According to the proposed method, any transfer of encryption assets beneficial ownership from the lender to the borrower will not be subject to capital gains tax.

Author: HM Revenue and Customs

Compilation: TaxDAO

Originally published on April 27th

Financial Service has been developing rapidly in recent years, including the rise of encryption assets (digital representations of value or contractual rights that can be used in financial transactions and may play an increasingly important role in financial innovation). New forms of encryption assets and the services supported by them are constantly evolving.

In March 2018, the then Chancellor of the Exchequer launched the government's financial technology (FinTech) industry strategy. It set out the government's ambition to work with the UK financial services industry to maintain the UK's position as a global leading financial center and the world's most innovative economy.

The government aims to establish a clear tax and regulatory system for encryption assets, placing the UK at the forefront of secure, sustainable, and rapidly innovative encryption assets and blockchain technology.

The Chancellor of the Exchequer reaffirmed the commitment to maintaining the UK's global leadership in fintech at TheCityUK National Conference in Edinburgh in December 2022.

One of the measures announced last April was to explore and resolve specific issues related to taxation of lending and stake activities in Decentralized Finance. Some stakeholders have emphasized the inconsistency between the current Capital Gains Tax (CGT) rules and the nature of the activities when applied to Decentralized Finance.

As part of the review of tax rules applicable to Decentralized Finance transactions, the government issued a call for evidence from July 5th to August 31st, 2022. Most respondents believe that changing the tax rules would benefit the industry and users.

Recent market events, including the failure of FTX, have highlighted the vulnerability of the entire encryption asset industry. In the Decentralized Finance system, policymakers and regulatory agencies also emphasize specific risks, including network risks and other technical risks, as well as the increased interdependence between the TradFi system and the DeFi system, and the lack of support during market pressure periods.

The proposed tax policy methods for Decentralized Finance lending and stake in this article have taken into account neutrality, fairness, and practicality. It does not mean to replace a broader regulatory framework for encryption assets. For more details on government regulation methods for encryption assets, please refer to the 'Future Regulatory Regime for Encryption Assets - Consultation and Call for Views' published by the UK Treasury on February 1, 2023.

What is Decentralized Finance loans and stake?

Decentralized Finance is a comprehensive term used to describe the provision of services similar to traditional Financial Service using Distributed Ledger technology. Decentralized Finance is typically executed through 'Smart Contract', which is a set of encoding rules that execute transactions on-chain when certain parameters are met. Therefore, Decentralized Finance can provide Financial Service without the use of traditional Financial Intermediary.

Decentralized Finance lending services allow users to deposit Tokens and receive financial returns in exchange, commonly referred to as Interest (although it is not considered Interest for tax purposes). Additionally, encryption asset holders (referred to as Liquidity Providers in this context) can provide their Tokens to the platform, where they pool together with other users' Tokens (a 'Liquidity pool'). This method of providing Liquidity to the platform is called 'stake' and allows the platform to utilize the pooled Tokens for other Decentralized Finance services. To incentivize encryption asset owners to provide this Liquidity to the platform, they will receive financial returns, typically paid periodically within the protocol's term or at the end of the term ('Decentralized Finance returns').

Policy Principles

The government is consulting on the implementation of tax schemes for Decentralized Finance lending and stake, aiming to exclude any disposal of beneficial ownership that occurs when encryption assets are staked or lent from CGT. Instead, capital gains tax will be incurred when encryption assets are disposed of in an economic manner (e.g. directly sold or used to exchange goods and services).

The Decentralized Finance transactions that are intended to be covered are those in which participants retain the economic benefits of lending or staking tokens during the transaction, despite the existence of legal or beneficial ownership transfers. This occurs when participants transfer encrypted assets to another party (the borrower) for a period of time and have the legitimate right to recover an equivalent amount of encrypted assets at a future point in time. If participants benefit from the change in token value during the loan or stake period, they will retain the economic benefits of lending or staking tokens.

In some cases, within the staking or lending period, participants may sell their rights in the equity Token to another party. These rights are typically represented by the LiquidityToken issuance on the platform. The new regulation will treat the disposal of rights to stake or lend Tokens as the disposal of the relevant Tokens. When the rights are disposed of, capital gains tax will apply as if the user had already sold the staked or lent Tokens.

staking or borrowing Liquidity Tokens or other Tokens representing staking or borrowing Token rights will not be considered as disposal.

