Given there is limited specific tax legislation in relation to cryptoassets, and not very much HMRC guidance, this consultation was welcomed by an industry which has long been asking for certainty on tax matters in relation to crypto and digital assets. However, it seems that the narrowly drawn exemption – where the tokens returned are of the same type and quantity – does not reflect the actual reality of DeFi transactions. 

The reality of DeFi transactions

Some of the most popular liquidity pools support ETH-USDT and USDC-ETH exchanges: on 8 August 2023, these were the second and third most liquid pairs on Uniswap, a decentralised cryptocurrency exchange https://v2.info.uniswap.org/pairs, with US$64.2m and US$59.5m of liquidity respectively.  However, HMRC’s position (as set out in the consultation) is that where a pair of tokens are returned but in different amounts or proportions, the conditions set out for the proposed lending exemption would not be satisfied.

A related complication arises in relation to the role of the AMM (automated market maker) in such a pool. An AMM algorithm uses a pre-set mathematical equation to ensure that the ratio of assets remains as balanced as possible in order to create constant liquidity and to eliminate discrepancies in the pricing of pooled assets. The AMM will either call for more tokens or return tokens (not unlike the role of variation margin in traditional securities financing). However the proposed DeFi exemption would appear to not cover this scenario.

It is also not clear whether yield optimiser strategies, which work through a series of pre-programmed smart contract interactions, would be in scope of the exemption. However, on the basis that they involve the locking up of assets to earn rewards, the market would view these as typical staking transactions.

HMRC in their consultation did seek feedback on how the rules could be modified to provide a fair outcome for some of these additional DeFi transactions and one hopes that they will use the industry feedback to tailor an exemption suited to the crypto industry – and not just to replicate the stock lending and repo exemptions for traditional securities – as, as explained above, the proposed exemption falls short of covering most DeFi lending models.

Going long on the crypto industry

As UK Finance stated in its response to the consultation, any exemption has to be viewed in the context of HM Government’s wider desire in wanting to develop a regulatory framework which is welcoming of innovation and supports the attraction of capital and developer interest, but wishes to provide certainty to firms and offers robust protection for consumers. Part of that is an implicit need for a tax favourable environment underpinning that vision.

There is, of course, precedent for aligning tax incentives with Government strategy. As an example, the Patent Box was designed to encourage companies to keep and commercialise intellectual property in the UK, and allowed them to apply a 10% rate of corporation tax to profits earned from patented inventions. According to HMRC’s Patent Box Evaluation, “There is some evidence to suggest that firms using the UK Patent Box increase their investment in the UK compared to equivalent firms, with caveats”.[1]

It would therefore not be inappropriate for there to be a favourable regime for cryptoasset technology and innovation: the proposed DeFi exemption is a start, but arguably does not go far enough.

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UK Finance Response to HMRC consultation on crypto lending