Decentralised Finance (DeFi) is an increasingly popular area of the crypto world. With DeFi market trading volume currently around $90 billion, it’s no wonder HMRC are reminding crypto users of their tax obligations. But how do DeFi taxes work? In this article, Recap, our crypto tax software partner, explains the complexities including deciding when DeFi transactions are capital or income in nature and what beneficial ownership means.     

What is DeFi? 

DeFi refers to financial services built on blockchain technology, enabling peer-to-peer transactions without traditional intermediaries like banks. Using platforms like Ethereum and Solana you can lend, borrow, trade, and invest in digital assets directly with other people through smart contracts.

What does HMRC say about DeFi?

HMRC published their first crypto guidance, the “Cryptoassets Manual” in 2018 - and years later released ‘Decentralised Finance: Lending and Staking’ to clarify the tax treatment of DeFi. Even though this guidance didn’t arrive till 2022, it applies to all prior transactions - not just those made after its release. 

The guidance confirms that DeFi may be subject to capital gains or income tax depending on whether the transaction is capital or revenue in nature. Additionally, when participating in lending, staking or liquidity pools you need to consider whether capital gains applies to the token when entering and exiting. 

Income tax for DeFi

When earning rewards, they will likely be subject to income tax and should be reported as Miscellaneous Income on your tax return (or trading income, if you are classed as a financial trader).

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Capital gains tax for DeFi

Normal capital gains tax rules apply when you dispose of crypto on a decentralised exchange. Additionally, where a change in beneficial ownership takes place the following DeFi transactions might also be subject to capital gains tax:

• Entering/ exiting a liquidity pool
• Lending cryptoassets
• Depositing crypto as collateral for a loan
• Staking cryptoassets

Confused? That’s understandable! HMRC’s DeFi guidance is extremely complex and difficult to apply to real life scenarios. The tax treatment often depends on the mechanics and T&C’s of the protocol you’re using and the type of activity, making it really difficult to calculate your tax liability. You need to consider:

1. Is the reward income or capital?

This depends on the structure of the transaction and how the return is earned and received. As a general guide:

• The reward is income in nature, when earned by providing a service and paid by the platform periodically at a known/agreed rate over a fixed or short term.
• The reward is capital in nature, when realised by the speculative increase in value of an asset owned by the provider over a long term.

2. Is beneficial ownership transferred?

Can be understood by examining the T&Cs for the activity. If you still have control of the token, it’s a strong indicator that you retain BO, where you are restricted it suggests that BO has transferred.

3. The tax treatment if you are the borrower or staker/ lender/ collateral provider.   

Using the decisions for 1 & 2 you can work out the tax treatment - various scenarios can play out here so take a look at Recap’s technical guide or get help from a professional. 

ℹ HMRC’s DeFi guidance was met with criticism from the crypto industry and there has been a call for evidence. We’re still waiting for the outcome, but remain optimistic that there will be positive change.  

Below we look at the tax implications for different types of DeFi activity with some examples. Please bear in mind that this is not tax advice and may not be the appropriate treatment for your circumstance - you should seek help from a tax professional for specific support.  

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Liquidity pool taxes 

In DeFi, users can provide liquidity by depositing their crypto tokens into a pool governed by smart contracts, these contracts automate the trading process matching buyers and sellers. When you add your crypto to a pool, you normally get rewarded with LP tokens. Then, when the pool helps with a trade, you get a slice of the fees collected, based on how much you contributed. Protocols like Uniswap and Compound offer liquidity pools based on different blockchains like Ethereum and Polygon.

The tax on your liquidity pool rewards depends on the nature of the reward - capital or income. Generally, short term rewards that are paid periodically will be subject to income tax and rewards that are realised through the growth of an asset’s value over time are capital. Protocols which reward you with both new tokens and LP tokens that increase in value complicate the tax consequences even further!

Additionally, often overlooked by taxpayers, HMRC’s guidance confirms that if you lose beneficial ownership of your tokens, you may have a tax liability when entering and exiting a liquidity pool. Let’s break this down from a tax perspective:

• When you add liquidity to a pool, you lock a way the principal token and receive an LP tokensome text
  • Disposal of the principal token
  • Acquisition of the LP token
• When you remove capital from the pool, you reacquire the principal token and dispose of the LP tokensome text
  • Acquisition of the principal token
  • Disposal of the LP token      

Example: Uniswap Liquidity Pool Tax 

When you add liquidity to a pool on Uniswap, you receive LP tokens in return and you’ll receive a portion of the transaction fees related to that pool. These rewards are not paid out as new tokens, instead, the value of your LP tokens increases. This means when you enter and exit the pool you need to consider the capital gains position. On entry, you need to calculate any gain on the disposal of the prinicipal token and on exit - exchanging your LP tokens for your principal token, you’ll realise a gain (or loss) on their increased (or decreased) value. 

Example: Compound Liquidity Pool Tax

When you add liquidity to a pool on Compound, you receive cTokens, which accrue in value as you receive rewards. As this reward is capital in nature, it is likely you will be subject to capital gains tax on entering and exiting the pool. Compound users also receive COMP tokens as an additional reward - these new tokens likely have the nature of income and may therefore be subject to Income Tax based on the fair market value when received.

Taxes on Lending Crypto

Like with liquidity pools, capital gains or income tax may apply to lending crypto on decentralised platforms depending on the nature of the reward and if there is a change in beneficial ownership. It all comes down to the protocols and terms. 

If you decide your lending rewards are income in nature, they will be taxed as miscellaneous income based on their sterling value on the date receivable. If capital in nature, then you realise a gain on the reward at the point of loaning out the token, based on its estimated value. This is then reassessed when the capital reward is received.

When loaning out and receiving repayment, you need to consider the capital gains tax position - this depends on whether beneficial ownership changes. 

Tax when Borrowing Crypto

Tax for borrowers is much easier to understand! When the loan is received there is an acquisition of the tokens at their sterling market value. When the loan is repaid it is treated as a disposal subject to capital gains tax. Remember there may be further taxable events depending on how the loan is used. 

Staking Taxes

Stakers earn rewards when locking up (staking) crypto in a blockchain network. Again, when staking cryptocurrency you could be subject to capital gains or income tax depending on the nature of the reward and beneficial ownership.

If the staking reward is classed as income in nature, then its taxed as miscellaneous income. When capital, the gain is realised at the time of staking, based on the estimated present value of the future reward and this is assessed when received. 

At the time of staking and receiving the staking reward you also need to understand if there is a change in beneficial ownership - this may differ depending on the platform. If you lose beneficial ownership then you will need to consider capital gains. 

Key Takeaways 

DeFi taxes are complex because the tax treatment depends on the mechanisms of the protocol and activity you are engaging in. You need to consider the nature of the reward and whether beneficial ownership is transferred and there are multiple tax consequences based on those factors. Very generally, if you do not lose beneficial ownership of your asset and earn new tokens then your rewards will likely be subject to income tax. When beneficial ownership transfers and you earn rewards through the increasing growth of an asset, it's likely you need to consider capital gains. 

HMRC DeFi guidance is vague and not really fit for purpose. Although it is currently being reviewed and we hope to see change, it’s important to comply with current tax rules.

Navigating DeFi tax calculations and reporting can be tricky which is why tools like Recap and professional tax assistance are essential to submitting an accurate tax return. To start calculating your crypto taxes head to recap.io and connect your exchanges and wallets. You can also reach out to Crunch’s team for tax advice.

The information provided in this article is for general informational purposes only and should not be construed as financial or tax advice. We recommend consulting with a qualified tax advisor or financial professional who can provide personalised advice tailored to your specific circumstances.