Taxation of Cryptocurrencies in the UK：Cutting-edge Practices and Reflections

1 Introduction

The development of cryptocurrencies has brought not only innovation and opportunities but also challenges and risks. In the field of taxation, the complexity and diversity of cryptocurrencies present new challenges and requirements for tax management. As one of the global leaders in financial technology, the UK plays a significant role in demonstrating cryptocurrency taxation policies to other countries. Meanwhile, the UK's reforms in cryptocurrency taxation are at the forefront of the world and deserve the attention of investors. This article will analyze the basics, current status, and future prospects of cryptocurrency taxation in the UK, exploring the development trends and challenges of cryptocurrency taxation in the country.

2 Basics: Overview of the UK General Tax System

Taxation in the UK is mainly administered and managed by Her Majesty's Revenue and Customs (HMRC). The types of taxes include income tax, property tax, capital gains tax, inheritance tax, and value-added tax, among others. Among them, income tax, capital gains tax, and inheritance tax are progressive taxes levied based on taxpayers' income levels, while property tax and value-added tax are proportional taxes levied at fixed rates.

2.1 Direct Taxes: Income Tax and Capital Gains Tax

Income tax is a direct tax levied on various sources of income for taxpayers. Taxable income includes salary, interest, dividends, rent, pensions, welfare, etc., but not all income is subject to income tax. For example, interest from Individual Savings Accounts (ISA) and National Savings Certificates (NSC), winnings from lotteries and premium bonds, and rental income (if below £7,500 annually) are exempt from income tax.

In the UK, there is a basic tax-free allowance called the Personal Allowance for each taxpayer before they start paying income tax. For the 2022-23 tax year, the Personal Allowance is £12,570, and any income exceeding this amount is subject to different income tax rates in different tax brackets. In England, Wales, and Northern Ireland, there are four income tax bands: the Starter Rate, Basic Rate, Higher Rate, and Additional Rate, whereas Scotland has five income tax bands.

Capital Gains Tax (CGT) is a tax levied on the profits obtained by individual UK residents from selling or transferring assets. The CGT rate depends on the individual's applicable income tax rate and the type of asset sold, with a certain tax-free allowance. If the individual's income tax applies at a higher or additional rate, the capital gains tax on residential property is 28%, while for other assets, it is 20%; if the individual's income tax applies at the basic rate, the capital gains tax on residential property is 18%, and for other assets, it is 10%. For the 2021/2022 tax year, the tax-free allowance for capital gains tax is £12,300.

UK Corporation Tax is a direct tax levied on the income and capital gains of companies or other legal entities engaged in business activities. This includes the capital gains realized when a company sells or transfers assets within the scope of corporation tax. Historically, the corporation tax had a single unified rate of 19%. However, from April 1, 2023, to increase revenue and encourage the development of small businesses, the UK government has introduced a new corporation tax plan: companies with profits over £250,000 will pay 25% corporation tax, companies with profits below £50,000 will continue to pay 19% corporation tax, and companies with profits between £50,000 and £250,000 will pay corporation tax on a marginal incremental basis.

2.2 Indirect Taxes: Property Tax and Value-Added Tax

There is no specific tax called "property tax" in the UK. However, there are two forms of indirect taxes related to properties and land: the Council Tax for residential properties and the Business Rates for commercial properties. These are local charges levied for residential or commercial properties to fund local government-provided services such as education, healthcare, waste disposal, road maintenance, and traffic management.

Value-Added Tax (VAT) is an indirect tax levied on the value added to goods and services during their production and sale. In the UK, there are three different VAT rates: the Standard Rate (20%), the Reduced Rate (5%), and the Zero Rate (0%). Different types of goods and services are subject to different VAT rates. For example, food, children's products, newspapers, etc., are subject to the zero rate, while the vast majority of goods and services are subject to the standard rate.

3 Current Status: Analysis of Cryptocurrency Taxation in the UK

3.1 Overview of the History of UK Cryptocurrency Taxation

The UK is one of the largest financial centers in Europe and an important participant in the global cryptocurrency market. However, the UK's taxation policies on cryptocurrencies were not initially clear and unified but underwent multiple revisions based on the rapid development of the cryptocurrency space.

