Accounting service leaders in the UK have disputed HMRC’s proposed taxation framework for decentralized finance (DeFi) transactions, labeling it as “not fit for purpose.”
In a letter sent to HMRC, the UK’s tax authority, written by experts, including tax calculation software provider Recap and chartered accountants, Wright Vigar highlights the need for a more nuanced and tailored taxation approach that captures the unique characteristics of the rapidly evolving DeFi sector.
This action is a response to the recent DeFi consultation undertaken by HMRC. According to the joint report, the examples used in the government’s consultation do not fully represent mainstream market activity. They exposed a lack of understanding of complex transactions involving multiple assets and the partial redemption of DeFi positions.
The experts have criticized the proposed “repo-like” solutions for DeFi taxation, highlighting that they fail to address the complexities and specifics of crypto assets and the DeFi sector.
The two organizations have also challenged the idea that all DeFi rewards should be classified as income, presenting arguments for potentially treating these rewards as capital with a Nil acquisition cost. Howitt, co-founder and CEO of Recap emphasized the importance of a well-informed and comprehensive regulatory framework. He stated,
“The UK has its sights set on becoming one of the most prominent hubs for crypto assets, and as such, it’s vital that the regulations and legislations around the sector be well-informed, all-encompassing, and as concrete as possible.”
Louise Lane, Associate Tax Director at Wright Vigar, underscored the complexity of navigating the crypto asset universe. She emphasized the importance of expertise and innovation in this field while criticizing the contrived nature of scenarios used in the HMRC report. According to Lane, treating rewards as capital simplifies and reduces complexity.
Proposed taxation system
Recap and Wright Vigar have proposed an “Asset Composition No Gain No Loss” approach as a potential solution to the complexities of the DeFi tax position. This rights-based approach, they believe, would work for all DeFi activity. They propose a process where rights — which exist on a per-asset basis — are collected into a position.
When a position, or an asset representing a position, is disposed of, a disposal calculation is performed for each right, taking into account the change in the composition of the assets received. Differences in asset composition are treated similarly to acquisitions, disposals, or swaps.
The details of this proposal encompass the No Gain No Loss (NGNL) disposal of principal tokens upon entry into all DeFi arrangements, passing the acquisition cost onto LP tokens/rights. The tax treatment on exit would then depend on the type and amount of tokens removed. If the same type and quantity of tokens were in and out, it would result in an NGNL disposal of LP/token on exit, with acquisition cost passed on to the returned tokens.
If the same type of tokens was involved but in different quantities to entry, an NGNL disposal of the LP token/rights on exit would be performed up to the principal tokens added. Any surplus or shortfall in principal tokens would then be subjected to Capital Gains Tax (CGT) upon exit. If different types of assets were to exit, a CGT charge would be applied.
Their approach is validated by ensuring that pool costs are correctly calculated in each scenario, given the gains or losses that could potentially be generated. The equation, “Total pool costs before = Total pool costs after + gains – losses,” serves as a fundamental formula in their proposed method.
Recap and Wright Vigar have formally requested clarity from HMRC on a taxpayer’s DeFi tax position for tax years preceding the introduction of any new legislation. They highlight the importance of having clear guidelines for fair and consistent treatment of DeFi transactions, providing certainty for individuals and businesses operating in this rapidly emerging sector.
Recap and Wright Vigar advocate for continued collaboration and dialogue with HMRC and other relevant authorities to achieve a well-informed and balanced regulatory environment for DeFi and crypto assets. The complete response from these crypto leaders can be seen here.