Welcome to our expert DeFi tax guide for UK residents! Whether you’re a seasoned DeFi investor or just getting started, it’s essential to understand how these innovative financial instruments are taxed in the UK.
In this guide, we’ll break down how HMRC taxes various decentralised finance activities, such as yield farming, staking, and trading. So, let’s dive in and learn how to stay compliant while participating in the exciting and rapidly expanding DeFi space.
What is Decentralized Finance?
Decentralized Finance (DeFi) uses the benefits of cryptocurrencies, blockchain technology, and smart contracts to provide geographically unlimited access to financial services such as crypto trading, loans, and deposits. The DeFi infrastructure consists of decentralized applications (DApps) and decentralized exchanges (DEXs) as the main platforms for offering decentralized financial services.
DeFi protocols eliminate the need for an intermediary, like a bank, to manage financial processes. Such autonomous operation is possible thanks to smart contracts, or automated protocols that run on a blockchain.
How is DeFi Taxed?
HMRC’s crypto-assets Manual offers guidance on the taxation of cryptocurrencies in the United Kingdom. The Crypto61000 section details the tax treatment of crypto assets you dispose of, whether by selling, gifting, exchanging, or using them to buy goods or services. The tax implications vary depending on the nature of the disposal and whether it resulted in a gain or a loss. Accurately calculating the gain or loss is critical, and different tax rules apply depending on whether the crypto asset is a personal possession or an investment asset.
While HMRC have issued some guidance on DeFi, more direction is needed and expected soon. For Defi taxes, the most important factor to consider is the “nature of the transaction” and whether it’s capital- or revenue-based. Depending on whether a transaction has the form of capital or income, your DeFi transactions may be subject to Capital Gains Tax (CGT) or Income Tax.
Crypto Capital Gains Taxes
Capital Gains Tax (CGT) is applied to the profit from selling an asset, including DeFi transactions. If you purchased a digital asset and sold it at a profit, the profit amount would be subject to CGT. Note that CGT is only applied to the gain made and not the total proceeds of the sale.
Let’s break it down with an example. Suppose you purchased one Bitcoin for £20,000 and sold it for £35,000. Your capital gain, in this case, would be £15,000, and you’d be liable to pay tax on this gain based on your capital gains tax rate.
The CGT rate that you’ll be charged depends on how much income you earn as an individual. In short:
- If your income was less than £50,270 – you will pay 10% on your crypto gains
- If your income was more than £50,270 – you will pay 20% on your crypto gains
Tax-Free Allowance on Crypto Gains
For the 2022-2023 tax year, HM Revenue and Customs (HMRC) have set the tax-free allowance for capital gains at £12,570. However, for the 2023/2024 tax year, individuals will only have a £6,000 capital gains tax allowance.
Crypto Income Tax
Income tax applies to any gain earned from activities such as staking and mining. This differs from CGT as it doesn’t apply to selling or swapping your assets but to the rewards you receive from them.
Cryptocurrency income can take many forms and names. For many of these, you may not find specific HMRC guidance but here is a helpful rule of thumb. If you open your wallet (or exchange account) and have more crypto there than you had before, the new assets are taxed as ordinary income based on their value when you first obtained control of the coins.
Tax-free Allowance for Crypto Income
The UK’s regular allowance for personal taxation, or income exempt from tax, is £12,570. Nonetheless, if your taxable income exceeds £125,140, you are not entitled to this personal allowance.
The table below shows you the tax rates applicable for each band (basic rate, higher rate, additional rate) based on your taxable income. Note that your income tax exemption also pertains to your regular income from employment, whether obtained through PAYE or self-employment.
HMRC’s Guidance on DeFi Taxes
The HMRC has released guidance for Decentralised Finance (DeFi), stating that although there is no legal or statutory definition of “staking” and “lending”, their guidance applies to anyone who transfers control of tokens to another party through lending or providing liquidity on a DeFi platform. This means that if you lend or borrow using a DeFi platform, provide liquidity, or deposit coins into any DeFi protocol in exchange for a yield, HMRC’s guidance applies to you.