Initial Exploration: 2014-2018

In 2014, Her Majesty's Revenue and Customs (HMRC) issued the first guidance on cryptocurrency taxation, covering three types of cryptocurrencies: exchange tokens, utility tokens, and security tokens, placing the UK at the forefront among EU countries at that time. The guidance stated that cryptocurrencies are not currencies or money substitutes but assets, and, therefore, existing tax frameworks apply. The guidance also outlined the basic principles and methods for income tax and capital gains tax on cryptocurrencies.

Mining income is not subject to VAT.

Gains and losses from holding and selling virtual currency are treated as gains and losses on other commodities or currencies.

Digital currencies purchased and held for personal reasons, not for speculative purposes, are not taxed.

VAT should be paid when cryptocurrency is sold as goods or services.

In 2018, the UK government established the Cryptoassets Taskforce to research and assess the impact and potential of cryptocurrencies and proposed a series of action intentions.

Refining Rules: 2019-2021

During this stage, HMRC issued the second, third, and fourth guidance on cryptocurrency taxation, continuing to classify cryptocurrencies according to the Cryptoassets Taskforce's report and providing more detailed and specific tax rules for utility tokens, security tokens, cryptocurrency businesses, mining, and staking, among others. Businesses engaged in cryptocurrency activities were required to keep records of all relevant information and determine their value and profits based on relevant accounting standards.

Responding to DeFi: From 2022 to Present

In this stage, HMRC issued the fifth guidance on cryptocurrency taxation, primarily focused on decentralized finance (DeFi). The UK Treasury released two consultation papers in 2022 and 2023, seeking opinions on the tax treatment of changing DeFi lending and staking and proposing corresponding legislative measures to standardize and regulate DeFi.

3.2 Tax Collection Methods for Cryptocurrencies in the UK

Due to the common law tradition and the flexibility of cryptocurrencies, the UK government has not chosen to create a separate set of cryptocurrency tax laws but instead incorporates them into existing tax frameworks based on the nature and use of cryptocurrencies. The main taxes applied to cryptocurrencies are income tax and capital gains tax. The methods of collecting these taxes are the same as for other types of income and assets. Taxpayers need to calculate their income and profits from cryptocurrencies for each fiscal year and declare them on the appropriate tax forms. The UK also provides certain tax-free allowances or reliefs, such as the Personal Allowance, Individual Savings Accounts (ISA) allowances, Annual Exempt Amount, among others.

In addition to income tax and capital gains tax, the UK may also levy other types of taxes on cryptocurrencies, such as value-added tax, stamp duty, stamp duty reserve tax, and stamp duty land tax. The application of these taxes depends on whether cryptocurrencies are involved in goods, services, securities, or land transactions. If cryptocurrencies are used as consideration for the purchase or transfer of land or buildings, then the stamp duty land tax is calculated based on the definition of "money or money's worth." However, for the other three types of taxes, the situation varies. Utility tokens and security tokens need to be assessed based on their specific characteristics and use to determine whether VAT, stamp duty, or stamp duty reserve tax should be paid, while exchange tokens are not considered commodities, services, shares, marketable securities, or chargeable securities, so they are not subject to these three types of taxes.

As the UK currency is de-pegged from the EU, taxpayers must convert cryptocurrency transactions into pounds sterling for tax calculations. HMRC specifies that the exchange rate used for conversion should be the fair market value at the time of the transaction or the closest to it. Taxpayers can use exchange rates provided by any reliable sources such as cryptocurrency trading platforms or brokers.

4 Future: Further Improvement of DeFi Taxation

4.1 Overview of the Second Consultation on DeFi

The UK government's current policy focus is primarily on DeFi tax regulation. In the second consultation paper, the UK government defines DeFi as "decentralized platforms or protocols that use cryptocurrency, smart contracts, and distributed ledger technology to provide financial services. DeFi encompasses a range of activities such as lending, staking, trading, insurance, etc., aiming to offer alternatives or supplements to traditional financial services. A key feature of DeFi is that it does not rely on any intermediaries or trusted parties but achieves automation and security through algorithms and code."

