On 2 February 2022, HMRC released a much anticipated and needed update to its Cryptoassets Manual, expanding its coverage of Decentralised Finance (“DeFi”).
In the guidance, HMRC applies the assertion that a chargeable event occurs when the beneficial interest in a crypto is transferred from one person to another (i.e. from an individual to a DeFi network). HMRC suggests that the beneficial interest is likely to have transferred where “the recipient of the tokens has the ability to deal with the tokens received as they want” (i.e. there are no restrictions on how the DeFi network can use the tokens once they are held).
At first glance, this clarity in guidance has some far-reaching implications: where crypto is deposited with a DeFi network (and the network can onward lend it), a gain will be made.
However, if we look at the mechanism behind the transaction, there does not appear to have been a change in stance from HMRC; only a further clarification of the general principles set out in its original guidance.
Depositing tokens
In normal circumstances, two things can occur when an individual deposits tokens with an exchange. In return for the tokens deposited, they will receive either:
- tokens native to that exchange, on which a return is paid; or
- an NFT which includes the information relation to the amount of crypto deposited with the DeFi network and other loan terms, including the duration of the loan and the amount of return which will be due over the term.
We note that in both instances there has been a change in the type of crypto or asset held by the individual, therefore a chargeable event has occurred.
Where a lender disposes of tokens for a right to receive a future quantity of tokens, the right represents deferred consideration. We have already ascertained above that a disposal has occurred as a result of the beneficial interest in the tokens being moved from the individual to the DeFi network. The tax treatment depends on whether the quantity of tokens to be received in the future is known or unknown.
The gains calculation is in line with the normal calculations for capital gains: the consideration (proceeds) less the cost equals the gain or loss on the transaction. The key point is what the value of the consideration should be, as explained below.
1. Gains calculation where the amount receivable in the future (being the principal and interest) is known
Where the future receivable is known, the consideration will be the number of tokens to be received recognised at their GBP value at the time the loan is made. It is important that the principal and the return elements of the amounts to be received are split out: only the principal element will feature in the capital gains calculation.
The return element is not included in the gain calculation. This is because the return element will be taxable when it is received (for individuals) or on an accruals basis over the term of the loan (for companies). This exclusion therefore stops any double taxation which could otherwise occur on the return element: being subject to tax under the gains rules and also under the income tax or corporation tax rules.
It is worth noting that if the token which was received as the return element is sold in the future, then any difference between the value in GBP when it was received, and the value in GBP when it is sold or exchanged, will be a chargeable event and a capital gains calculation will be required.
Example
Susan is a higher rate taxpayer who has already utilised her annual exemption for capital gains. She deposits 10 BTC with a DeFi network, in exchange for an NFT which outlines the agreement.
The agreement is such that she will receive a return of 10% p.a. which will be payable in BTC at the end of the term in 12 months’ time. The value of BTC at the date of the agreement is £31,500. The s104 pool value of the BTC is £17,000 per BTC.
Step 1 – Capital gains calculation on transfer of BTC to DeFi network
- Deemed proceeds: £315,000 [10 BTC at today’s value = 31,500 * 10]
- S104 pool cost: (£170,000) [10 BTC at cost = 17,000 * 10]
- Chargeable gain: £145,000 On which capital gains tax at 20% will be levied
- Capital gains tax (CGT) due: £29,000 [145,000 @ 20%]
This CGT will be payable in the tax year in which Susan deposits the BTC with the DeFi network.
Step 2 – Income tax calculation on return when the return is paid to Susan
Note: the value of BTC has increased from £31,500 (when the agreement was entered into) to £42,000 (when the return paid in BTC was paid to Susan).
- Return paid in BTC: £42,000 [1 BTC at value when received]
- Income tax: £16,800 [Higher rate income tax on the value = £42,000 @40%]
2. Gains calculation where the amount receivable in the future (being the principal and interest) is unknown
Where amounts to be received are unknown there can be two situations. The consideration is calculated differently depending on which situation is the case.
2a. The amount of principal to be returned is known and the return is unknown
In this scenario there are two elements to the consideration:
- the known future return of principal, which is calculated as (the number of tokens to be received in the future recognised at their GBP value at the time the loan is made);
- the market value for the right to receive the future return asset (known in the tax world as the Marren v Ingles right).
The market value would be the amount which you would sell the right to receive asset to an unrelated third party.
2b. Both the amount of principal to be received and the return on it is unknown
This is the more unlikely instance. If it applies then there is a single element which is the Marren v Ingles right as described above. However, in this instance it will be the market value of the right to receive both the principal and interest.
It is not possible to split out the return element from the gains calculation as you are acquiring an asset (being the right to receive future amounts which are unknown). This means that the chargeable event arising on the return element is accelerated to arise in the period in which the DeFi transaction occurs, rather than when the return element is received.
When the return element is received, another chargeable event occurs as the Marren v Ingles right is disposed of, in exchange for a known amount of crypto. It may be that the market value of the Marren v Ingles right was higher than the value of the crypto eventually received: this would result in a capital loss. Where this occurs, it may be possible to offset this loss against the gain made in the initial transaction.
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Our other articles on the February 2022 updates to HMRC’s Cryptoassets Manual:
