DeFi Tax Reform! HM Revenue & Customs in the UK publicly consults on taxing DeFi lending and staking.

During the eight-week period from April 27, 2023, to June 22, 2023, there will be a consultation on the taxation of DeFi lending and staking. According to the UK tax authority announcement, legislative changes regarding the taxation of DeFi lending and staking of cryptoassets will be explored. The rules will also apply to similar services in centralized finance that resemble DeFi lending and staking.

DeFi Transactions Under Existing Rules to be Taxed: Change Needed

The UK tax authority HMRC stated that under the current crypto asset guidance, transactions involving lenders or liquidity providers may be considered as a disposal in certain circumstances, even if the beneficial ownership of the crypto assets remains with the provider. This could lead to tax consequences not reflecting the economic reality, resulting in a tax liability being triggered in a transaction without any realized gains.

On the other hand, the current regulations require determining and recording the market value of assets at each step of the transaction, which could lead to disproportionate administrative burdens.

Three Proposed Approaches for DeFi Tax Reform

The UK tax authority HMRC outlined three approaches in the consultation:

• Legislating to bring DeFi lending and staking under repo and stock lending rules, defining crypto assets as "securities" to align with repo or stock lending legislation. Excluding DeFi transactions from capital gains tax.
• Legislating to create standalone rules for DeFi lending and staking similar to those applicable to repo and stock lending, excluding lending and staking activities from capital gains tax.
• Adopting a "no gain no loss" treatment for DeFi loans and staking, deferring tax obligations until the assets are economically disposed of.

Actual Cases of DeFi Taxation

DeFi loans or staking typically involve three stages:

1. Transfer of tokens to another party
2. Duration of the loan/stake
3. Return of the lent/staked tokens

HMRC specifies the taxable points for different scenarios of DeFi loans or staking, with the basic principle being taxation upon the actual conclusion of the loan term or receipt of staking rewards.

For example:

User A transfers Token1 (T1) to another party via a platform or smart contract for a year with a fixed annual return of 30%, there will be no Capital Gains Tax (CGT) because User A is considered to still own T1.

Upon the end of the one-year lending period, User A retrieves 1 T1 from the counterparty and receives an additional 30% (0.3 T1) lending return of T1. Neither User A nor the counterparty in possession of T1 will incur CGT. The extra 0.3 T1 will be taxed as miscellaneous income based on the market value at the time of payment.