This article has been written for ACCOINTING.com by Sam Inkersole, a manager at BKL chartered accountants and tax advisers. Sam is part of BKL’s crypto tax team, advising people and businesses on the UK taxation of their cryptocurrencies and NFTs.
Ethereum’s blockchain has allowed for a plethora of different protocols to be developed, leading to some innovative methods of financing. When looking to determine which tax rules need to be applied to a transaction, the transaction needs to be reviewed and understood, with the correct rules applied.
In the three examples below, we have outlined the tax treatments for certain transactions we have seen recently. This list is not exhaustive, nor should you conclude that the transaction you have undertaken would lead to the same tax treatments. We would recommend that you seek specific professional guidance from a chartered tax adviser with UK crypto tax experience.
Example 1 – borrowing against cryptocurrency (and DeFi network liquidation)
Ms A borrowed an amount against a cryptocurrency she held. The smart contract was written in such a way that only 50% of the value of the crypto held was lent against the whole cryptocurrency amount which was held by the DeFi network as collateral, with the lending in a stablecoin. If the value of the crypto held started to fall past a certain point, the crypto held as collateral was sold by the DeFi network in order to repay the original loan amount.
The initial lending was not a taxable event as the loan was to be repaid: the lending had occurred in a similar fashion to that of a pawnbroker lending against a gold bar.
When Ms A made repayments to the DeFi network, those were also not taxable. Nor was the return of the collateral to her.
The value of the remaining crypto collateral fell to such an extent that the DeFi network automatically began to sell off the crypto in order to repay the remaining loan amount. This was a taxable event for Ms A, leading to a capital gains tax charge as her base cost was lower than the value achieved by the DeFi network.
Example 2 – Lending to DeFi networks
Mr B lent a sum of cryptocurrency to a DeFi network, whereby he gained a return of 10% a year with the returns given to him on the return of the crypto he had lent to the DeFi network. He lent the amounts over a two-year period.
The return on the lending is akin to interest income and subject to tax under the income tax regime. In this specific example, the tax arose entirely in the second year with reference to the value of the additional crypto received back at the date it was received.
Example 3 – Self-repaying loans
Mrs C borrowed some stablecoin from a DeFi network and put another cryptocurrency up as collateral. The protocol was written in such a way that the collateral would never be liquidated and Mrs C would not need to make any loan repayments. The DeFi network would use her collateral to generate a return: this return would be used to repay the loan given in stablecoin to Mrs C. Upon full repayment of the loan, the collateral would be returned to Mrs C.
The initial borrowing by Mrs C was not a taxable event. Nor was the return of the initial crypto collateral by the DeFi network after the loan had been fully repaid.
The return generated by the DeFi network, used to repay the loan, was taxable on an annual basis on Mrs C. The returns were subject to Income Tax as she was obtaining a return on her asset, rather than generating income by disposing of her asset.