DeFi taxation is under review by the United Kingdom’s HM Revenue and Customs (HMRC), as they explore the potential for reforming the tax treatment of lending and borrowing on decentralized finance (DeFi) platforms. The aim is to simplify the process and reduce the administrative burden for taxpayers involved in DeFi transactions.
A consultation initiated on April 27 will run until June 22, inviting investors, professionals, firms involved in DeFi, as well as representative bodies and think tanks to share their opinions on the government’s proposed tax treatment for DeFi activities.
Proposed Changes to DeFi Tax Treatment
Under the proposed DeFi taxation legislation, cryptocurrencies used in DeFi transactions would not be considered a disposal for tax purposes, which typically triggers a Capital Gains Tax (CGT) event. Instead, CGT would apply, and a taxable event would occur when cryptocurrencies are disposed of in non-DeFi transactions.
A transaction must meet specific criteria to qualify as a DeFi transaction. It should involve the initial transfer of crypto assets from a lender to a borrower, or via a smart contract, with the borrower being obligated to return the tokens.
The consultation’s primary goal is to establish a framework that “better aligns” the taxation of cryptocurrency assets used in DeFi lending and staking transactions, making it easier for users to comply with regulations.
Five-Step Process for Implementing Changes
This consultation is the second phase in a five-step process that includes drafting legislation, implementation and monitoring, and ultimately, reviewing and evaluating the changes.
In July , the British government took the first step by soliciting feedback on the taxation of crypto asset loans and staking within the DeFi taxation context. Simplifying the administrative process and reducing costs for taxpayers participating in DeFi were noted as the main objectives.
Financial Innovation and Cryptoassets
The government’s FinTech Sector Strategy, introduced in March 2018, sets out the government’s ambition to collaborate with the UK’s financial services sector to maintain the country’s position as a leading global financial center and the world’s most innovative economy.
The government aims to establish clear tax and regulatory treatment of cryptoassets to place the UK at the forefront of safe, sustainable, and rapid innovation in cryptoasset and blockchain technologies. The commitment to retain the UK’s global leadership position in fintech was reaffirmed in December 2022 at TheCityUK’s National Conference in Edinburgh.
Addressing Inconsistencies in Capital Gains Tax for DeFi
In April of last year, one of the measures announced was to explore and resolve specific issues regarding the DeFi taxation of lending and staking. Stakeholders highlighted inconsistencies in the current rules for Capital Gains Tax (CGT) when applied to DeFi, which do not align with the substance of the activity.
A Call for Evidence was conducted between July 5 and August 31, 2022, as part of the review of tax rules for DeFi transactions. Most respondents agreed that a change in tax rules would benefit both the industry and users.
DeFi Taxation: Navigating Risks
Recent market events, such as the failure of FTX, have exposed vulnerabilities in the broader cryptoasset sector. Policymakers and regulators have identified specific risks within decentralized finance, including cyber risks, technical risks, increased dependencies between traditional and decentralized financial systems, and a lack of backstops during market stress periods.
The tax policy approach for DeFi taxation proposed in this document considers neutrality, fairness, and practicality. It is not intended to replace the broader regulatory framework for cryptoassets. More information on the government’s approach to the regulation of cryptoassets can be found in the Future Financial Services Regulatory Regime for Cryptoassets – Consultation and Call for Evidence, published on February 1, 2023, by HM Treasury.
Next Steps in DeFi Taxation Policy Development
This consultation represents the next stage of the policy-making process. The government is inviting feedback on a potential legislative solution aiming to better align the DeFi taxation of cryptoassets used in transactions with the underlying economic substance. In addition to the specific questions posed, more general comments on the issues discussed are welcome.
The UK Treasury’s efforts to reform the tax treatment of DeFi lending and staking transactions demonstrate a proactive approach to embracing financial innovation and ensuring that the regulatory framework is aligned with the rapidly evolving DeFi sector. By simplifying the tax process and reducing the administrative burden for taxpayers, the government aims to create an environment that fosters growth and innovation in the cryptoasset and blockchain technology space, positioning the UK as a global leader in the fintech industry.