Now the government’s consultation on proposed changes to the DeFi tax framework has drawn to a close, it will be interesting to see how the new legislation shapes up. I have been vocal in my reservations about the plans, and along with our long-term partners Wright Vigar, an independent firm of chartered accountants and crypto tax specialists, I have lent our voice to the consultation.
In our view, the examples the government cites are not a true reflection of how the crypto market actually works. Specifically, they fail to take into account the complexities of transactions involving different types of assets (tokens), or the partial redemption of DeFi positions.
Since the collapse of BlockFi, Celsius, Voyager and FTX, the crypto market has shifted towards decentralised, counterparty-free services that operate in a permissionless environment on various blockchains. Most of the market today is centred around liquid staking protocols (Lido) and liquidity pools (such as Uniswap/Curve), with transactions sometimes comprising multiple assets in and out of a position, and/or a partial redemption of positions.
The proposed ‘repo-like’ tax rules overlook the complexities of transactions involving multiple assets and fail to consider the partial redemption of DeFi positions. Of the estimated 5.7m crypto users in the UK, we estimate that around 1.2m are involved in DeFi lending and staking activity. It’s therefore critical that taxation policies reflect the economic substance of transactions, with rules that are clear and easy to understand for taxpayers.
When formulating our response to the government’s consultation, we considered a number of tax options, including ‘sterling value on entry and exit’, and ‘no gain, no loss on entry and exit’, as well as a ‘repo-like’ solution. But none of these approaches adequately capture the economic substance of the activity – a key objective of the consultation.
Under its proposals, the government suggests treating DeFi rewards as income, rather than capital gains, because of the tax complexities around classifying revenue and capital.
It’s a view we fundamentally oppose. In order to reduce administrative burdens, and better reflect the economic substance of these rewards, the tax process could be simplified by applying CGT at the time of disposal.
This addresses a number of taxation challenges, such as identifying rewards received in a bundle with reclaimed tokens, obtaining reliable reward values at the time of receipt, and the pricing volatility and low liquidity risks associated with providing for the tax bill on income. It doesn’t have to be arduous either: most crypto users are already subject to CGT, which is straightforward to calculate using crypto taxation software.
A way forward
The alternative framework we’ve proposed builds on the no gain, no loss (NGNL) principle, but it is based on the composition of assets. The problem with not taxing when exiting a DeFi position is that it only works if the tokens returned are of the same type and quantity. Our approach, in contrast, reflects the complexity of trading activity while also future-proofing the tax treatment of DeFi transactions. Our framework comprises two parts:
Final thoughts
The government’s goal – ‘to establish clear tax and regulatory treatment of crypto-assets to place the UK at the forefront of safe, sustainable, and rapid innovation in crypto-asset and blockchain technologies’ – is laudable.
Certainly, we want to see the UK become a leader in crypto and a hub for all the innovation associated with it. However, it would be a mistake to treat rewards as income, and to apply repo-like rules because the quantity and composition of assets redeemed might be different to what was originally added to the DeFi position. The framework we have proposed covers three eventualities, and applying it can help to reduce the administrative burden.
Finally, as the government presses ahead in developing the framework, we have formally requested clarity on what a crypto user’s DeFi tax position will be for the tax years leading up to the roll out of new legislation. In particular, we want to see robust rules established to ensure fair and consistent treatment of DeFi transactions, so that individuals and businesses can understand how their tax obligations could impact their investments.
Dan Howitt, Recap
Now the government’s consultation on proposed changes to the DeFi tax framework has drawn to a close, it will be interesting to see how the new legislation shapes up. I have been vocal in my reservations about the plans, and along with our long-term partners Wright Vigar, an independent firm of chartered accountants and crypto tax specialists, I have lent our voice to the consultation.
In our view, the examples the government cites are not a true reflection of how the crypto market actually works. Specifically, they fail to take into account the complexities of transactions involving different types of assets (tokens), or the partial redemption of DeFi positions.
Since the collapse of BlockFi, Celsius, Voyager and FTX, the crypto market has shifted towards decentralised, counterparty-free services that operate in a permissionless environment on various blockchains. Most of the market today is centred around liquid staking protocols (Lido) and liquidity pools (such as Uniswap/Curve), with transactions sometimes comprising multiple assets in and out of a position, and/or a partial redemption of positions.
The proposed ‘repo-like’ tax rules overlook the complexities of transactions involving multiple assets and fail to consider the partial redemption of DeFi positions. Of the estimated 5.7m crypto users in the UK, we estimate that around 1.2m are involved in DeFi lending and staking activity. It’s therefore critical that taxation policies reflect the economic substance of transactions, with rules that are clear and easy to understand for taxpayers.
When formulating our response to the government’s consultation, we considered a number of tax options, including ‘sterling value on entry and exit’, and ‘no gain, no loss on entry and exit’, as well as a ‘repo-like’ solution. But none of these approaches adequately capture the economic substance of the activity – a key objective of the consultation.
Under its proposals, the government suggests treating DeFi rewards as income, rather than capital gains, because of the tax complexities around classifying revenue and capital.
It’s a view we fundamentally oppose. In order to reduce administrative burdens, and better reflect the economic substance of these rewards, the tax process could be simplified by applying CGT at the time of disposal.
This addresses a number of taxation challenges, such as identifying rewards received in a bundle with reclaimed tokens, obtaining reliable reward values at the time of receipt, and the pricing volatility and low liquidity risks associated with providing for the tax bill on income. It doesn’t have to be arduous either: most crypto users are already subject to CGT, which is straightforward to calculate using crypto taxation software.
A way forward
The alternative framework we’ve proposed builds on the no gain, no loss (NGNL) principle, but it is based on the composition of assets. The problem with not taxing when exiting a DeFi position is that it only works if the tokens returned are of the same type and quantity. Our approach, in contrast, reflects the complexity of trading activity while also future-proofing the tax treatment of DeFi transactions. Our framework comprises two parts:
Final thoughts
The government’s goal – ‘to establish clear tax and regulatory treatment of crypto-assets to place the UK at the forefront of safe, sustainable, and rapid innovation in crypto-asset and blockchain technologies’ – is laudable.
Certainly, we want to see the UK become a leader in crypto and a hub for all the innovation associated with it. However, it would be a mistake to treat rewards as income, and to apply repo-like rules because the quantity and composition of assets redeemed might be different to what was originally added to the DeFi position. The framework we have proposed covers three eventualities, and applying it can help to reduce the administrative burden.
Finally, as the government presses ahead in developing the framework, we have formally requested clarity on what a crypto user’s DeFi tax position will be for the tax years leading up to the roll out of new legislation. In particular, we want to see robust rules established to ensure fair and consistent treatment of DeFi transactions, so that individuals and businesses can understand how their tax obligations could impact their investments.
Dan Howitt, Recap