Having covered both types of tax that can apply to your cryptocurrencies, in the following sections we explain the principles governing the taxation of different types of DeFi transactions and activities on DeFi platforms.
Buying and Selling on DEXs
Decentralized exchanges (DEXs) allow users to purchase, sell or trade cryptocurrencies without the need to use a centralized platform. DEXs use automated market makers (AMMs) to facilitate trades. To exchange tokens, users transfer them to the AMM’s smart contract. The contract then calculates the exchange rate based on the tokens’ supply and demand, determines the amount of the other asset the user will receive, and transfers it to the user.
Every time you exchange one digital asset for another, a swap occurs. The HMRC considers this a taxable event because it involves trading one digital asset for another (known as a crypto-to-crypto trade). If you buy cryptocurrency in exchange for another digital asset (including stablecoins), Capital Gains Tax (CGT) applies. However, CGT does not apply when purchasing cryptocurrency with fiat currency (e.g., GBP).
If you record a loss, you will not be required to pay any taxes. Nevertheless, it’s important to keep track of your losses so that you can use them to offset profits and lower your tax bill.
Taxes on Staking
Staking involves users holding digital assets in a particular protocol or chain. In return, they receive rewards in the form of additional digital assets, usually in the same cryptocurrency being staked. Nodes play a crucial role in the DeFi ecosystem, performing essential tasks such as verifying and broadcasting transactions, executing smart contracts, and storing a copy of the blockchain. Blockchain networks like Polkadot offer nodes which earn rewards for validating transactions.
To stake, users transfer their digital assets to a staking protocol, which uses them to validate transactions on the network. The rewards earned through staking are then distributed back to the users as more digital assets they can hold or sell on an exchange. Popular staking protocols include Ethereum, Cardano, and Cosmos. However, users should exercise caution and thoroughly research the staking protocols they are considering using to understand the risks involved before delegating their funds.
Regarding taxation, staking income is subject to Income Tax, which is considered a means of making money. Swapping or selling earned tokens is subject to CGT, and node rewards are also subject to Income Tax.
Airdrop Taxes
In DeFi, an airdrop refers to the distribution of tokens to eligible users’ wallets to incentivise the adoption of a project. A user must fulfil certain criteria, such as holding a specific cryptocurrency or interacting with a particular dApp, before the tokens are automatically sent to their wallet from the project’s smart contract.
One example of a DeFi airdrop is the 2020 Uniswap airdrop, which distributed 400 UNI tokens to all users who had used the platform before September 1, 2020. As the DeFi space expands, more crypto projects are opting to carry out airdrops to encourage adoption by retail investors.
According to HMRC, if a user completes any actions to receive an airdrop, this is considered income and is subject to Income Tax. If you sell or swap coins received in an airdrop, CGT will also apply (on the appreciation over the value of the income tax). The cost basis for airdrops is the asset’s fair market value (FMV) on the day it was received in GBP.
Taxes on Liquidity Mining
Liquidity pools are a smart contract-based solution that enables users to pool their cryptocurrency funds together to provide liquidity for trades, particularly on decentralised exchanges and automated market makers (AMMs). By contributing assets to a liquidity pool, users earn a portion of the trading fees generated by the pool, which is determined by their allocation of the pool. In exchange for providing liquidity, users receive liquidity pool tokens that represent their share of the pool, which can be redeemed at any time for the underlying assets. Several DeFi protocols, including Uniswap, Curve, Balancer, and SushiSwap, offer liquidity pools built on various blockchain platforms like Ethereum and Polygon.
According to the HMRC community forum, adding or removing LP tokens is subject to CGT if users receive LP tokens in exchange for providing assets. Moreover, receiving new liquidity pool tokens or reward assets while holding a position in a liquidity pool is subject to Income Tax. The tax implications of receiving LP tokens through DeFi protocols depend on how rewards are paid and may be subject to either CGT or Income Tax.
Uniswap V2 vs V3
Uniswap is a decentralised exchange (DEX) that allows users to trade cryptocurrencies, create LP positions and trade NFTs. In Uniswap V2 and V3, users can add funds to liquidity pools and earn a share of the trading fees generated. Uniswap V2 is an improved version of the original protocol that supports ERC-20 token pairs, providing more efficient pricing and improved trading fees by implementing a constant product market maker algorithm that balances the price of each token based on demand.
