08 February 2022
On 2 February 2022, HMRC published new guidance on the taxation of cryptocurrency transactions involved in decentralised finance (DeFi). The new rules could send taxpayers into a tailspin.
Clarity from HMRC on how these transactions should be taxed is welcome. However, the rules set out in the new guidance are complex and essentially retrospective, as HMRC had not published earlier, detailed guidance on the subject.
A previously submitted tax return that does not follow the approach outlined by HMRC in its new guidance could potentially be exposed to an enquiry. It might also open the door for HMRC to look into a cryptocurrency investor’s tax affairs over a longer period than it is able to under usual enquiry rules, using its ‘discovery’ powers.
The number of DeFi transactions has grown enormously, with an estimated $78bn of cryptoassets locked in DeFi projects, up around 55 per cent from the previous year. In simple terms, DeFi relates to financial services carried out on the blockchain rather than using traditional financial institutions like banks. For example, it is possible to obtain an income return similar to interest by undertaking an activity known as ‘staking’. It is also possible to lend cryptocurrency to others in a similar way to peer-to-peer lending, or to add your cryptocurrency to a pool of assets that provides liquidity to the wider cryptocurrency markets.
A key issue in the new HMRC guidance is that it outlines how many DeFi activities will trigger a sale of the cryptoasset. This, in turn, can result in capital gains tax (CGT) becoming due, which is likely to be a surprise to many cryptoasset investors.
As this is the first time HMRC has issued detailed guidance on this particular subject, it is likely that thousands of cryptocurrency investors and traders will not have prepared their tax returns following the approach now laid down by HMRC. Crypto investors are left in a quandary as to whether they should amend tax returns submitted previously or whether they simply follow the approach suggested by HMRC in the future. We believe HMRC should clarify the position and confirm whether it intends to enforce these rules retrospectively.
The guidance itself is HMRC’s best interpretation of how tax law should apply to cryptocurrency, and it cannot be criticised for that. It highlights HMRC’s view that cryptoassets are not currency and that there is a desperate need for clarity over the application of the legislation in this area in general, and is intended to make applying the existing rules simpler for taxpayers. If the UK is to make the most of the economic opportunity presented by blockchain and cryptocurrency technology, the Government must refocus and introduce legislation that makes the UK a viable location for businesses and investors involved in cryptoasset transactions. With rules as complex as those described in HMRC’s guidance, it’s inevitable that taxpayers will make mistakes and are being set up to fail.