Uniswap's subsidiary DEF responds to UK tax authorities: How to approach DeFi taxation.

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

Original Author: TaxDAO

Uniswap's subsidiary DEF replied to the UK Customs and Excise Department ("HMRC") on June 22 regarding DeFi tax consultation, stating four principles:

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

The basic economic essence of typical DeFi transactions remains consistent;

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

By minimizing the administrative burden on taxpayers and demonstrating maximum clarity and simplicity, we aim to promote tax compliance to the greatest extent possible.

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

Its application should be flexible and comprehensive to adapt to future innovations.

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

Use standard market terminology to describe the arrangement of related tax obligations.

Summary of Main 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.

Question: Does the right of the borrower to receive lent or pledged tokens have legal nature? Please refer to any specific DeFi model you have participated in to answer this question, and emphasize 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:

The correct description of the rights of "lenders" must be noted that describing the right of "lenders" to receive tokens for "lending" or "pledging" as having legal nature is inaccurate. 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;

In DeFi transactions, the "counterparty" of users is usually a smart contract, making it difficult to determine legal relationships and identify parties that can defend the rights of "lenders". Therefore, establishing traditional legal frameworks for these relationships becomes complex and not as straightforward, as there is no corresponding party 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.

The basic concept of DeFi is to create a financial infrastructure that establishes trust through software protocols rather than traditional legal relationships and mechanisms. Legal relationships are only necessary when the operation of such relationships requires trust in human discretion - in traditional finance, consumers must trust intermediaries to issue transactions, and in the case of loans, they must trust borrowers to repay. On the other hand, DeFi is built on autonomous code (smart contracts) that can operate without intermediaries. This implies that trust is established through legitimate means within DeFi, which is fundamentally innovative.

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.

Although we understand HMRC's interest in determining the conditions or requirements for DeFi transactions to have legal binding, we believe this should not be their main focus or requirement. Despite opposition to taxing transactions without legal asset transfers or legal rights/obligations in creation/disposal, we expect the desire to tax economic activity in DeFi to take precedence over technical issues of legal characteristics. The essence of DeFi, both now and in future developments, revolves around eliminating reliance on legal structures to establish trust between parties. If HMRC only seeks to provide tax treatment certainty when establishing clear enforceable legal rights, this will leave a large part of the market in uncertainty and may hinder their ability to tax revenue from what was originally considered revenue-generating activities.

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.

In most cases, the rights generated by DeFi lending and collateral arrangements may be inconsistent with traditional legal frameworks, and the rights involved (if any) are more subtle and not easily classified within established legal concepts. Therefore, HMRC should take a comprehensive approach, recognizing the unique characteristics of DeFi transactions. This will ensure a fair and accurate assessment of the tax implications and wealth creation resulting 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?

Question: Do you agree to change the rules and always consider DeFi returns as income? What are the advantages and disadvantages?

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

Overall, we support changing the rules and defaulting to treating DeFi returns as income.

Pros

Advantages

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.

Previously, the HMRC guidance would determine whether DeFi returns should be treated as capital or income, burdening taxpayers. By defaulting to treating DeFi declaration forms as income, it will provide clarity for individual taxpayers on the tax classification of their DeFi declaration forms.

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

Enterprise taxpayers usually maintain a neutral attitude towards the income and capital treatment of DeFi returns.

Cons

缺点
translates to

Disadvantages
in English.

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「.

Treating the DeFi declaration form as miscellaneous income may prevent individual taxpayers from using allowances available for dividend and interest income to offset their tax obligations on the DeFi declaration form. However, given the decentralization of DeFi "lending" and "staking", we acknowledge the challenge of describing DeFi returns as interest, dividends, or royalties due to the complexity associated with determining the source and determining the obligation to withhold taxes.

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.

According to the proposed DeFi tax system, non-trading individuals who may otherwise benefit from the current lower CGT tax rate on DeFi capital returns will not benefit.

Possible solutions

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.

This legislation can stipulate that DeFi returns are automatically considered miscellaneous income. However, if certain requirements are met, such declarations can be considered personal capital and deferred to the end of the contract or otherwise generated for all taxpayers. These requirements may be consistent with the principles outlined in the HMRC guidelines 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.

HMRC should consider introducing a separate allowance similar to the personal allowance for interest income. This approach would ease the administrative burden for users involved in small-scale transactions, balance tax incentives (through allowances) between DeFi rewards, interest, and dividends, and demonstrate the UK government's commitment to maintaining its position as a leading financial center.

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.

Question: Do you anticipate any difficulties for users engaging in these and similar transactions in determining the value proposition of DeFi returns? If so, please provide examples of how this could be a problem.

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:

As a starting point, we hope users will refer to the guidance CRYPTO23000 published by HMRC for assessing crypto assets for UK tax purposes. As a reference, we have listed the following excerpts:

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.

Many cryptocurrencies (such as Bitcoin) are traded on exchanges that do not use British pounds, so the value of any gains or losses must be converted to pounds on self-assessment tax returns.

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.

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

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.

Reasonable and cautious measures should be taken to appropriately evaluate transactions using consistent methods. The details of the valuation method should be retained.

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.

The taxpayer needs to determine the total assets received and deposited, and determine which portion of the returned assets is attributed to the re-weighting of "pledged" (LPed) assets, and which tokens can be attributed to the earned fees (DeFi returns).

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.

Taxpayers need to determine the statutory value of assets when depositing and withdrawing. This will pose difficulties, and HMRC will need to clarify which statutory valuation data sources taxpayers should use when calculating 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.

For the convenience of management, we suggest that HMRC consider establishing an official exchange rate list that users can refer to when evaluating their encrypted assets.

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

Question: What impact do you expect the implementation of the recommendations in this document to have on the administrative burden and costs for DeFi users?

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.

Overall, these proposals are a positive step towards reducing the management burden and costs for DeFi users, and will promote compliance. Eliminating CGT's impact on certain steps in the typical DeFi transaction lifecycle (such as initial borrowing and collateralization of crypto assets; and the withdrawal or return of borrowed or collateralized tokens at the end of the term) reflects the fundamental economic ownership of liquidity providers.

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:

Assuming that DeFi transactions fall within the scope of the new DeFi tax regulations, "lenders" will be concerned with three "tax events".

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

The DeFi returns received during the "borrowing" or "pledging" period.

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

When the "borrower" goes bankrupt, the loss of "pledged" or "lent" tokens may trigger a taxable event.

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

If the "credit party" sells its "rights" to the "borrowed" or "pledged" 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.

Each of the above events occurs regularly. If there is no accurate and automated way to review transactions to show the gains/losses or income obtained under proposed DeFi tax rules, the new rules will still be a significant management burden for users.

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