In contrast, Uniswap V3 introduced concentrated liquidity, which allows liquidity providers to indicate a price range for their funds. This resulted in reduced slippage and more efficient use of capital. As a Uniswap user, you should consider the different versions of the protocol as they offer specific features and benefits that cater to different trading needs and preferences.
HMRC has yet to issue clear guidance on whether migrating liquidity from Uniswap V2 to V3 incurs a taxable event. Typically, it would not be taxable as you still hold the same assets, but allocating liquidity between a specific price range may be subject to CGT.
Taxes on DeFi Lending
Decentralised lending services in DeFi use liquidity pools where lenders deposit their cryptocurrency, and borrowers use their cryptocurrency as collateral to take out loans. The interest rates for lending are market-driven and can fluctuate based on supply and demand. Popular DeFi protocols that offer lending services include Aave, Compound, and MakerDAO, which are known for providing competitive interest rates, permissionless lending and borrowing, and transparency and security for users.
When it comes to taxation of disposing of crypto on a lending platform, it depends on who retains beneficial ownership of the coins/tokens in the transaction. If the lender transfers beneficial ownership, it is a taxable disposal subject to CGT. However, if beneficial ownership is not transferred, it is not taxable. Determining beneficial ownership would require examining the contract and terms and conditions. HMRC states that if the recipient is restricted from dealing with the asset, it is a strong indicator that beneficial ownership has not been transferred. On the other hand, if the recipient can deal with the asset, then it is likely that beneficial ownership has been transferred. Income Tax applies to any return derived from the lending activities if the return is paid at intervals continuously during the lending period.
Taxes on DeFi Borrowing
In the world of DeFi, borrowing refers to the process of acquiring a loan without intermediaries. This is possible by depositing collateral into a lending pool and utilising smart contracts to regulate the tokens supplied until the loan is repaid. Collateral is typically over-collateralised to minimise risks, and if its value falls below a specific threshold, the position is liquidated to repay the lender. Some examples of DeFi borrowing protocols include Aave, Compound, and Oasis, available on different blockchain networks such as Ethereum, Binance Smart Chain, and Polygon. The borrower’s flow of funds comprises depositing collateral, obtaining the borrowed funds, paying interest, and repaying the loan.
It is important to note that the CGT is incurred upon loan repayment to the DeFi protocol. Furthermore, any income that arises from DeFi borrowing activities is subject to Income Tax.
Taxes on Yield Farming
Yield farming is a method of generating additional tokens by lending or staking your existing tokens on a DeFi protocol in exchange for rewards. These rewards are often a portion of transaction fees or interest generated from borrowers. However, yield farming comes with risks, such as impermanent loss and price slippage, especially during volatile markets.
To participate in yield farming, a user deposits their crypto assets into a smart contract-based liquidity pool, which enables the user to provide liquidity. The rewards are then paid out by the protocol from the pool, and the value of the rewards is directly proportional to the amount of liquidity the user provides. When the user wants to withdraw their assets, they return the tokens to the liquidity pool and receive their share of the pool’s assets in return. Popular yield farming protocols include Aave, Curve Finance, and Beefy Finance.
Returns generated from yield farming protocols are considered income and subject to Income Tax. This includes earning new tokens from deposited assets.
Crypto Bridges Tax
Similar to real-world bridges, DeFi crypto bridges facilitate the interaction between different blockchain networks. Their function involves securing or immobilising digital assets on one blockchain (originating chain) while generating an equivalent quantity of assets on another blockchain (destination chain). The movement of funds occurs by transferring assets to the bridge contract, which then produces new assets on the target blockchain. For instance, if you wish to utilise Bitcoin or Ether in DeFi applications or smart contracts on diverse blockchains, you require versions of these coins that adhere to the token standard of each respective blockchain. These versions are generated through a process called “token wrapping.”
