Under the current rules, DeFi lending, providing liquidity and certain proof-of-stake staking arrangements may give rise to capital gains tax (CGT) liability when depositing tokens to the relevant protocol or platform and when receiving the lent/staked tokens back. Following feedback from the industry, the UK HM Revenue and Customs (HMRC) has consulted on amending the current rules as follows: The potential disposal of beneficial ownership for tokens lent or staked in a liquidity pool in a decentralized finance (DeFi) transaction would be disregarded for CGT purposes, meaning that no CGT would be due. Instead, a chargeable disposal would arise when the tokens are subsequently disposed of in a non-DeFi transaction (such as an outright sale or when they are exchanged for goods and services). Consensys proposes to extend this principle to liquid staking and delegated custodial staking arrangements on Proof of Stake (PoS) networks such as Ethereum.
Reply: The taxation of decentralised finance involving the lending and staking of crypto assets - consultation
We welcome HMRC’s efforts to engage with the industry on the taxation of DeFi and appreciate the opportunity to respond to this consultation.
Consensys’ key positions
We generally support the proposed framework as it would bring much-needed clarity while reducing the administrative burden on taxpayers compared to the current rules.
Even though the consultation states that the activity of “staking tokens as part of a proof-of-stake transaction verification process” is out of scope of the proposed rules, in our view the criteria set forth by the proposed framework could be applied to some types of PoS staking arrangements.
In our view, in the interest of greater clarity as to the appropriate taxation of PoS staking, the proposed rules should be extended to apply to PoS staking transactions that meet the specified criteria.
This response builds on our response to the HMRC’s Call for Evidence submitted in August 2022. Please also refer to the expanded version of our response to the Call for Evidence.
Background on Consensys
Consensys is the leading Ethereum software company. We enable developers, enterprises, and people worldwide to build next-generation applications, launch modern financial infrastructure, and access the decentralised web. Our software suite, composed of MetaMask, Infura, Quorum, Truffle, and Diligence, is used by millions and supports billions of blockchain calls. Consensys Staking is a self-custodial software-as-a-service offering leveraging Consensys’ leading industry position and deep Ethereum expertise to help institutions achieve optimised staking rewards while eliminating risk, complexity, and reliance on trusted third parties. Ethereum is the largest programmable blockchain in the world, leading in developer community, user activity, and business adoption. On this trusted, open source foundation, people around the world are building the digital economies and online communities of tomorrow.
The consultation uses the term “staking” to refer to the activity of providing liquidity. As stated in our response to the Call for Evidence, in our view, using the term staking in that context is overly broad and imprecise; instead, to avoid confusion, the term “providing liquidity” should be used. “Staking” should be used to refer to the process of “locking up” tokens to participate in transaction validation on a PoS blockchain.
For an analysis of the differences between staking, providing liquidity, and lending, please see section 1 of our response to the Call for Evidence.
Question 1: Do you consider that the rules above are sufficiently wide to cover most DeFi lending and staking models available in the market? If not, please provide details of the models that would not be covered.
The consultation states that the activity of “staking tokens as part of a proof-of-stake transaction verification process” is carved out of the scope of the proposed framework. However, in our view, some PoS staking offerings could nonetheless be construed as meeting the criteria set out in section 2 (Policy Approach - Proposed scope of the rules) of the consultation, as discussed below. In their current form, the proposed rules therefore risk creating uncertainty among taxpayers as to whether to rely on the express carve-out or whether to apply the guidance more broadly to PoS staking transactions that appear to meet the criteria. The HMRC has the opportunity through this process to bring clarity to PoS staking taxation. We respectfully encourage HMRC to take that opportunity, either by extending the proposed rules to PoS staking models that meet the proposed criteria (which is our preferred option), or by carving out such PoS staking models more explicitly to avoid confusion.
As HMRC mentions in the consultation, one of the benefits of the proposed rules is that participants do not need to carry out an analysis of the particular terms and conditions of individual transactions to establish whether they amount to a disposal of beneficial ownership. The question of beneficial ownership also arises in some staking arrangements. We have analysed this question in detail with respect to PoS staking and concluded that the analysis is nuanced and complex, and that taxpayers cannot generally be expected to carry out this exercise. It would greatly benefit the market to have clear guidance from HMRC with respect to taxation of PoS staking arrangements. Expanding the proposed rules to cover PoS staking transactions would achieve this objective while ensuring consistent treatment with other types of DeFi transactions.
It is important to distinguish between different types of PoS staking arrangements. Please refer to our detailed description of the staking models, our analysis of staking, and our response to the Call for Evidence for more information on the different arrangements. Solo staking on the Ethereum network, for example - i.e. where a user deposits 32 ETH into the official deposit smart contract, runs open source Ethereum client software, and receives rewards directly from the protocol - is clearly out of scope of the proposed regime, as there is no involvement of a third party in the process. There is, therefore, no question as to whether the legal and the beneficial ownership over the staked tokens passes from the staker to another party. Similarly, there is no change in beneficial ownership in the self-custodial software-as-a-service model as stakers remain in control of their withdrawal keys at all times.
The situation is less clear for other staking models, namely delegated custodial staking service and smart contract-facilitated liquid staking. We consider these arrangements below.
According to the consultation, a transaction is intended to be within the rules if it contains all of the following elements:
“a) there is an initial transfer of cryptoassets from one party (the lender) to another party (the borrower) and/or there is a transfer of cryptoassets through the use of a smart contract”
Consensys comment: This element is present when a user stakes through a delegated custodial staking service or smart contract-facilitated liquid staking.
