The DeFi market TVL sits at more than£40 billion according to DeFi aggregator DeFi Llama, showing that the DeFi boom is far from over. Naturally, HMRC wants its cut in taxes. Just how much exactly? We’ve teamed up with crypto tax calculator Koinly to give you the rundown on all things DeFi tax.
Note: We're only covering DeFi tax in this article, so if you need to learn about the basics, we've got you covered in our Crunch UK Crypto Tax article.
What does HMRC say about DeFi?
HMRC offers extensive guidance on DeFi transactions in their crypto assets guide. However, the guidance is complicated and often lacks the real-world examples needed to show how different protocols are affected, from a tax perspective, so we’ll break it down. But, please bear in mind that this isn’t tax advice and you should always consult with an experienced crypto accountant for advice on your investments and tax liability.
Whether or not crypto cashback is taxable or not depends on the 'nature of the transaction' and whether that transaction has the nature of capital (Capital Gains Tax) or the nature of revenue (Income Tax).
In other words, you need to look at your DeFi transactions and figure out which applies. So if you're making a transaction more akin to a disposal - which is typically a sale or a swap, it's likely your transaction has the nature of capital and would be subject to Capital Gains Tax.
Meanwhile, if you're earning a return, like receiving new tokens or coins on a regular basis, then it's more likely your transaction has the nature of revenue and would be subject to Income Tax.
It's a lot of jargon, so let's take a look at some of the common DeFi transactions including liquidity pools, staking, lending, and yield farming with examples of popular protocols to see what the tax implications might be.
Liquidity pool taxes
Many investors assume that adding and removing liquidity from a pool is not a taxable event - but HMRC is clear that it is.
When you add liquidity to a pool, you'll generally receive a liquidity pool token (LP token) in return. An LP token represents your capital in the pool. Similarly, when you want to remove your capital from the pool, you'll exchange your LP token to do so.
From a tax perspective, this is a crypto-to-crypto trade and therefore a disposal. Your LP token inherits the cost basis of your added capital at the point you added it. It’s worth noting that this guidance is being reviewed under a recent call for evidence from HMRC, and there’s ongoing debate as to whether this should be the correct tax treatment.
As for your rewards for providing liquidity - it all depends on how your protocol pays out rewards. If your LP tokens accrue value - but that value is not realised until you exchange your LP tokens for your original capital - this is more likely to be subject to Capital Gains Tax. Meanwhile, if you earn new tokens in return for your capital, this is more likely to be subject to Income Tax. Even more confusingly, there are some DeFi protocols that actually pay out rewards both through LP tokens that accrue value, and new tokens as an added incentive. So let's take a look at a couple of examples.
Uniswap is a popular decentralised exchange. Uniswap investors are rewarded for providing liquidity to the exchange so that other investors can trade tokens.
When you add liquidity to a given pool on Uniswap, you’ll receive LP token(s) in return, representing your capital in the pool.
In return for providing liquidity, you’ll receive a portion of the transaction fees related to that pool, proportional to your amount of capital in the pool.
Your transaction fees aren’t paid out as new tokens, instead, the value of your LP tokens increases. You’ll only realise a gain at the point you exchange your LP tokens for your assets in the pool.
In this example, and for any other DeFi protocol that works in this way, HMRC would likely view these transactions as having the nature of capital and any gain would be subject to Capital Gains Tax.
Compound is a popular Etheruem-based DeFi lending protocol. When you add liquidity to a Compound pool, you receive LP tokens in return - specifically cTokens.
cTokens accrue value as you receive rewards for having your capital in the pool. Like in our Uniswap example above, when you want your capital back, you’ll exchange your cTokens to do so. So, like above, these transactions are likely to be viewed as a crypto-to-crypto trade, therefore, a disposal in HMRC’s view with gains subject to Capital Gains Tax.