When you decide to reclaim your original assets, you send the wrapped tokens back to the bridge contract, which proceeds to eliminate them and release the original assets to you. However, bridges carry certain risks, such as glitches or vulnerabilities in the smart contract code and potential attacks or exploitations by malicious individuals.Prominent bridges include the Hop protocol and other bridges connecting Ethereum to various blockchains like Polkadot, Cosmos, Optimism, Arbitrum, and Avalanche.
Taxation related to bridges in DeFi can be a challenging matter, as different jurisdictions may have varying rules on whether moving an asset from one chain to another constitutes a taxable event. In some cases, such a move may be considered a crypto-to-crypto trade because of the difference in the smart contract, even though the asset being held remains the same. However, in other cases, it may be viewed as a non-taxable self-transfer since the asset’s pricing remains unchanged. Therefore, it is advisable to consult with a cryptocurrency tax expert to ensure compliance with applicable tax laws when bridging assets in DeFi.
DAOs Taxation
Decentralised autonomous organisations (DAOs) are blockchain-based digital entities that function without a central authority. They operate through smart contracts and are managed democratically by their members, eliminating the need for a central authority.
DAOs rely on governance tokens, which give holders the right to vote on proposals and protocol changes. Additionally, members can earn rewards for actively participating in the governance process, contributing liquidity, or completing other project-related tasks. Noteworthy examples of such organisations include Maker DAO and Decred.
When acquiring a token issued by a DAO, it is important to consider the applicability of CGT due to the nature of the transaction (crypto-to-crypto trade). Furthermore, any income derived from involvement with a DAO, such as airdrops or staking, is subject to Income Tax.
Synthetic Assets
A synthetic asset is a tokenised derivative that digitally represents various assets, such as fiat money, stocks, cryptocurrencies, commodities, or physical possessions. These assets are created through smart contracts, with their existence determined by community voting. Popular protocols like Synthetix and UMA offer platforms for trading synthetic assets. When users purchase a synthetic asset, they deposit collateral, typically a cryptocurrency, into a smart contract, generating the corresponding synthetic asset. Subsequently, when users wish to redeem the synthetic asset, they return it to the smart contract, and their collateral is returned to them.
From a tax perspective, engaging with synthetic assets entails capital gains tax implications due to the involvement of crypto-to-crypto trades.
Options / Margin Trading
Options trading and margin trading are two ways for users to profit from buying or selling assets. In options trading, users can buy or sell assets at a specific price and time. On the other hand, in margin trading, users can borrow funds to buy or sell assets and deposit collateral into a smart contract to determine their trading or borrowing limit. If the market moves in their favour, they can earn profits, but losses and liquidation can occur if the market moves against them. Various DeFi protocols like Opyn, Aave, and dYdX offer these services on different chains like Ethereum, Binance Smart Chain, and Solana.
Regarding taxation, the HMRC has not provided specific guidance on cryptocurrency margin trading. However, HMRC considers trading as speculative, like gambling, which means that no taxes must be paid on any profits earned. If you trade as a private investor, profits from closed positions are subject to CGT. It is important to remember that if your position gets liquidated, it is considered a disposal from a tax perspective and should be reported.
Perpetuals
Perpetuals are a specific type of contract that enables traders to speculate on the future price of an asset without owning it. These contracts implement a financing rate that aligns the perpetual’s price with the spot price of the underlying asset. Traders can opt for long or short positions and must deposit collateral to open and maintain their positions. The value of the underlying asset’s price fluctuation can result in either gains or losses for traders. Notable DeFi platforms that offer perpetuals include Perpetual Protocol and dYdX. It is worth noting that all profits obtained from closed positions are subject to CGT.
Futures and Derivatives
Futures and derivatives are financial instruments that allow users to speculate on the future price of an asset. A futures contract is a commitment to buy or sell an asset at a pre-agreed price and time in the future. On the other hand, a derivative’s value is linked to the underlying asset’s price, such as Bitcoin or Ethereum.