“b) the borrower has an obligation to return to the lender the borrowed tokens and/or the smart contract allows the lender to withdraw the tokens”
Consensys comment: In delegated custodial staking, the service provider has a contractual obligation to return to the customer the staked tokens. Smart contract-facilitated liquid staking automatically enables the user to withdraw the staked amount of ETH upon request. An example of this would be Lido’s withdrawal functionality.
“c) the tokens can be returned at the instigation of the lender, at the request of the borrower, or automatically at the end of a pre-determined period”
Consensys comment: Following an upgrade of the Ethereum network in March this year, it is now possible to withdraw staked tokens at the request of the staker by making a withdrawal request to a custodial staking service or to a smart contract-facilitated liquid staking protocol.
“d) the lender has the right to withdraw at least the same quantity of the same type of tokens that were originally lent or staked”
Consensys comment: In PoS staking, stakers have no guarantee that they will be able to withdraw the same or greater quantity of tokens that were originally staked. This is an important differentiating factor from lending or providing liquidity and goes to the heart of what PoS staking is - a mechanism creating well-balanced incentives for participants running validation software that performs a critical data integrity function for the network. Without validation, the network’s global data set is not updated with new transactions nor maintained over time with essentially absolute certainty about its history. Staking rewards are a compensation for this activity, which is fundamentally different from a yield on a loan or a return on providing liquidity. The staked tokens act as an incentive to run the software in accordance with the rules of the network - if the participant fails to do so, the protocol punishes the participant by destroying some of their staked ETH.
However, many providers of staking services offer slashing protection that ensures that, if a slashing event occurs, the staker nevertheless has a contractual right to withdraw the amount originally staked plus any accumulated staking rewards. There could be an argument that in this scenario prong (d) is satisfied, as the staker has a contractual right against the service provider to withdraw at least the same quantity of tokens originally staked.
Separately, HMRC mentions in the consultation the scenario where, as an alternative to receiving the same number of tokens of the same type, the lender receives another type of cryptoasset which is representative of their right to get their original cryptoassets back. HMRC further notes that if a lender sells their rights in the lent or staked cryptoassets, the rules will regard the disposal of the rights as a disposal of the relevant cryptoassets at the time the rights are sold. Smart contract-facilitated liquid staking works on the same principle whereby users receive another type of token, called a liquid staking token (LST), that acts as a receipt for/evidence of legal and beneficial ownership of a corresponding portion of the underlying staked assets. If a user sells LSTs, this has the economic effect of disposing of the underlying staked tokens. Under HMRC’s proposed rules, “the buyer of rights of staked or lent tokens will be regarded as having acquired the lent or staked tokens, such that there will be no CGT consequences when those rights are exercised and the staked or lent tokens are withdrawn. For example, there will be no CGT when the buyer of a liquidity token uses it to withdraw cryptoassets that were originally staked by another user.” We encourage HMRC to extend this rule to liquid staking transactions as well, given the functional similarities.
In sum, certain PoS staking arrangements satisfy the proposed criteria. We encourage HMRC to consider extending the proposed rules to PoS staking transactions to which the applicable criteria can apply under similar reasoning.
Question 2: Do you consider that the rules above would give rise to any unintended consequences or significantly restrict the development of the DeFi lending and staking market? If so, please provide details.
We do not currently expect that the rules above would give rise to any unintended consequences or significantly restrict the development of the DeFi lending and staking market.
Question 3: Do you consider that the rules would be open to abuse?
We currently do not foresee that these rules would give rise to a risk of abuse.
Question 4: 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.
With respect to PoS staking, the answer depends on the type of staking arrangement. Users of a delegated custodial staking service will typically have a contractual right to receive the staked tokens. A user of a self-custodial software-as-a-service staking offering is able to withdraw the staked assets at any time without involvement of the service provider by submitting an exit transaction to the blockchain. Smart contract-facilitated liquid staking offerings have a withdrawal function programmed into the smart contract, giving users the ability to withdraw at any time. Such offerings typically have no terms and conditions, so the withdrawal rights are typically not expressed in a written contract.
Question 6: 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?
We agree that the proposal to treat all returns received from DeFi lending or provision of liquidity as miscellaneous income would reduce the administrative burden for taxpayers.
In respect of rewards from PoS staking, Consensys has consistently argued that for the reasons set forth in papers like those published by the US Proof of Stake Alliance, in our view the proper policy would be to codify treatment of block rewards as property that is taxed as miscellaneous income only after disposition, and not incrementally when each block reward accrues. This is because a staker does not receive block rewards from another person; instead, the tokens are generated or created because of how the block validation mechanism works, which is fundamentally different from a yield on a loan or a return on providing liquidity. Staking rewards are created property, like crops are a farmer’s created property or a painting is a painter’s created property. In the same way, stakers should only be taxed on any gains they realise when they sell the rewards.
Question 7: a) Do you agree that the proposed treatment of DeFi transactions has been applied correctly in each of Examples 1 to 5?
Yes, we agree that the proposed treatment has been applied correctly in each of Examples 1 to 5.
c) Please provide any further examples of DeFi transactions that you think would be helpful, including an explanation of how the proposed tax treatment would apply.
Many of the examples provided in the consultation can be applied to PoS staking using a delegated custodial staking service or a smart contract-facilitated liquid staking offering. The key difference is that, unlike in the case of lending or providing liquidity, in PoS staking there is no fixed annual return. While this difference is important for understanding the nature of PoS staking (as explained in our response to question 1), it does not affect the validity or relevance of the examples with respect to PoS staking.
Example 1 in the consultation can be accurately applied to a delegated custodial staking arrangement (with the exception of the fixed return). Examples 2 and 3 from the consultation can be applied to a smart contract-facilitated liquid staking transaction (again, with the exception of the fixed return), with aToken2 (aT2) being a liquid staking token representing the user’s rights in the staked tokens.
22 June, 2023
CONSENSYS SOFTWARE INC.