Accounting services leaders in the UK have challenged HMRC’s proposed decentralized finance transaction (DeFi) tax regime, labeling it “not fit for purpose”.
In a letter to HMRC, the UK tax authority, written by experts including tax calculation software provider Recap and chartered accountants, Wright Vigar emphasizes the need for a more nuanced and tailored tax approach that captures the unique characteristics of the rapidly evolving DeFi sector. .
This action is in response to HMRC’s recent DeFi consultation. 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 multi-asset transactions and the partial redemption of DeFi positions.
The experts have criticized the proposed “repo-like” solutions for DeFi taxation, stressing 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 zero acquisition costs. Howitt, co-founder and CEO of Recap emphasized the importance of an informed and comprehensive regulatory framework. He claimed,
“The UK aims to become one of the most prominent hubs for crypto assets, which is why it is vital that industry laws and regulations are well-informed, comprehensive and as concrete as possible.”
Louise Lane, Associate Tax Director at Wright Vigar, underlined the complexity of navigating the crypto asset universe. She stressed the importance of expertise and innovation in this area, while criticizing the contrived nature of the scenarios used in the HMRC report. According to Lane, treating rewards as capital simplifies and reduces complexity.
Proposed tax system
Recap and Wright Vigar have proposed an “Asset Composition No Gain No Loss” approach as a possible solution to the complexity of the DeFi tax position. This rights-based approach, they say, would work for all DeFi activities. They propose a process whereby entitlements – which exist based on assets – are accumulated in 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 in the same way as acquisitions, divestitures or swaps.
The details of this proposal include the No Gain No Loss (NGNL) deletion of master tokens upon entry in all DeFi arrangements, with acquisition costs passed on to LP tokens/entitlements. The tax treatment at exit would then depend on the type and number of tokens removed. If the same type and number of tokens were in and out, this would result in a sale by NGNL of LP/token at exit, with the purchase cost being passed on to the returned tokens.
If the same type of tokens were involved, but in different amounts for entry, an NGNL disposal of the LP token/entitlements would be performed on exit up to the added master tokens. Any excess or shortfall of principal tokens would then be subject to capital gains tax (CGT) upon exit. If various types of assets disappeared, a CGT surcharge would be applied.
Their approach is validated by ensuring that pool costs are calculated correctly in each scenario, taking into account the profits or losses that could potentially be generated. The equation “Total pool cost before = Total pool cost after + profits – losses” serves as a fundamental formula in their proposed method.
Recap and Wright Vigar have formally requested HMRC to clarify a taxpayer’s DeFi tax position for tax years ahead of the introduction of new legislation. They emphasize the importance of clear guidelines for the fair and consistent treatment of DeFi transactions, providing reassurance to individuals and companies operating in this rapidly emerging industry.
Recap and Wright Vigar advocate for continued collaboration and dialogue with HMRC and other relevant authorities to achieve an informed and balanced regulatory environment for DeFi and crypto assets. The full response from these crypto leaders can be seen here.