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The taxation of digital assets used for lending and borrowing would benefit from clear-sighted guidelines.
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Why crypto treads an uncertain path through tax minefield
02 February 2024
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The ATO has not released much formal (binding) guidance on the taxation treatment of crypto assets and continues to slowly publish general (non-binding) advice via its website. Additionally, the BoT’s report following its review into the appropriate policy framework for the taxation of digital assets was delayed beyond December 2022 and is now due by 29 February 2024.
Against this backdrop, the ATO has recently published some new informal guidance on its website concerning the tax treatment of lending and borrowing with decentralised finance (DeFi) with a focus on liquidity pools.
DeFi and liquidity pools
DeFi is a blockchain-based form of finance that does not rely on a financial intermediary. Instead, it is peer-to-peer with many apps, protocols and platforms commonly built on the Ethereum blockchain.
A liquidity pool is an arrangement whereby crypto assets are gathered and “locked” in place with a smart contract. The use of liquidity pools facilitates decentralised lending and adds liquidity to crypto asset trading.
A lender provides crypto assets to the liquidity pool for use by the DeFi protocol and typically receives new crypto assets as compensation (generated from transaction fees and often described as “interest”).
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Tax treatment
Crypto lenders typically understand that the market value of the interest they receive is taxable. What they may find alarming is that the ATO also considers that the mere act of depositing (lending) the crypto assets into a liquidity pool amounts to a disposal of the crypto asset, thereby triggering CGT event A1.
CGT event A1 occurs because, in the ATO’s view, depositing the crypto asset into a liquidity pool results in a change in beneficial ownership.
Whether or not investing (depositing) into a particular liquidity pool results in the lender relinquishing (and so transferring) beneficial ownership of the crypto asset will depend on the precise terms of the underlying protocol. Retaining a right to withdraw will not necessarily mean the depositor has retained beneficial ownership.
If the lender only has a contractual right to withdraw the deposited asset, then beneficial ownership will most likely have transferred. On the other hand, if, for example, a “trust relationship” is established, it may be possible that the depositor has retained beneficial ownership.
The creation of a trust relationship does not necessarily mean that there has been no change in beneficial ownership. The High Court has held that the trustee of a unit trust – and not the beneficiaries of that trust – holds the beneficial ownership of trust assets. However, the types of trusts to which the High Court was referring can be distinguished from other trust relationships such as a special type of trust known as a bare trust, where the beneficiary – and not the trustee – will continue to hold beneficial ownership of the trust’s assets.
The existence of a bare trust may be incompatible with the commercial reality of a DeFi protocol, which may require all the deposited assets to be mixed. Given the assets are homogenous and fungible, depositors may otherwise be indifferent as to whether the assets are mixed and so whether their subsequent withdrawal contains the exact same assets they deposited or merely equivalent ones (like depositing $20 in a bank account and then withdrawing another $20 note). In this respect, the mixing of the assets may not only reveal the lack of a bare trust arrangement but may also help explain the risk profile of the investment.
Other arrangements may fall short of transferring beneficial ownership and should not trigger CGT event A1, such as where the crypto assets are merely offered as collateral.
Interest-earning bank account
As alluded to above, the analogy of a bank account may not assist crypto liquidity pool investors. Technically, depositing funds into a bank account would trigger CGT event A1 but for the Commissioner’s indulgence in Taxation Determination TD 2002/25, where he states that he does not regard Australian currency as a CGT asset to the extent it is used as legal tender to facilitate a transaction. Without that indulgence, there would – arguably – be a disposal of the notes and coins (a change in beneficial ownership) in exchange for a new asset, being the chose in action/bank account. Crypto assets will not attract this indulgence as they are not Australian currency being used as legal tender.
Foreign currency
Foreign currencies have their own regime and so are typically taxed outside of the CGT regime. Yet the Commissioner has never accepted that cryptocurrencies are a foreign currency, and that position has since been enshrined in legislation.
In ATO ID 2003/551, the Commissioner states that the definition of a CGT asset includes a bank account denominated in foreign currency. Depositing foreign currency into that account increases its cost base, and withdrawing the foreign currency triggers CGT event C2 from a cancellation of part of the debt owing under that chose in action/bank account.
Takeaway
There is limited formal ATO guidance to help crypto users and their advisers understand the taxation consequence of various DeFi (and other crypto) arrangements.
The ultimate tax position will depend on the particular terms of the protocol and what rights and obligations they confer on the parties.
The BoT is due to release its report this month, which will hopefully pave the way for important legislative reform so that crypto assets are not taxed any more harshly than more traditional financial assets.
In the meantime, crypto users and creators need to ensure that they obtain advice on the taxation ramifications of their crypto arrangements. As the above analysis shows, the legal position and the corresponding taxation implications are not straightforward.
Jeremy Makowski is a partner at Coghlan Duffy Lawyers.
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