But wait, there’s more! All active Compound users receive COMP tokens as an additional reward. In this instance, you’re earning new tokens which you can claim at any point. As you’re earning new tokens, this would more likely have the nature of revenue and therefore be subject to Income Tax based on the fair market value of your tokens in GBP at the point you receive them.
HMRC has guidance on staking as part of a PoS consensus mechanism and it’s pretty straightforward. Your staking rewards will generally be subject to Income Tax upon receipt based on the fair market value in GBP at the time you receive them. When these tokens are later sold, you’ll need to consider whether there’s Capital Gains Tax to pay in addition to the Income Tax component when receiving the staking rewards.
But when it comes to DeFi staking - it’s not quite so simple. In some instances, the existing guidance on staking will apply, but in other instances, you may have a disposal that would be subject to Capital Gains Tax instead. It all depends on how your protocol works, and whether you’re trading tokens or earning new tokens. Here’s an example.
Sushiswap is a popular decentralized exchange that also offers a litany of yield farming opportunities.
Like with Uniswap, you can add liquidity to pools and receive LP tokens in return - specifically SLP tokens. You can then stake your SLP tokens in farms to earn SUSHI tokens. In this instance, as you’re earning new tokens, it’s likely this transaction has the nature of revenue and would therefore be subject to Income Tax based on the fair market value of your SUSHI tokens in GBP at the point you receive them.
However, another staking transaction on the same platform can work very differently. You can actually stake your SUSHI token at the Sushi bar to earn XSUSHI - a native token that collects a percentage of trading fees from all pools on the exchange. When you stake your SUSHI tokens in this example, you’ll receive XSUSHI tokens in return, and you won’t earn new XSUSHI tokens, instead, they accrue value and it’s only when you unstake your SUSHI tokens by trading your XSUSHI tokens that you’ll realise a gain. So in this instance, this transaction is more likely to be seen as a crypto-to-crypto trade and any gain is subject to Capital Gains Tax.
Lending and borrowing crypto taxes
We’ve already covered this somewhat with our example of Compound above, but HMRC has some specific guidance around DeFi crypto loans worth knowing on top of this for both lenders and borrowers.
For lenders, HMRC says when you loan crypto you make a disposal, regardless of whether or not you receive tokens in return as you no longer retain beneficial ownership of your tokens. Similarly, when you receive your crypto back after loaning it, this is then treated as an acquisition - but any return is not. Like with our examples above, your return may be subject to either Capital Gains Tax or Income Tax depending on the nature of the transaction. So if your protocol utilises LP tokens that accrue value, Capital Gains Tax likely applies, whereas if you receive new tokens, Income Tax likely applies- or indeed both if your protocol pays out rewards in two different ways.
For borrowers, HMRC says loans are treated as an acquisition (like buying crypto) and that any loan interest payments are an allowable expense. When the borrower pays back their loan, this is treated as a disposition, and any gain is subject to Capital Gains Tax.
Yield farming taxes
Yield farming can refer to a huge number of investment activities in the DeFi market - so like in all of the examples we’ve covered above, it depends on the protocol you’re using and how it works.
Broadly speaking, the easiest way to think of it is anytime you’re earning new tokens, these transactions likely have the nature of revenue and therefore will be subject to Income Tax, while any time you’re trading tokens - including LP tokens - these transactions more likely have the nature of capital and therefore will be subject to Capital Gains Tax. For guidance on the DeFi tax you'll pay, check out our guide on paying crypto tax in the UK, or explore our range of online tax calculators.
If you’d like to learn more about UK DeFi tax, check out Koinly’s complete DeFi tax guide.
How to calculate, report and file your DeFi crypto taxes
If you’re an active investor with a lot of DeFi investments, calculating your crypto taxes is time-consuming - but not with Crunch and Koinly.
Our crypto tax partner, Koinly, can help you calculate your crypto taxes in a fraction of the time - including complicated DeFi transactions - and generate your HMRC crypto tax report, ready to hand over to your Crunch accountant.
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