HMRC consults on proposals to change the tax treatment of lending and staking tokens in the UK

The UK government has published a consultation on modifying the tax treatment of decentralised finance (DeFi) lending and staking of tokens and other cryptoassets (using the OECD definition of "Crypto-Assets"). The consultation follows an earlier Call for Evidence published in 2022, under which most respondents agreed that a change in the tax rules would be beneficial for the industry and users.

One particular concern raised was that the current UK tax rules can lead to certain DeFi transactions being treated as disposals by the lender or liquidity provider, 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 potentially 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 new proposals aim to create a regime that better aligns the taxation of cryptoassets used in DeFi transactions with the underlying economic substance, while reducing the administrative burden on users.

The proposals include two legislative changes which would mean that:

• The use of cryptoassets in most DeFi transactions would no longer be treated as giving rise to a disposal for capital gains tax (CGT) purposes. Instead, a CGT charge would only arise when the cryptoassets are economically disposed of (for example, in an outright sale or an exchange for goods and services). This tax treatment would apply broadly to DeFi transactions where lenders retain the economic interest in the lent or staked tokens over the duration of the transaction, even though there is a transfer of legal or beneficial ownership.
• All DeFi returns under the new tax framework would be treated as being revenue in nature and charged to a new miscellaneous income charge specific for cryptoassets transactions. Under the current rules, the DeFi return can be either taxed as miscellaneous income (if it is of a revenue nature) or taxed as a capital gain (if it is of a capital nature), and the answer to this question is not always straightforward.

Implications for funds

Tokens and other cryptoassets are an increasingly attractive asset class for venture capital and private equity funds and we are seeing a number of managers looking to "sweat the asset" by staking or lending the tokens to generate additional income. This new regime brings welcome certainty that those DeFi transactions falling within the scope of the rules will not trigger CGT payment or filing obligations for investors.

While the clarification that all DeFi returns will be taxed as miscellaneous income provides certainty, it raises concerns for funds with non-UK resident investors (who are generally subject to UK tax and tax filing obligations in respect of UK source miscellaneous income, unless relief can be claimed under a double tax treaty).

The consultation also does not address the question of when staking and lending activity could be viewed as trading activity (even if the draft regulations, proposing to add cryptoassets to the list of investment transactions for the investment manager exemption, give fund managers some limited comfort on the investment status of the cryptoassets themselves).

Osborne Clarke comment

The government's aims to improve the taxation of cryptoassets used in DeFi transactions so that it better aligns with the underlying economic substance and to reduce the administrative burden on users is welcome. However, there are some lingering questions – most notably around managing UK tax exposure for non-UK resident investors and the risk of trading activity in respect of lending and staking tokens. While additional clarity may emerge as this new regime develops, for now fund managers will still need to consider whether to hold staked or lent tokens through holding vehicles to shelter investors from these risks.

We will be responding to the consultation, which closes on 22 June 2023, to address some of the specific queries raised. If you would like to discuss the consultation and our proposed response in more detail, please speak to one of our contacts.

This is the third in a series of Insights on the government's tax administration and maintenance proposals for spring 2023. The series opened with an Insight on reform of the Construction Industry Scheme with the second Insight looking at the government's proposals to modernise UK stamp duty on shares.