1โƒฃ
Is the Reward Income or Capital?
HMRC guidance at CRYPTO61214 helps determine whether the return received by the lender/liquidity provider should be treated as income or capital.
This will depend on how the transaction is structured. As there are many different structures that are ever-evolving, HMRC has set out some guiding principles in CRYPTO61214. General guidance from HMRC on determining the nature of a receipt as capital or revenue can be found at BIM35000.
The tax treatment of the reward is determined by whether it is an income or capital reward. It is irrelevant whether or not beneficial ownership of the principal tokens has been transferred upon entering the yield generating activities. Therefore, even where beneficial ownership has not been transferred, it is necessary to work out if the reward is income or capital.
Below is a table summarising the indicators that HMRC note would point towards whether returns/rewards would be capital or revenue (income) in nature. HMRC stress this list is by no means exhaustive, and no single factor is determinative, so it will be a judgement call. It is believed that HMRC expect most rewards to be taxable as income.
Text
Capital Return
Income Return
Return earned by providing a service to the borrower/DeFi lending platform (ie borrower agreeing to pay 5% pa of the principal to a lender over the period of borrowing)
โ€‹
โœ…โ€‹โ€‹
Return known at time agreement made (ie 5% pa)
โ€‹
โœ…โ€‹โ€‹
Return is paid by the borrower/DeFi lending platform to the lender/liquidity provider
โ€‹
โœ…โ€‹โ€‹
Return is paid periodically throughout the period of the lending/staking
โ€‹
โœ…โ€‹โ€‹
The period of the lending is fixed or short-term
โ€‹
โœ…โ€‹โ€‹
Return unknown and speculative at time agreement made (and could result in a loss from the activity)
โœ…โ€‹โ€‹
Return is realised through the disposal of a capital asset
โœ…โ€‹โ€‹
Return realised from the capital growth in value of an asset owned by the lender/liquidity provider
โœ…โ€‹โ€‹
Return is paid upon repayment of the principal as a one-off payment
โœ…โ€‹โ€‹
The period of the lending is indefinite or long-term
โœ…โ€‹โ€‹

Tax treatment

Income rewards

  • Taxable as miscellaneous income when received (based on sterling market value on date of receipt); subject to income tax but not national insurance.
  • Income reward tokens are excluded from the capital gains calculations needed at the time of locking away the principal tokens and at the time the principal is returned.
  • CGT acquisition cost is the sterling market value of the tokens received, at the date of receipt.
  • Income reward tokens are subject to capital gains tax in the future when they are disposed of, based on the appreciation or depreciation in value between acquisition and disposal.

Capital rewards

  • Capital reward tokens are subject to capital gains tax, not income tax.
  • Capital gain is realised on the capital reward upon entry into the yield generating activity (based on estimated present value of the future capital reward) and then re-assessed upon receipt of the capital reward (usually upon exit) based on the value of the reward when received.
  • Upon entry, when the capital reward is subjected to capital gains tax, there is also an acquisition of a โ€˜Marren v Ingles right' to receive a future capital reward. The acquisition cost of this right is the estimated present value of the future capital reward.
  • There is a disposal of this 'Marren v Ingles right' upon receipt of the reward (usually upon exit). The disposal proceeds are the value of the capital reward tokens received and the acquisition cost is the estimate of the future capital reward that was made upon entry. There is a capital gain where the estimation upon entry was too low, or capital loss where is was too high.
  • Acquisition cost of the tokens received as a reward is the sterling market value of the tokens received, at the date of receipt.
  • Reward tokens are subject to capital gains tax in the future when they are disposed of, based on the appreciation or depreciation in value between acquisition and disposal.

How do I work out the taxable capital reward upon entry?

Disposal proceeds included in capital gains calculation upon entry are the taxpayerโ€™s best estimate of present sterling market value of the capital reward to be received in the future.
There is little guidance on how to estimate the present value of the future reward tokens. It is especially difficult to estimate, because the characteristics that are inherent in a capital return include an unascertainable and speculative element, which is possibly related to growth in value.
The Valuation Office Agency work with HMRC on valuations for tax purposes and they offer some guidance on such valuations at Section 8 of their Practice Note 3: โ€œChose in Actionโ€. However this is not regarding cryptoassets, but in the context of land with planning permission.

-> Step 2

After deciding if the reward is income or capital, you need to decide if beneficial ownership of the tokens locked away has been transferred.