On DeFi platforms, futures and derivatives are typically traded via smart contracts. To initiate a trading position, users deposit collateral into the smart contract. This deposit acts as a safeguard in the event of liquidation. As the underlying asset’s value fluctuates, the trading position’s value also changes, potentially resulting in gains or losses for the user. Various protocols offer futures and derivatives trading on DeFi, such as dYdX, Synthetix, and Hegic, which are accessible on multiple chains, including Arbitrum, Ethereum, Binance Smart Chain, and Solana.
The HMRC has determined that trading futures or derivatives is subject to CGT. For more detailed information on the tax implications of these investments, it is advisable to consult a cryptocurrency tax specialist.
Rebasing Tokens Tax
Rebasing tokens experience changes in their circulating supply controlled by an algorithm that automatically adjusts the token’s value by burning or minting new tokens. However, interacting with these tokens is considered risky due to their unique supply adjustment mechanism, causing their value to fluctuate constantly. Furthermore, many rebasing tokens have a relatively small market cap and low liquidity, which can increase the risk of volatility and make trading at desirable prices challenging. One of the most popular DeFi protocols that offer rebasing tokens is Ampleforth ($AMPL).
As with any investment, conducting thorough research and understanding the risks before trading rebasing tokens is essential. Trading rebasing tokens involves a crypto-to-crypto transaction and is subject to CGT.
Wrapped Tokens Tax
Wrapped tokens in DeFi refers to tokens representing an underlying asset, such as cryptocurrency or traditional assets like gold or fiat currency, enabling users to interact with assets not natively supported on a particular blockchain. To function, a custodian holds the underlying asset and issues an equivalent amount of the wrapped token on the destination blockchain.
You can trade wrapped tokens on decentralised exchanges and redeem them for the underlying asset anytime. Compound, Aave, and Uniswap are popular protocols supporting wrapped tokens, with examples including Wrapped Bitcoin (WBTC) and RenBTC, which are pegged to Bitcoin’s value. Wrapped tokens, therefore, provide interoperability between chains in the DeFi ecosystem.
How are wrapped tokens taxed?
Wrapping a token refers to a crypto-to-crypto trade, as illustrated by converting Binance Coin (BNB) to wrapped Binance Coin (wBNB). This exchange is a taxable event since, although they have the same market value, they are regarded as two different cryptocurrencies in terms of smart contract comparison. Hence, it is classified as a crypto-to-crypto trade subject to CGT.
Insurance Protocols
Insurance protocols in DeFi aim to shield users from potential losses by pooling funds from investors, which provides coverage against various risks, including smart contract failures, oracle malfunctions, and hacking incidents. When a user purchases insurance, they can file a claim and receive a payout from the protocol if a covered event occurs. To participate, users must deposit funds into the smart contract pool, which is then invested to generate returns for the protocol and cover claims. Notable insurance protocols in DeFi include Cover Protocol, Nexus Mutual and InsurAce. These protocols payout directly to the user’s wallet in the same cryptocurrency used to purchase coverage.
Is Crypto Insurance Tax-Deductible?
This is an ongoing question in crypto taxation. However, it’s important to note that investors who stake their assets to receive a reward are engaging in a taxable event. Similarly, users who earn rewards from staking, governance, and claim assessment on insurance protocols may also be subject to taxation.
Flashloans Taxation
Flash loans are a type of loan that allows users to borrow funds for a short period, typically less than one block confirmation, without the need for collateral. This is done by borrowing funds from a lending pool, executing a specific trading strategy, and returning the loan in the same transaction—failure to repay the loan results in a reversal of the transaction and termination of the flash loan. However, gas taxes paid during the transaction are not refunded. Some popular DeFi protocols offering flash loans include Aave, dYdX, and Uniswap, with repayment often done in the same cryptocurrency. Any gains from selling crypto assets are subject to the CGT.
Play to Earn Tax
Play-to-earn games are a new concept in DeFi, where players can earn cryptocurrency by playing blockchain-based games. These games provide a straightforward way to earn rewards by performing in-game activities such as completing quests or solving puzzles. Players can earn tokens by playing the game and then sell them on various exchanges for other cryptocurrencies or fiat. These tokens can also be staked in liquidity pools for additional rewards.
Popular protocols that offer play-to-earn games include Axie Infinity (where players collect, breed, and battle fantasy creatures known as Axies), Star Atlas (a space-themed game where players can explore and conquer the galaxy), and many more.
