The tax authority in the United Kingdom has released a consultation document that proposes changes to the way decentralized finance (DeFi) lending and staking are taxed. Currently, DeFi transactions may be considered disposals, which can result in tax outcomes that do not reflect the underlying economic substance. The proposed framework aims to address this issue by introducing a taxable disposition only when cryptocurrencies are economically sold off through a transaction that is not related to Decentralized Finance.
Proposed Changes to Taxation of DeFi Lending and Staking
Under the current regulations, DeFi transactions may be viewed as disposals and accounted for as sales or gifts by crypto lenders or yield generators like liquidity providers, even when the asset’s ownership remains unchanged. This can result in tax outcomes that do not reflect the underlying economic substance, as well as a tax liability resulting from a transaction in which no gain has been realized in a form that can be used to meet the liability.
The proposed framework aims to address this issue by introducing a taxable disposition only when cryptocurrencies are economically sold off through a transaction that is not related to Decentralized Finance. This means that if a crypto lender or yield generator uses their digital assets in a DeFi transaction, it would not be considered a disposal for tax purposes. Only when the cryptocurrencies are sold off through a transaction that is not related to DeFi would a taxable disposition take place.
The proposed framework is aimed at decentralized finance (DeFi) lending and staking, but it is also unequivocally applied to centralized finance (CeFi), which offers similar services often through intermediaries. According to the document, the need to determine and record the market value of assets at each step in the transaction may also give rise to a disproportionate administrative burden. The consultation will be available for a total of eight weeks before coming to an end on June 22.
Reasons Behind the Proposed Changes
The proposed changes to the taxation of DeFi lending and staking come amid increased scrutiny of the cryptocurrency industry by regulatory bodies around the world. Recent failures in the crypto market, such as the closure of the FTX exchange and the bankruptcies of crypto lending giants like BlockFi and Celsius, have highlighted specific risks, including cyber risks and other technical risks. There is also an increased dependency on traditional and decentralized financial systems, which may pose a threat to financial stability. HM Revenue and Customs (HMRC), the tax authority in the United Kingdom, has stated that there is a lack of backstops in periods of market stress, which may result in significant losses for investors.
The proposed changes aim to address some of these risks by ensuring that the tax treatment of Decentralized Finance lending and staking is aligned with the underlying economic substance of the transactions. By introducing a taxable disposition only when cryptocurrencies are economically sold off through a transaction that is not related to Decentralized Finance, the proposed framework would prevent tax outcomes that do not reflect the true economic substance of the transactions.
Potential Impact on the DeFi Industry
The proposed changes to the taxation of DeFi lending and staking may have a significant impact on the DeFi industry. If implemented, the proposed framework would align the tax treatment of Decentralized Finance transactions with the underlying economic substance of the transactions. This would result in more accurate tax outcomes and could reduce the tax liability for crypto lenders and yield generators. The proposed framework may also make it easier for investors to participate in DeFi lending and staking without having to worry about the tax implications of their transactions.
Conclusion
the proposed changes to the taxation of Decentralized Finance lending and staking by the UK tax authority aim to address tax outcomes that do not reflect the underlying economic substance of the transactions. The proposed framework introduces a taxable disposition only when cryptocurrencies are economically sold off through a transaction that is not related to DeFi.
