Taxation of Decentralized Finance

No matter how decentralized the web3 space is, HMRC pays a lot of attention to transactions happening in the world of DeFi. That is why, as a user of such apps as Aave, Uniswap, or GMX, you still need to declare your crypto profits and account for the tax with the UK authorities.

But don’t worry! As a helping hand in crypto taxes, we’ll examine what charges apply to DeFi and explain how they should be settled with HMRC.

What is Decentralized Finance (DeFi)?

In the summer of 2020, a new trend caught the attention of web3 enthusiasts. Crypto projects started to reproduce various financial services we know from the “real world” – lending companies, exchanges, derivatives – but in a decentralized manner. Users, investors, and people passionate about blockchain technology quickly got involved in the so-called DeFi (decentralized finance) space. Attracted by not only profit and high yields but also the vision of more equal and accessible financial services.

Now, after almost three years, we can confidently perceive DeFi as a long-time trend and a valuable alternative to the centralized and complicated world of traditional finance. And even if some of the “big names” of the 2020 DeFi summer failed to succeed, most of them are still used by web3 enthusiasts. With a great prospect of attracting more people from outside the crypto world in the near future.

Decentralized Finance applications

As we mentioned, DeFi apps very much resemble traditional financial services we know. However, they utilize blockchain technology and smart contracts to make them decentralized and leave the control of assets in users’ hands.

The most popular examples of DeFi apps (so-called dApps) – web3 wallets and decentralized exchanges – rely exactly on these two features. However, it’s only the tip of the iceberg when it comes to DeFi space’s offerings. The world of decentralized applications also includes such projects as:

• Crypto lending platforms,
• Yield farming protocols,
• DAOs,
• Staking platforms,
• Stablecoins,
• Derivatives,
• Prediction markets,
• Liquidity pools.

DeFi regulations – crypto tax in the UK

As cryptocurrencies serve as financial instruments, HMRC pays much attention to tax rules related to the crypto space. No matter if we are discussing centralized or decentralized applications, there are specific taxable events that force web3 users to report their incomes and capital gains.

In the following paragraphs, we’ll examine how UK crypto taxes apply to different DeFi activities.

DeFi taxation – liquidity pools

Adding liquidity to various token pools is essential for the entire DeFi space. Thanks to such activities, decentralized services can work in a convenient and secure manner.

Therefore, DeFi protocols need to encourage web3 users to lock their tokens in their pools – usually using financial incentives. And depending on the type of such encouragement, different taxes will be applied:

1. When you’re not receiving new tokens in exchange for liquidity providing. In this case, you earn money only thanks to the increasing value of the cryptocurrency you deposited. Therefore, your profit (if you decide to withdraw the token and sell it) will be seen as a “capital in nature” and become subject to UK Capital Gain Tax.
2. When you receive tokens in exchange for liquidity providing. In this situation, your gains will be subject to UK Income Tax. However, please remember that your only profit is the percentage of the tokens you earned due to the liquidity providing – not the entire stake.

DeFi taxation – trading and derivatives

DeFi obviously enables various trading operations (including the ones that use derivatives) similar to those performed through centralized exchanges. And even though activities on platforms like dYdX or GMX are done in a decentralized manner, still every profit gained on them should be reported to HMRC. In such cases, the taxable event occurs not at the time of trading but at the time of disposal (realized gain).

Usually, you’ll have to pay UK Income Tax in such circumstances. However, if your trading becomes extensive and resembles business activities, HMRC can perceive it as subject to UK Capital Gains Tax.

DeFi taxation – decentralized lending

In DeFi, you can also become the lender of cryptoassets (feel free to read more about this strategy in our Crypto Loan. Such activities may result in obtaining a valuable source of passive income, which, on the one hand, provides you with additional funds but, on the other, makes your earnings subject to UK crypto taxes.

Decentralized lending taxation also depends on whether the profit realized on such activities was perceived as an income or a capital gain. There are multiple factors that are taken into account, including:

• whether the potential revenue was known before the loan;
• whether the loan period is short or long-term;
• whether the return was realized at the time of disposal;
• whether the return is paid multiple times during the lending period or one time.

As you can see, decentralized lending is a very complex topic from the taxation point of view. As every such activity is very individual, we advise you to discuss your situation with a tax advisor specialized in crypto.

DeFi taxation – decentralized borrowing

Crypto lending platforms allow you to borrow tokens as well. In this case, the HMRC’s interpretation is very straightforward – as you don’t receive any income or increase your capital, you won’t be subject to any UK crypto taxes.

Moreover, if you need to deposit collateral to borrow crypto, it also won’t be perceived as a taxable event.

DeFi taxation – staking

You may have heard that tax institutions from all over the world are considering treating every reward from staking as a taxable event. It’d mean that you’d have to pay Income Tax each time the reward from staking is transferred to your web3 wallet (e.g., every day).

Fortunately, such ideas haven’t been put into practice (yet). However, profits from staking still need to be reported to HMRC – although only when you decide to dispose of them (sell or exchange for another token). In this case, you should apply UK Income Tax to the profit earned on staking.

DeFi taxation – wrapped tokens

While moving around the DeFi space, you’ll often have to “wrap” your tokes to perform certain activities. It’s a consequence of the lack of interoperability between various DeFi protocols – something that is likely to change in the near future.

However, for now, if you want to, for example, buy Ethereum using Bitcoin on one of the decentralized exchanges, you’ll first have to wrap your BTC. This way, your BTC will be exchanged for its representation on the Ethereum network (as BTC is not an Ethereum-based token), making it perfectly convertible to other Ethereum tokens (such as ETH itself).

Such activities are not seen as taxable events by HMRC. However, as it’s a crypto-to-crypto exchange, it’s wise to declare and report it to UK tax authorities.

DeFi taxation – yield farming

Yield farming refers to a bunch of various investment strategies rather than a single taxable event. Therefore, activities that fall into this category (mostly related to adding liquidity to cryptocurrency pools) should be analyzed separately – to determine whether the tax should be applied.

However, as yield farming is focused specifically on… earning yield, such investments will likely be subject to Income Tax.

DeFi and tax avoidance

Even though the current UK crypto tax regulations are relatively new and still yet to be finalized, HMRC focuses very much on enforcing them. Therefore, DeFi tax avoidance is definitely not a good way of increasing crypto savings.

UK authorities are not only able to track transactions on centralized exchanges and non-custodial wallets. They can also easily connect KYC accounts assigned to you with activities done on your self-custody wallet (connected to DeFi protocols). Then, no matter if we’re discussing centralized or decentralized finance, HMRC can spot nearly every taxable event.

We strongly advise you against any kind of DeFi tax avoidance. Especially since you can use crypto tax software to make your life much, much easier. Check out Cryptiony free trial and make filling your cryptocurrency taxes stress-free!