UK Revenue Guidance On Cryptoasset Lending And Staking Using Decentralised Finance – Tax

In early February, HMRC published a new chapter in its
Cryptoassets Manual dealing with decentralised finance
(“DeFi”). DeFi is an umbrella term encompassing a range
of products which are comparable with traditional financial
services. DeFi platforms can provide services such as decentralised
exchanges, saving, lending and derivatives, using distributed
ledger technology.

HMRC’s guidance focuses on the taxation of
“lending” and “staking” services which are
entered into between unconnected lenders and borrowers through a
DeFi platform.

“Lending” in this context occurs when a person
transfers crypto-tokens to another person. The transfer results in
the recipient (a “borrower”) taking control of the
tokens. The “lender” acquires a right to demand the
transfer, in return, of a determined quantity of tokens to satisfy
the “loan” at some point in the future.

“Staking” occurs when a person transfers control of
tokens to a DeFi lending platform. The transferor, also known as a
“liquidity provider,” receives one or more different
tokens from the DeFi lending platform in return. The tokens which
have been transferred to the DeFi lending platform by the liquidity
provider can be transferred by the platform to third party
“borrowers.” That “borrower” is required, at a
future date, to provide a return to the DeFi lending platform, all
or part of which is passed on to the liquidity provider.

These arrangements might appear to have certain familiar
hallmarks of collateralized lending transactions outside the
cryptoasset sector. Elements of the arrangements are familiar to
observers of peer-to-peer financing arrangements, or stock lending
transactions. However, given the unique form of cryptoassets as, in
the view of HMRC, not constituting “money” or
“currency,” the treatment of the rate of return on the
“lending” and “staking” does not constitute
“interest” for UK tax purposes.

Accordingly, HMRC follow a different approach to the taxation of
lending and staking of cryptoassets to the way in which, for
example, loan relationships or deemed loan relationships might be
taxed in the UK. The provisions in UK tax legislation for taxing
loan relationships (and deemed loan relationships) therefore do not
apply to cryptoassets.

How any DeFi return is taxed when arising to the lender and
liquidity provider will depend, for both income tax and corporation
tax purposes, on whether the activity amounts to a trade, and
whether any return produced has the nature of being a capital
receipt or a revenue receipt.

Trading or investing?

The HMRC guidance states that the relevant considerations to be
made when determining whether a trade is being carried on involving
the making of DeFi loans would be similar to those made when
considering whether there is a trade in shares, securities and
other financial products. This leads tax practitioners to the
familiar, but complicated, case law analysis being used to
determine whether a trade is being carried on (or not) or whether,
alternatively, the activity which generates the return falls
outside the scope of any trade. There is little
cryptoasset-specific case law in the UK; as a general observation,
only deliberate and organized cryptoasset lending and staking is
likely to constitute a trade.

If a trade is carried on, the cryptoassets may be held as
trading stock. Where no trade is being carried on, or the activity
falls outside of the scope of trading, the making of a DeFi loan or
staking (both involving transfers of cryptoassets) may be the
disposal of a capital asset, subject to capital gains tax for
individuals and corporation tax on chargeable gains for
companies.

DeFi return: an income or capital receipt?

Any DeFi return is taxed in accordance with the receipt being of
a capital nature or revenue nature. A return of a capital nature
would be subject to tax on the chargeable gain realized. Where the
return has a revenue nature, the return might be taxed as trading
income if (exceptionally) the activities are deliberate and
organized enough, or (more likely) could be taxed within the scope
of the miscellaneous income provisions (in sections 979-981, within
Part 10 of the Corporation Tax Act 2009).

HMRC note in their guidance that the nature of the return
received by the lender or liquidity provider will depend on how the
transaction is structured. The lending or staking of tokens through
DeFi is acknowledged to be a rapidly evolving area. Perhaps
unsurprisingly, HMRC set out “guiding principles” to
assist with determination of the nature of the activities being
undertaken, coupled with several examples, instead of laying out
rules which are set in stone.

A key distinguishing question is stated by HMRC to be whether
the return earned by the lender or liquidity provider has resulted
from the provision of a service to the borrower of a DeFi lending
platform. This might identify the return as being of a revenue
nature. By contrast, if the return was realised from the growth of
an asset owned by the lender or liquidity provider, the treatment
might be more compatible with a capital return.

Complicating factors are listed in the HMRC guidance as being
the various DeFi operating models, including whether the return to
be received by the lender/liquidity provider is known at the time
the agreement is made (being suggestive of a revenue receipt), as
opposed to a more speculative return (being suggestive, in
HMRC’s view, of a capital receipt). The length of the period of
the lending or staking arrangement, any periodical nature of
interim payments and the linking of any return to the disposal of
the tokens are all identified as additional factors to be taken
into account. HMRC confirm that this list is not exhaustive, and
that no single factor is determinative.

Examples and questions

The HMRC guidance includes a number of worked examples covering
the treatment of cryptoasset disposals when loans are made, loan
satisfaction, and the tax position when a borrower’s collateral
is enforced or liquidated. Following the examples, and implementing
the legal arrangements regarding DeFi in a tax context, is likely
to lead to additional questions around compliance and
interpretation. This is perhaps particularly so given the fact that
the UK case law which governs the identification of a trade, and
the nature of capital and income receipts, is far from new. It will
be interesting to see how well case law couched in terms of fruits
and trees (Ryall v Hoare [1923], cited
by HMRC in their guidance) fares when dealing with taxation
questions arising from cryptoassets and DeFi platforms.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.