HMRC releases tough new DeFi guidance
HMRC released proposed guidance for crypto DeFi tax on the 3rd of February 2022 with serious tax implications for investors involved with liquidity pools, yield farming and other lending protocols. In summary, you’re likely to pay more tax. But just how much tax, and at what stage? Koinly unpacks it all with our UK Head of Tax.
What is the new DeFi guidance from HMRC?
In one word - confusing.
The proposed guidance revolves around lending and staking on DeFi protocols and the taxation of different transactions, like adding liquidity, removing liquidity, earning new tokens, and using lending protocols. While the HMRC offers a lot of wording on both, what it boils down to is this - you may pay Income Tax or Capital Gains Tax depending on the nature of the transaction.
What do they mean by ‘nature of the transaction’? Well, in their words, if the transaction has the nature of capital, you’ll pay Capital Gains Tax. If the nature is revenue, you’ll pay Income Tax. That definition is obviously not very clear as DeFi transactions are complex and involve many transactions involving investors, DeFi protocols, together with the various third-party platforms that get tacked on to further yield.
Capital Gains Tax on DeFi
HMRC starts the capital gains section by clarifying that repos (a sale and repurchase of a security that has special tax treatment) don't apply to crypto because crypto is not a security - in general.
This matters because they’re setting out their justification for taxation in the next few sections, with serious ramifications for investors adding and removing capital from liquidity pools.
The current tax position on providing liquidity goes like this: if an investor contributed coins to a pool, it was seen simply as a wallet-to-wallet movement, with no tax implications. It’s useful to add that many protocols issue liquidity pool tokens (LP Tokens) to the investor as a claim to the liquidity provided, held by the investor for the duration of the contract. Also, in theory, the investor has not lost ownership of their coin. Once the contract is closed, the investor receives their asset back, again as a swap or wallet-to-wallet movement of sorts.
Under the new proposed guidance, however, adding and removing liquidity is seen as a disposal and not a swap, and subject to Capital Gains Tax. So you’ll have two capital gains taxable transactions - one when you add liquidity and one when you remove liquidity.
You want to add liquidity to a BUSD-BNB pool on PancakeSwap. When you add your tokens, you get a set amount of BUSD-BNB liquidity pool tokens in return for your capital. This transaction is now subject to Capital Gains Tax. When you want your capital back, you’ll trade your BUSD-BNB liquidity pool token(s) for your original capital. This transaction is also subject to Capital Gains Tax. In this example, the return (reward) would also be subject to Capital Gains Tax due to the nature of the transaction - but this isn’t always the case.
This is the situation in principle, but let’s dig deeper.
When it comes to moving your capital around by adding liquidity to various DeFi protocols, according to HMRC what it all comes down to is whether the protocol or person you lend it to gains "beneficial ownership" of your tokens. As with the example before, if the protocol/borrower does gain beneficial ownership of your tokens, it's a disposal and subject to Capital Gains Tax. If the protocol/borrower is specifically restricted from dealing with the loaned capital, then it is not seen as a disposal and it won't be subject to Capital Gains Tax.
To clear that all up - it's assumed that most DeFi and crypto lending platforms take beneficial ownership of the provided liquidity. So, prepare for capital gains triggers inbound and outbound.
Tony Dhanjal, Head of Tax at Koinly adds, “Beneficial ownership effectively transfers when the protocol/borrower is able to do what it wants with your staked coins/tokens. Invariably, this means they will want to obtain an economic benefit on your coins, similar to how a traditional bank works, you deposit your money in the bank and earn interest as your reward, the bank will then lend out your money to borrowers, and earn a margin in return. The first place to help determine whether beneficial ownership has been transferred from the lender to the borrower, should be the smart contract.”
Think that was complicated? There's more. We’ll break this down into lending P2P and adding/removing liquidity to a DeFi protocol.
HMRC has announced a second consultation on DeFi and staking. Specifically, the tax office is considering disregarding Capital Gains Tax implications from any disposal of beneficial ownership that may occur through lending or staking. If this outcome occurs, it would make the UK particularly appealing for crypto investors from a tax perspective as few other countries have taken this view. Koinly will be participating in the consultation and we'll update this guide as soon as more guidance follows.
Lending P2P Tax
When it comes to lending - where a lender transfers the control of tokens to a borrower, the lender makes a disposal for a right to receive a future quantity of tokens. If you know the quantity you will receive as a reward in return for your loan, this would be subject to Capital Gains Tax and you should include the quantity of tokens to be received in the future as a consideration in your capital gains calculation at the point of disposal.
If there isn't an agreed return, the lender should still treat this as a disposal, when you get your capital back from your loan you will then need to make another Capital Gains Tax calculation to assess the return and subsequent capital gain. To further confuse things, there are also instances where you can choose to remove the return from this calculation and treat it as income and apply Income Tax instead.
When the loan is 'satisfied' this also has tax implications for the borrower - when the borrower transfers the beneficial ownership of tokens back to the lender - this is a disposal and subject to Capital Gains Tax. Use the fair market value of the tokens returned (including any interest paid on the loan as these are now allowable costs) as your consideration.
