UK and International Tax news

Consultation On the Taxation Of Decentralised Finance Transactions

Thursday 18th May 2023

The Government is seeking views on modifying the tax treatment of decentralised finance (DeFi) lending and staking. The intention of the consultation is to create a regime that better aligns the taxation of cryptoassets used in DeFi lending and staking transactions (DeFi transactions) with the underlying economic substance, whilst reducing the administrative burden on users.

DeFi is an umbrella term to describe services akin to traditional financial services that are provided using distributed ledger technology. DeFi is often executed through ‘smart contracts’ which are a codified set of rules that execute transactions on the blockchain when certain parameters are met. For this reason, DeFi enables the provision of financial services without the use of traditional financial intermediaries.

DeFi lending services allow users to deposit their tokens and receive a financial return in exchange, often described as interest (even though it is not treated as such for tax purposes). Additionally, cryptoasset owners (known in this context as liquidity providers) can provide their tokens to a platform to pool with those of other users (a ‘liquidity pool’). This provision of liquidity to a platform is known as ‘staking’ and allows the platform to perform other DeFi services with the pooled tokens. To encourage cryptoasset owners to provide the platform with this liquidity, they will offer a financial return, typically paid periodically during the term of the arrangements or at the end of the term.

Under current tax rules, DeFi transactions can be treated as disposals by the lender or liquidity provider in some situations even though the effective economic ownership of the cryptoassets is retained. This can lead to tax outcomes that do not reflect the underlying economic substance, and to a tax liability from a transaction where no gain has been realised in a form which can be used to meet the liability. The need to determine and record the market value of assets at each step in the transaction may also give rise to a disproportionate administrative burden.

To gain further insight into DeFi lending and staking the government conducted a Call for Evidence which closed on 31 August 2022. Nearly all respondents agreed that the application of current tax rules to this activity causes difficulty and should be changed.

Under proposed changes, the use of cryptoassets in DeFi transactions would no longer be treated as giving rise to a disposal for tax purposes. Instead, a tax disposal would arise when the cryptoassets are economically disposed of in a non-DeFi transaction.

A transaction is intended to be within the rules if it contains the following elements:

  • there is an initial transfer of cryptoassets from one party (the lender) to another party (the borrower) and/or there is a transfer of cryptoassets through the use of a smart contract
  • the borrower has an obligation to return to the lender the borrowed tokens and/or the smart contract allows the lender to withdraw the tokens,
  • the tokens can be returned at the instigation of the lender, at the request of the borrower, or automatically at the end of a pre-determined period,
  • the lender has the right to withdraw at least the same quantity of the same type of tokens that were originally lent or staked

The proposed tax framework to apply is as follows:

  • The transaction will be disregarded for CGT purposes for both the lender and the borrower.
  • Where there is a sale of rights related to the lent or staked tokens, this will be treated as a disposal of the tokens to which those rights relate.
  • Any DeFi return which accrued on the tokens prior to the sale of such rights is taxable on the lender at the time the rights are disposed of.
  • The buyer of rights to lent or staked tokens is treated as acquiring the lent or staked tokens
  • the lender will be treated as having disposed of the staked or lent tokens if the borrower is not able to return the borrowed tokens. This will occur at the time the borrower loses the ability to return them

The proposed tax framework is also intended to apply to the lending and staking of cryptoassets carried out through an intermediary.

Comments have been requested by 22 June 2023.

If you would like further information on the consultation, please contact Keith Rushen on 0207 486 2378.

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