According to these proposals, the buyer of stake or borrowed Token rights will be deemed to have acquired the stake or borrowed Token. This means that no capital gains tax will be incurred when these rights are exercised and the stake or borrowed Token is withdrawn. For example, when a purchaser of LiquidityToken uses it to retrieve encryption assets originally held by another user, no capital gains tax will be incurred.

When Token is borrowed or staked, the returns from Decentralized Finance will gradually accumulate during the transaction period. If participants sell their rights in stakeToken during the transaction period, a portion of the Decentralized Finance returns generated before the sale is usually sold together with the rights in stake or lending Token. The original owner is considered to have realized the accumulated Decentralized Finance returns up to the time of sale.

Proposed Rule Scope

Based on the above principles, if the transaction contains the following elements, the transaction is expected to comply with the regulations:

a) Encryption assets are initially transferred from one party (lender) to another party (borrower), and/or transferred encryption assets through the use of Smart Contracts;

b) The borrower is obligated to return the borrowed Token to the lender, and/or the Smart Contract allows the lender to withdraw the Token;

c) Tokens can be automatically refunded at the instigation of the lender, at the request of the borrower, or at the end of the predetermined period;

d) The lender has the right to retrieve at least the same amount of tokens as the initial loan or stake of the same type of tokens.

Application of Rules

a) For lenders and borrowers, this transaction will not generate capital gains tax;

b) Any sale of rights related to lending or staking Token is considered as a disposal of the rights associated with these Tokens;

c) Before selling such rights, any Decentralized Finance income accumulated on the Token should be taxed by the lender when the rights are disposed of;

d) The purchaser of the right to lend or stakeToken is deemed to have obtained the lent or staked Token;

e) If the borrower is unable to repay the borrowed Token, the lender will be deemed to have disposed of the stake or borrowed Token. This will occur when the borrower loses the ability to return the Token.

Proposed Design of the New Tax Framework

Loan or stake arrangements typically have three stages:

• Transfer Token to another party
• Loan / Equity Term
• Lend out / stakeToken return

The first stage of borrowing or staking arrangements involves the original owner (lender) transferring the encrypted assets to another party (borrower/Liquidity pool) or providing Tokens as Liquidity through a Smart Contract. The borrower is obligated to return the same amount of Tokens of the same type as requested or at the end of the scheduled period. In some cases, the lender may receive a different type of encrypted asset that represents their ownership of the original encrypted asset.

Under the proposed approach, the transfer of ownership of encryption assets benefits from the lender to the borrower will not be subject to capital gains tax. For tax purposes, any encryption assets (or any other form of rights) received from the borrower representing the right to lend or stake tokens are treated as original tokens held by the lender.

The second stage of Decentralized Finance lending and stake trading refers to the term of the loan/equity. The length of this term varies, and some arrangements can exceed several years.

For most lenders, there will be no expected capital gains tax consequences in the second stage (but please note that any receipts of Decentralized Finance returns should be taxed upon receipt).

However, at this stage, some lenders may sell their rights in the encryption assets they lend or mortgage. In this case, the rules will treat the disposal of rights as the disposal of the relevant encryption assets when the rights are sold.

In addition, in certain circumstances, borrowers may not partially or fully repay the borrowed Tokens. In this case, when a default occurs, the proportion of encryption assets that cannot be repaid will be treated as disposed by the original lender. The consideration is the amount received from the borrower as compensation for the unrecoverable Tokens.

The third stage of Decentralized Finance lending or stake trading is when the lender reclaims the borrowed Token. This occurs either because the lending or stake period has ended or because the participant has exercised their right to withdraw the loan/stake Token (e.g. by returning LiquidityToken).

According to the proposed rules, this situation usually does not result in any capital gains tax consequences for participants.

If the lender receives fewer Tokens than originally lent, for example, due to borrower bankruptcy, then the proportion of unrecovered Tokens is deemed to have been disposed of by the lender when the borrower is unable to repay.