision of collateral. As an incentive to participate the crypto Defi platform may provide a lender with a return on their loan. This allows their crypto to provide a source of income along with any increase in their value.
A person (a company or individual) known as the lender may transfer the control of their tokens to another person who is the borrower. When the transfer occurs, the lender acquires the right to demand the borrower transfers to them the control of an equivalent quantity of tokens at a future date to satisfy the loan.
When a person known as the liquidity provider transfers control of their tokens to a crypto DeFi platform this may be termed “staking” or “providing liquidity”. The DeFi platform simultaneously transfers control of one or more different tokens to the liquidity provider.
The DeFi platform is able to transfer control of the liquidity provider's tokens to other persons known as borrowers. This is usually done on terms requiring the borrower to provide a return to the DeFi lending platform exceeding the quantity of tokens they originally received.
This return, or a part of it, will be passed onto the liquidity provider as their compensation for providing the liquidity to the DeFi lending platform. HMRC's updated guidance for crypto DeFi platforms has focused on the tax treatment of these transactions.
Overview of the tax treatment of crypto DeFi platforms
There are a number of operating models carried out on crypto DeFi platforms which are discussed in more detail below. Depending on the circumstances, HMRC may consider the the lending to a crypto DeFi platform to be a trading activity. Alternatively where they consider this does not amount to a trade, it may be considered to be a disposal for chargeable gains purposes.
How the liquidity provider to a crypto DeFi platform is rewarded, and how any return is calculated, will depend on the operating model of the transaction. In HMRC's view this may determine whether any return is regarded as taxable income or as a capital gain.
The operating models
These are set out below
A loan of crypto to a borrower with no DeFi lending platform involved
This arrangement was used prior to the introduction of DeFi lending platforms. It involves the transfer of control of crypto from one person to another. However, it does not necessarily require a transaction to transfer tokens between public addresses of the lender and borrower.
Loan to a DeFi lending platform without receipt of crypto
This involves the lender transferring control of their crypto to a DeFi lending platform. These are then held in a general pool of crypto by the DeFi platform. This is referred to as a liquidity pool.
A borrower is able to request a loan from the DeFi lending platform. When the loan is accepted, the control of the relevant crypto is transferred from the DeFi lending platform to the borrower for the term of that loan.
Loan to a DeFi lending platform with receipt of crypto at a fixed rate
In addition to the above, the DeFi lending platform transfers control of different crypto to the lender in return. As part of this transaction, a fixed ratio of crypto is provided to the lender for each crypto transferred to the DeFi lending platform.
For example, Tony transfers 15 ether to the Ziva DeFi lending platform and receives 15 Ziva ether (zETH) from Ziva. When Tony wants to end the loan he transfers the 15 zETH to Ziva and receives his 15 ether in return.
Another person borrower is able to request a loan from the DeFi lending platform. When the loan request is accepted then the control of the specified quantity of crypto is transferred by the DeFi lending platform to the borrower.
Loan to a DeFi lending platform with receipt of crypto representing their share in the liquidity pool
In this case, the lender transfers control of their crypto to a DeFi lending platform which is then included in a general pool of crypto. In return the DeFi lending platform transfers control of different crypto to the lender. This crypto is representative of the lenders interest or ‘stake’ in the general pool of crypto. This form of crypto is commonly referred to as a liquidity token
For example, Amy transfers 5 ether to the Gibbs DeFi lending platform. At that time the exchange rate is 0.020520. Amy receives 243.66 Gibbs ether (gETH). When Amy wants to end the loan she transfers the 243.66 Gibbs ether to Gibbs. At that time the exchange rate is 0.022775. Amy receives 5.549 ether in return
Another borrower is able to request a loan from the DeFi lending platform. When the loan request is accepted then the control of the specified quantity of tokens is transferred from the DeFi lending platform to the borrower.
Loan to a DeFi lending platform with NFT which records the terms of the loan
As above, the DeFi lending platform includes the lender's crypto in a general pool. However in this case the DeFi lending platform transfers to the lender control of a NFT. This NFT records the terms and conditions of the loan. Another borrower is able to request a loan from the DeFi lending platform.
When the loan is accepted, then the control of the specified quantity of crypto is transferred from the DeFi lending platform to the borrower. The DeFi lending platform may also issue the borrower with an NFT that records the terms of the loan.
The tax treatment
HMRC does not regard any consideration received by the lender to be interest for tax purposes. Therefore any taxing provisions specifically for interest will not apply to the return. How that consideration is taxed will depend on whether the receipt has the nature of capital or revenue.
The nature of the return received by the lender will depend on how the transaction is structured. Because the lending/staking of crypto through decentralised finance (DeFi) is a constantly evolving HMRC have not set out all the circumstances in which a lender earns a return from their activities and the nature of that return.
When a consideration from a DeFi lending platform may be regarded as income
Where proven that consideration paid to the lender for the provision of a service of lending/staking crypto, then HMRC consider any return received by the lender has the same nature as interest and will be regarded as income. HMRC have cited the case of Ryall v Hoare when applying these principles.
There are various instances where HMRC consider any payment to a lender from a DeFI lending platform will be income. For example where the return to the lender is known at the time the agreement is made and is paid periodically throughout the period of the loan.
When a consideration from a DeFi lending platform may be regarded as capital
Where the lender is not rewarded by the borrower or the DeFi platform, but seeks to benefit from their activities through the growth in value of their crypto this may be regarded as capital in nature.
An example, the lender may realises their return through disposing of a capital asset. This may represent their lending and the disposal proceeds are uncertain as opposed to receiving an agreed rate of return. Depending on the specific circumstances, HMRC may consider that the lender has realised a return from the increase in value of a capital asset and therefore a capital receipt.
Crypto used as collateral on a DeFi lending platform
Many DeFi lending platforms require a borrower to provide collateral before they are allowed to borrow from the DeFi lending platform. HMRC have suggested that in certain circumstances they may consider the actual giving of collateral is regarded as a disposal for capital gains tax purposes.
Where a DeFi lending platform is free to deal as it wishes with the crypto received as collateral, this may indicate that the beneficial ownership of those tokens has been transferred. If that's the case HMRC consider that the borrower will have disposed of their beneficial ownership of those tokens
Where HMRC take the view that a disposal has occurred, the consideration for the disposal will be the market value in sterling of the crypto given. The capital gain or loss will then be computed as normal.
When the collateral is withdrawn from the DeFi lending platform HMRC regard this as an acquisition. The acquisition cost of the crypto will be the market value in sterling of the crypto received.
HMRC's view on the tax treatment of the above transactions is somewhat controversial and may well be tested in the courts at some stage.
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