In the existing cryptocurrency tax system, the treatment of DeFi lending and staking activities is overly complex. Taxpayers need to record the details of each DeFi staking/lending transaction, including the type, quantity, value, time, source, and purpose of the cryptocurrency, and calculate and declare taxes based on different tax types and rules. Furthermore, the taxation treatment of DeFi lending and staking activities may lead to double taxation issues due to the nature of these transactions. Therefore, the UK government seeks to simplify and standardize the taxation treatment of DeFi staking/lending activities through a reform plan to better reflect their economic essence and reduce administrative burdens on taxpayers. The reform plan includes the following elements:

Cryptocurrencies used in DeFi transactions will no longer be treated as disposed for tax purposes but only when they are economically disposed in non-DeFi transactions. This approach will avoid double taxation of the same cryptocurrency and simplify taxpayers' record-keeping and reporting obligations.

All DeFi income will be treated as miscellaneous income and counted towards a new miscellaneous income allowance specifically for cryptocurrency transactions. This will unify the tax treatment of different types of tokens and eliminate the need to distinguish between trading and non-trading activities.

The new miscellaneous income allowance will apply to both individuals and corporations, subject to the corresponding income tax or corporation tax rates. This will maintain fair competition between individuals and businesses and keep consistency with the existing tax framework.

The new miscellaneous income allowance will allow taxpayers to offset costs and losses related to DeFi transactions, but it will not permit offsetting or transferring losses against other types of income or profits. This will reflect the reality of DeFi transactions and prevent potential abuse or avoidance.

The UK government considers that the economic essence of DeFi lending and staking is similar to repurchase agreements, as users do not relinquish their economic interest in cryptocurrencies in DeFi transactions but only temporarily transfer ownership or control. Therefore, the UK government intends to treat DeFi lending and staking as repurchase agreements, thus excluding them from tax disposal, meaning that users will not incur gains or losses in DeFi transactions. Instead, gains or losses will only occur when users economically dispose of cryptocurrencies in non-DeFi transactions (e.g., selling, exchanging, or gifting), calculated based on the market value.

4.2 Responses to the DeFi Reforms

Representative organization of the UK cryptocurrency asset community, Bitcoin Policy UK (BPUK), expressed support for the government's objectives in developing a tax framework for DeFi. They believe that this will help the UK become a global leader in financial technology and provide taxpayers with greater certainty. BPUK supports the government's view that DeFi lending/staking transactions should be treated as repurchase agreements and suggests allowing taxpayers to choose whether the new rules apply to their past DeFi transactions to avoid double taxation or unfair outcomes.

However, there are also differing opinions regarding the treatment of DeFi lending/staking transactions as repurchase agreements. The Institute of Chartered Accountants in England and Wales (ICAEW) stated in its response on June 23, of this year that it supports the government's objectives in developing a tax framework for DeFi and hopes that the government will further study the broader cryptocurrency market's tax issues. ICAEW further believes that the No Gain/No Loss (NG/NL) rule is more easily applicable to the majority of DeFi market situations than treating DeFi transactions as repurchase agreements, as it is more convenient for taxpayers and has a wider coverage of DeFi transactions. DeFi Education Fund also expressed in their response on the same day that treating DeFi transactions as repurchase agreements will result in unfair and unreasonable tax treatment, as well as administrative complexity and difficulties. They recommended that HMRC should develop a simpler, clearer, consistent, and fairer tax framework to accommodate the complexity and diversity of DeFi transactions.

5 Possible Ways to Improve DeFi Taxation

Overall, the UK government's regulatory attitude towards DeFi is positive and cautious, acknowledging the innovation and potential of DeFi while also recognizing its risks and challenges. The UK government will determine the need for regulation based on the specific circumstances of DeFi and adopt appropriate regulatory measures, following principles such as protecting consumers and investors, promoting market competition, maintaining market stability, and preventing market abuse. The UK government will also continue to monitor new technologies and models in the DeFi space and make corresponding regulatory adjustments and updates.

Regarding the treatment of DeFi lending/staking transactions as repurchase agreements, after considering various institutional opinions, this article believes that the UK government may reassess the plan to treat DeFi lending and staking as repurchase agreements and make adjustments and modifications based on market feedback and actual circumstances. The UK government may seek a balance between protecting consumers and investors, promoting market competition, maintaining market stability, and preventing market abuse, allowing DeFi more flexibility and space. In this regard, the UK government may consider the applicability of the NG/NL rule.

In conclusion, the development trend of cryptocurrencies in the UK is characterized by regulation, innovation, and cooperation. This presents both opportunities and challenges for participants in the cryptocurrency field, acting as both incentives and constraints.