Adding/Removing Liquidity Tax
As discussed before, adding liquidity to a DeFi protocol is seen as the exchange of one token for another and therefore it is subject to Capital Gains Tax.
So when you add liquidity to a given pool you need to:
Get the cost basis of the token(s) you add.
Identify the fair market value of those token(s).
Use the fair market value of the token(s) you add as your cost basis for the liquidity pool token(s) you receive.
Subtract the cost basis of your tokens from the fair market value of the liquidity pool tokens.
Calculate your subsequent capital gain or loss.
Your liquidity pool token(s) will then use this calculation as your cost basis for when you want to remove your capital by exchanging your liquidity pool token(s) back.
When you remove liquidity by withdrawing your staked token(s) from the DeFi protocol - you'll dispose of your liquidity pool token(s) to do so. HMRC says this is a crypto to crypto trade and subject to Capital Gains Tax. So you'll use the cost basis of your liquidity pool token(s) from above and subtract that from the fair market value of your original capital.
Just so you know - Koinly lets you realise gains from liquidity transactions and calculates all this for you.
Collateral for DeFi lending protocols
Collateral for loans also has specific tax treatment now and like the above, it depends on whether the DeFi protocol can benefit from said collateral. If they can - and most do - collateral for a loan is seen as a disposal and subject to Capital Gains Tax. If they can't, collateral for a loan is not seen as a disposal.
Because of this clarification, when you get your collateral back for a loan - this is now treated as an acquisition if you've previously treated it as a disposal. Similarly - if your loan is liquidated by the DeFi protocol - there are no tax consequences as you've already disposed of the asset.
Conversely, if you don't treat the collateral as a disposal, you won't treat the withdrawal of collateral as an acquisition. But you would treat any liquidation as a disposal.
Examples of DeFi taxation
HMRC released a variety of examples and tax implications to help clarify their stance.
Income Tax on DeFi
For the most part, Income Tax on DeFi is only concerned with returns - so the rewards you might receive from your DeFi activities.
In their own words, “the Income Tax treatment of the return received by the lender/liquidity provider will depend, in part, on whether their activities form part of a trade.”
This is kind of like the current guidance on buying and selling crypto - where the HMRC states that only in exceptional circumstances would they consider activities involved in the making of DeFi loans to be carrying on a trade.
So if you're seen to be "carrying on a trade" - which is akin to having a second income or earning a living - then your DeFi activities would be subject to Income Tax and this would take priority over Capital Gains Tax.
Where you're not seen to be carrying on a trade - as is the case for the typical UK crypto investor - for the most part your DeFi transactions are going to be subject to Capital Gains Tax.
However, even for those not carrying on a trade, HMRC does stipulate that rewards (returns) may be subject to Income Tax instead - depending on the nature of the return.
Returns are not interest
HMRC clarifies that returns are not interest for tax purposes. They'll tax your return depending on the nature of the return - whether it's a capital receipt or a revenue receipt.
They also clarify if it is considered a revenue receipt (income) then the return will be considered miscellaneous income - so it shouldn't be subject to National Insurance Tax and in some cases, the trading and miscellaneous income allowance will apply (£1,000 tax free!).
On to the big question - how do you know whether your return has the nature of capital or revenue?
It’s not really all that clear, but here are the factors HMRC lists to help you determine whether it’s revenue or capital:
If the amount of return to be received is known at the time the crypto is loaned - for example, 5% per annum - this is more likely to be revenue.
If the amount of return to be received is unknown and speculative - this would indicate capital.
If the return is realised through the disposal of a capital asset - like trading back a liquidity pool token that's risen in value - this would indicate capital.
If the return is paid by the borrower/DeFi lending platform - this would indicate revenue.
If the return is paid periodically throughout the period of lending/staking, this is more likely to indicate revenue.
If the return is paid upon repayment of the principal - this is more likely to indicate capital.
Tony Dhanjal, Head of Tax at Koinly explains_, “HMRC is responsible for the administration of UK taxes and are unlikely to prescribe answers to your direct scenario - instead they issue ‘guidance’ based on tax statutes, acts of parliament that embody tax law. You will need to apply some judgment based on the facts and any evidence you can produce to your particular scenario when it comes to determining whether income tax (revenue in nature) or capital gains tax (capital gains) should apply to your DeFi returns – if you are in doubt, always approach this logically and make a good faith effort.”_
HMRC also adds that the period of staking/lending is a consideration in whether it’s income or capital too, “Whether the period of the lending is fixed or indefinite, short-term or long-term.”
The bottom line? Whether your DeFi rewards are taxed as income or a capital gain all depends on the specific way the DeFi platform operates.
Just so you know - Koinly lets you pick how you want to treat rewards from a tax perspective in our settings.
Watch this space
It's important to note that at the moment - this is proposed guidance. There are going to be a lot of questions for HMRC from crypto investors and accountants about the implications of these changes and a lot needs clarifying. So watch this space - we're reaching out to crypto accountants to get their take on it, as well as waiting for more clarification from HMRC. Read our guide on how to pay less tax on crypto in the UK.