The P2P taxation works the same as if you were earning cryptocurrency. At present, there is no clear-cut guidance on how taxes apply to gamified DeFi. However, any income earned through such activities may still be subject to taxation. If you acquire new tokens from play-to-earn games, you may be required to pay Income Tax depending on the token’s fair market value on the day you received it. Furthermore, any profits made from selling or trading the tokens earned will be taxed under CGT.
Gas Fees Taxation
When using Ethereum, every transaction and execution of a smart contract requires a fee known as gas. Gas measures the computation necessary to execute an operation or smart contract. More complex operations require more gas. These gas fees are paid entirely in Ethereum’s cryptocurrency, ETH.
If gas fees are related to acquiring an asset, they are considered part of the cost basis of the acquired asset or can be allocated as an advertising cost related to the disposal transaction if that transaction occurred separately on the blockchain. However, gas fees that cannot be directly linked to acquiring a crypto asset are generally not deductible under current assessments. It is recommended to consult a tax advisor if significant gas fees have been incurred.
Crypto as Collateral
Taxation for lending and collateralised transactions in DeFi depends on who has beneficial ownership of the coins or tokens used as collateral. If beneficial ownership of the collateral is transferred, then the transaction will be subject to CGT as if the collateral had been disposed of for its market value in GBP. The gain or loss would then be calculated on the disposal as usual.
On the other hand, when the collateral is withdrawn from the platform, it will be treated as an acquisition of that coin or token at that moment in time, and the acquisition price would be the value of the coin or token in GBP at the time of receipt.
However, if beneficial ownership does not transfer, there is no Capital Gains Tax on the collateral. If a borrower’s position gets liquidated, CGT would apply based on the market value of the coins or tokens at the time of liquidation and the number of coins or tokens lost. The HMRC provides an example of this situation within their DeFi guidance.
Calculate your DeFi taxes with Crypto Tax Software
DeFi investors and enthusiasts can make use of crypto tax software as a hassle-free solution for calculating your DeFi taxes. The Accointing tax tool simplifies generating a crypto tax report by automating the calculation of gains and losses and helping you keep track of transactions across exchanges and wallets.
Here are some of the advantages of using Accointing to report your DeFi taxes:
User-friendly interface: Accointing offers an intuitive interface that simplifies the tracking of crypto transactions and the generation of accurate tax reports. It doesn’t require expertise in tax matters to navigate.
Integration with various exchanges and wallets: With over 400 rapid integrations covering exchanges, wallets, blockchains, and services like Binance, Coinbase, and Kraken, Accointing enables effortless connection of accounts and automated importation of transactions, eliminating the need for manual entry.
Comprehensive reports: As per the guidelines of the HMRC for cryptocurrency taxation, we create a comprehensive tax report that includes a detailed breakdown of all your transactions. We utilize the pooling method and adhere to the same-day rule and bed and breakfast rule to calculate capital gains and income tax.
Leading crypto portfolio tracking and insights: Take charge of your crypto data with Accointing’s portfolio tracking and insights tool. The portfolio dashboard offers an overview of your transactions, providing information on your entire crypto portfolio. Real-time updates on buy and sell data, net profit, and total profit facilitate informed decision-making and keep you up-to-date with your investments.
Accurate Crypto Tax Calculator: Accointing employs an advanced algorithm to calculate the acquisition cost of each crypto transaction, ensuring precise reflection and documentation of capital gains for tax purposes.
Expert resources: Besides the “UK Crypto Tax: The Definitive Guide 2023” and “How to File Your Crypto Taxes – UK“, Accointing provides additional resources to assist users in navigating the complexities of crypto taxes.
Dedicated customer support: Accointing offers dedicated customer support to address any inquiries or concerns regarding the platform or crypto taxes. Prompt assistance is available through email, live chat, or the help centre.
The information contained in this guide, including any supplemental materials, is for general information purposes and does not constitute financial, investment, legal or tax advice. The present content is not intended as a thorough, in-depth analysis, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties. Please consult your tax advisor.
