11 Feb 2022

Crypto, collateral-backed lending and the unexpected capital gain

Publications

On 2 February 2022, HMRC released a much anticipated and needed update to its Cryptoassets Manual, expanding its coverage of Decentralised Finance (“DeFi”). It included a section on collateral-backed lending: where one token (usually a stablecoin) is borrowed and another is used as collateral.

DeFi lending and disposals

The key question is whether the provision of the collateral (and transfer of it) to the DeFi lending platform represents a disposal.

On the question of whether a disposal has occurred or not, HMRC has kept a consistent voice throughout its updates to the Cryptoassets manual (designated CRYPTO60000). It states:

“Where, under their terms and conditions, a DeFi lending platform is allowed to deal as it wishes with the tokens received as collateral, this will be a strong indicator that the DeFi lending platform has acquired the beneficial ownership of those tokens”.

It is therefore imperative that the underlying agreement is understood and that the borrower knows whether the DeFi lender is able to use the collateral as their own, or whether they must simply hold it as a custodian.

If there is a change in beneficial ownership of the tokens:

  • A disposal will be deemed to occur when the collateral is transferred to the exchange. When calculating the capital gain, the consideration used in the calculation will be the market value in GBP of the tokens given as collateral to the DeFi lending platform.
  • When the loan has been settled in full and the collateral is withdrawn from the DeFi lending platform, this will be an acquisition. The cost of the crypto for future gains purposes will be the market value in GBP of the crypto at the time at which the crypto is reacquired (i.e. the beneficial interest in the crypto reverts back to the borrower).
  • If the borrower’s position becomes liquidated by the DeFi lending platform, no gain will arise on the liquidation as the borrower is treated as already having disposed of the tokens.

If the provision of collateral doesn’t lead to a change in beneficial interest of the tokens then, as outlined above, there is no capital gain arising. The crypto is simply being held by the DeFi network and they are not allowed to do anything with the crypto.

If the borrower’s position needs to be liquidated by the DeFi lending platform then they are treated as a nominee for the borrower, so that the dealings of the DeFi lending platform with the collateral/security are, for capital gains purposes, dealings of the borrower. Consequently any gain or loss on a disposal of the tokens held as collateral by the DeFi lending platform is deemed to be the gain or loss of the borrower. The tokens disposed of to settle the borrower’s position are treated as disposed of at their market value in GBP.

Where a penalty is applied by the DeFi network for the liquidation, this is not an allowable deduction for the purposes of calculating the gain on the tokens. This is because the penalty does not meet the definition of a deductible expense per the capital gains legislation.

Find out more about our crypto tax and accounting services here.

Our other articles on the February 2022 updates to HMRC’s Cryptoassets Manual: