Crypto Currency and Tax: New HMRC DeFi Guidelines Explained
It’s not for the faint-hearted, but a growing number of investors are starting to dabble in DeFi (Decentralised Finance): blockchain-based transactions using crypto currency to borrow, lend, buy assets (and more).
Earlier this year, HMRC released guidance on the taxation of crypto assets used in DeFi transactions. Here’s a closer look at what this guidance could mean for your tax return.
‘Decentralised Finance’ is a broad term for a whole ecosystem of blockchain-based digital finance tools. It covers things like cryptocurrency, digital securities, CBDCs (Central Bank Digital Currency) and NFTs (Non-Fungible Tokens).
More specifically, DeFi also covers a range of financial services conducted on a ‘peer-to-peer’ basis; e.g. borrowing, lending and asset trading conducted between individuals without the involvement of traditional financial gatekeepers and institutions. It is these borrowing/lending activities that have been subject to HMRC’s special attention
Most people get involved in DeFi services through ‘dapps’ (decentralised apps) running on the Ethereum blockchain. Ethereum is currently the second-most popular cryptocurrency (behind Bitcoin). Whereas the distributed ledger system (i.e. ‘blockchain’) behind Bitcoin is just a simple database of accounts (aka ‘wallets’), Ethereum’s blockchain is more sophisticated. The Ethereum network supports “smart contracts”: i.e. automated execution of contracts when defined conditions have been fulfilled, as well as the creation of private cryptocurrencies or tokens.
Broadly, you can do the following on Ethereum-based dapps:
- Lend out your crypto with the objective of earning interest
- Obtain loans (including very short-term “flash loans”)
- Trade crypto assets with other individuals
- Place crypto in savings account alternatives
- Derivatives trading (the crypto version of options and futures)
What does the HMRC Crypto guidance cover?
The new guidance is concerned mostly with DeFi ‘lending’ and ‘staking’…
Lending. Dedicated DeFi lending platforms allow users to lend crypto to other users and earn interest on the loans. This includes very short term loans (effectively margin trading options), as well as longer term arrangements for higher interest.
Staking. This is where you transfer control of some of your crypto assets to a DeFi lending platform to contribute to the liquidity pool of that platform. The platform offers crypto loans to borrowers in exchange for a return in the form of more crypto assets.
How does HMRC view crypto: the broad position
HMRC’s view on cryptocurrency and DeFi remains very much a work in progress. However, the following general principles are relevant:
- HMRC treats cryptocurrency as an asset rather than a currency. So, broadly, if you sell or dispose of crypto – even if it just to convert it into regular fiat currency to fund an immediate purchase – this sale/disposal is likely to be regarded as a potential capital gains event.
- If you primarily buy and sell cryptocurrencies for personal investment purposes, you will likely be considered an ‘investor’. Transactions will therefore be subject to Capital Gains Tax.
- For a small number of people, crypto trading becomes a primary source of income. HMRC will look at the frequency, volume and sophistication of activities to determine whether their activities effectively constitute a one-person financial trading operation. If so, they would be treated as a ‘trader’. In these cases, rather than assessing each transaction as a capital gains event, overall trading profits for the year are treated as personal income.
The new guidance: what has changed?
The guidance covers treatment of the principal – i.e. the original amount of crypto assets loaned or staked.
In earlier guidance, HMRC’s main emphasis seemed to be on the taxation of returns from DeFi activities. As such, taxpayers may have been forgiven for assuming that when you transfer a crypto asset at the point of making a stake or loan, no actual disposal occurs at that point.
In the updated guidance however, HMRC makes the point that it considers ‘staking’ and ‘lending’ to be a disposal of an asset on which tax would be due where there has been a gain.
So if you are lending money on a dapp platform, you are basically involved in two potential taxable disposals: the first is when you lend tokens, and the second upon receipt of tokens received on satisfaction of the lending arrangement.
What does this mean in practice?
Let’s say you transfer crypto tokens worth £500 to a borrower via a DeFi exchange.
HMRC would firstly expect you to look closely at the T&Cs of the arrangement to determine whether beneficial ownership of those assets has indeed been relinquished. If so, you need to calculate the difference between those assets’ base costs at the time you acquired them and their market value at the time of the loan. CGT is payable on any gain.
When the loan is repaid, this gives rise to a second disposal for CGT purposes. There may, in addition, be an income-like ‘return’ that is subject to income tax.
This guidance represents HMRC’s current interpretation of the law. In terms of application however, there are going to be practical difficulties. Not least; DeFi lending exchanges offer individuals the possibility of entering into large volumes of relatively low value loan transactions, giving rise to potentially huge quantities of chargeable disposals.
It may be that the exchanges start integrating accurate tax calculation tools into their platforms. If HMRC were to authorise one or more of these applications, it will massively simplify tax calculations. This is one of several areas linked to crypto that remains a work in progress for the tax authorities.
In the meantime however, and given the volatility of the crypto markets, taxpayers need to tread carefully when using DeFi services. You should be especially wary of sleepwalking into a potential dry tax charge, where you are deemed liable for CGT but where you have not actually received any ‘real’ cash to discharge that liability.