Uniswap's institution responds to the UK tax authority: How to view taxation on DeFi

Original: 《Open Consultation: The Taxation of Decentralised Finance (DeFi) Involving the Lending and Staking of Cryptoassets (the "Consultation")

Compiled by: TaxDAO

On June 22, the institution DEF under Uniswap responded to the UK HM Revenue and Customs ("HMRC") regarding the DeFi tax consultation, indicating four key principles:

(i) align with the underlying economic substance of a typical DeFi transaction;

(ii) exhibit utmost clarity and simplicity to promote tax compliance by minimising administrative burden on taxpayers;

(iii) be flexible and comprehensive in its application to account for future innovation;

(iv) describe arrangements and associated tax obligations using standard market terminology.

Summary of Key Issues:

Question: Are the rights of the lender to receive the lent or staked tokens of a legal nature? Please respond to this question with reference to any specific DeFi models you have an involvement in, highlighting any legal uncertainties.

1. In relation to the proper characterisation of a "lender's" rights, it is essential to note that describing the "lender's" rights to receive the "lent" or "staked" tokens as being of a legal nature is not accurate. There are two key reasons for this:

a. In a DeFi transaction, a user's "counterparty" is typically a smart contract, making it challenging to determine the legal relationship and identify parties who could defend against the "lender's" rights. Therefore, establishing a traditional legal framework for these relationships becomes complex and less straightforward as there is no "counterparty" with legal personality;

b. DeFi's foundational concept aims to create a financial infrastructure in which trust is established through software protocols rather than traditional legal relationships and mechanisms. A legal relationship is only required when trust in human discretion is required for the relationship to function --- in traditional finance, consumers must trust intermediaries to issue transactions and, in the case of loans, borrowers to repay. On the other hand, DeFi is built on autonomous code (smart contracts) that functions without intermediation. Suggesting that such trust is established through legal means in DeFi would run counter to its fundamental innovation.

2. While we understand HMRC's interest in determining whether transactions in the DeFi space should have a condition or requirement of being legally binding, we believe that should not be their primary focus or demand. Although there is an argument against taxing transactions where no legal transfer of assets or creation/disposal of legal rights/obligations occurs, we expect that the desire to tax economic activity in DeFi should take precedence over technical concerns about legal characterisation. The nature of DeFi, both presently and as it evolves in the future, is centred around removing dependence on legal constructs to establish trust between parties. If HMRC only seeks to provide certainty in tax treatment when clearly enforceable legal rights are established, it would leave a significant portion of the market in a state of uncertainty and HMRC may risk hindering their ability for revenue collection from what would otherwise be recognised as revenue-generating activity.

3. In the majority of cases, the nature of rights arising from DeFi lending and staking arrangements may not align with traditional legal frameworks, and the rights involved, if any, are more nuanced and not easily categorised within established legal concepts. Therefore, HMRC should adopt a comprehensive approach that recognises the unique characteristics of DeFi transactions. This would ensure a fair and accurate assessment of the tax implications and treatment of wealth creation derived from DeFi transactions.

Question: Do you favour a change in the rules to always treat the DeFi return as being of a revenue nature? What are the pros and cons?

1. Overall, we favour a change in the rules to treat the DeFi returns as being of a revenue nature by default.

Pros

2. Previous HMRC guidance placed the burden on taxpayers to determine whether DeFi returns should be treated as capital or revenue. By defaulting to treating DeFi returns as revenue, it would provide individual taxpayers with clarity regarding the tax classification of their DeFi returns.

3. A corporate taxpayer will generally be neutral on the revenue vs capital treatment of DeFi returns.

Cons

4. Treating DeFi returns as miscellaneous income may prevent individual taxpayers from offsetting their tax liabilities on DeFi returns using allowances available for dividends and interest income. However, we acknowledge the challenges of characterising DeFi returns as interest, dividends, or royalties due to the complexities related to ascertaining source and determining withholding tax obligations given the decentralised nature of DeFi "lending" and "staking".

5. Under the proposed DeFi tax regime, non-trading individual taxpayers who might otherwise receive a capital DeFi return will not benefit from the currently lower CGT rate.

Possible solutions

6. The legislation could specify that DeFi returns are treated as miscellaneous income by default. However, if certain requirements are met, such returns could be treated as capital for individuals and deferred for all taxpayers until the end of the contract or a return otherwise arises. These requirements could align with the principles outlined in HMRC guidance in CRYPTO61214.

7. HMRC should consider introducing a separate allowance similar to the personal allowance regime for interest income. This approach would alleviate the administrative burden for users engaging in low-volume transactions, equalise tax incentives (via allowances) between DeFi returns, interest, and dividends, and demonstrate the UK government's commitment to maintaining its global position as a leading financial centre.

Question: Do you foresee any difficulties for users who engage in these and similar transactions to establish the value of the DeFi return? If so, please provide examples where this may be an issue.

8. As a starting point, we expect that users will refer to HMRC published guidelines on valuing cryptoassets for UK tax purposes in CRYPTO23000. For reference, we set out the extract below:

Many cryptoassets (such as bitcoin) are traded on exchanges which do not use pound sterling, so the value of any gain or loss must be converted into pound sterling on the Self-Assessment tax return.

If the transaction does not have a pound sterling value (for example, if bitcoin is exchanged for Ether) an appropriate exchange rate must be established in order to convert the transaction to pound sterling.

Reasonable care should be taken to arrive at an appropriate valuation for the transaction using a consistent methodology. Details of the valuation methodology should be kept.

The taxpayer would then need to determine total assets received vs. deposited and determine which portion of assets returned is attributable to the reweighting of "staked" (LPed) assets and which of the tokens are attributable to the fees (the DeFi returns) earned.

9. The taxpayer would need to determine the fiat value of the assets at the time of deposit and the time of withdrawal. This will present difficulties and HMRC will need to clarify which sources of fiat-pricing data will be acceptable for taxpayers to use as they calculate their tax obligations.

10. For administrative ease and clarity, we recommend HMRC consider establishing a list of official exchange rates that users may refer to when valuing their cryptoassets.

Question: What impact do you expect the proposals in this document, if implemented, to have on administrative burdens and costs for users of DeFi?

11. Overall, the proposals are a positive step towards alleviating administrative burdens and costs for users of DeFi and will promote compliance. Removing the CGT consequences on certain steps on the lifecycle of a typical DeFi transaction (e.g., the initial lending and staking of cryptoassets; and the withdrawal or return of the lent or staked tokens at the end of the term) reflects the underlying economic ownership of a liquidity provider.

12. Assuming a DeFi transaction falls within the scope of the new DeFi tax rules, there are 3 "tax events" that a "lender" would be concerned with:

a. DeFi returns that are received during the term of the "lending" or "staking";

b. When a "borrower" becomes insolvent as this could give rise to a taxable event as a result of lost "staked" or "lent" tokens; and

c. If the "lender" sells their "rights" to the "lent" or "staked" tokens to another person.

13. Each of the above events occurs regularly. Without accurate and automated means through which transactions can be reviewed to show gains/losses or revenue earned in accordance with the proposed DeFi tax rules, the new rules remain a significant administrative burden for users.