Collateral — The Critical Question
Is posting collateral a disposal? The answer depends entirely on the protocol. Learn the test and what happens on liquidation.
Collateral — The Critical Question
This is the section most relevant to users of Aave, Compound, MakerDAO, and similar protocols where you must post collateral to borrow.
The Test: Is Posting Collateral a Disposal?
The answer depends entirely on the protocol's terms and smart contract behaviour:
| Condition | Indicator | Tax Result |
|---|---|---|
| Protocol can deal freely with collateral tokens (re-lend them, use them) | Protocol has acquired beneficial ownership | Disposal — CGT event at deposit |
| Protocol cannot deal with collateral tokens (locked in smart contract, ring-fenced) | Borrower retains beneficial ownership | No disposal — no CGT event |
If Collateral IS a Disposal
- At deposit: Disposal at market value → compute gain/loss as normal.
- At withdrawal: New acquisition at market value.
- If liquidated: No additional CGT consequence (already disposed of at step 1).
If Collateral is NOT a Disposal
- At deposit: No CGT event.
- At withdrawal: No CGT event.
- If liquidated: s.26(2) TCGA 1992 applies — the protocol acts as nominee. The disposal by the protocol is treated as a disposal by the borrower. Gain/loss computed at market value at time of liquidation.
Liquidation Penalties
If a DeFi protocol takes an extra portion of collateral as a liquidation penalty (common on Aave — typically 5–10% bonus to the liquidator):
- The tokens taken as penalty do NOT qualify as allowable expenditure under s.38 TCGA 1992.
- The borrower cannot deduct the penalty amount from their gain calculation.
- The penalty is effectively a dead loss with no tax relief.
This is a harsh outcome. If you are liquidated and the protocol takes a 10% penalty, you lose those tokens and get no tax benefit for the loss.
HMRC's Own Words
HMRC guidance at CRYPTO61640 states:
"Where, under their terms and conditions, a DeFi lending platform is allowed to deal as it wishes with the tokens received as collateral, this will be a strong indicator that the DeFi lending platform has acquired the beneficial ownership of those tokens."
"Conversely if the DeFi lending platform is specifically restricted from dealing with the tokens received as collateral, this will be a strong indicator that the DeFi lending platform has not acquired beneficial ownership of those tokens."
HMRC CRYPTO61640 — Collateral (Chargeable Gains).
TCGA 1992, s.26(2) — Nominee holdings.
TCGA 1992, s.38(2) — Restrictive list of allowable expenditure.
Explain Like I'm 5
Imagine you leave your favourite toy at the shop as a promise while you borrow something else. If the shop locks your toy in a safe and cannot touch it, you still own it. But if the shop can play with your toy or lend it out, then it is like you gave it away. And if the shop has to sell your toy because you did not pay back in time, you lose it and you cannot even tell the government it was unfair.
Key Takeaways
- Whether posting collateral is a disposal depends on whether the protocol can deal freely with your tokens.
- If the protocol locks tokens and cannot re-use them → no disposal (most common for Aave V3).
- If the protocol can re-lend your collateral → disposal at market value on deposit.
- On liquidation where no prior disposal, s.26(2) treats the protocol as nominee — you are deemed to have disposed.
- Liquidation penalties (e.g. Aave's 5–10%) are NOT deductible — a dead loss with no tax relief.
Educational only - not financial advice