Decentralized finance, or DeFi for short, is looking to tackle the issues faced by traditional financial systems and instead provide global, decentralized finance for all. While we’re still in the very early stages of DeFi, the potential is huge and it’s got crypto investors around the world and in the UK excited for new investment opportunities. We’ll be looking at what DeFi is, how HMRC views DeFi and how various DeFi transactions are taxed in this guide.
Update February 2022
HMRC have finally released proposed guidance on DeFi tax. We've updated our guide to reflect the new guidance.
What is DeFi?
You can learn more about exactly what DeFi is in our DeFi guide. But, in brief, DeFi is an umbrella term for a variety of financial applications and services built using blockchain technology.
DeFi platforms have attracted more than $90 billion in collateral since the term was coined in 2018.
DeFi hopes to eventually provide all of the services that centralised financial institutions do, but without any of the limitations created by borders, regulations and policies. Instead, DeFi hopes to empower investors through borderless, decentralized and transparent financial services.
Most DeFi applications currently are built on the Ethereum blockchain. This is due to Ethereum's smart contract capabilities.
Smart contracts work just like real contracts, but they're completely digital. The contract is a computer program stored inside a blockchain. These programs will have a variety of specific conditions that need to be met to execute the contract, otherwise the funds will be liquidated and the contract will be cancelled.
Smart contracts can be used for practically anything - from crowd funding to loans. The important thing to note is that technology automates the process - so it can't be slowed down or halted by human error - and that the technology removes the need for a third party - like a bank.
What can DeFi do?
DeFi apps are constantly evolving and adding new functionalities. What this means is there is an ever-growing list of transactions that UK investors can make with DeFi apps. Currently this includes:
- Send money to anyone, anywhere.
- Buy, sell and trade cryptocurrencies.
- Invest in stable currencies.
- Loan or borrow crypto.
- Earn interest and rewards through staking, yield farming and liquidity mining.
- Advanced trading like derivatives, margin and leveraged trading.
- Crowdfund and invest in new DeFi projects.
- Insure your crypto investments.
- Manage and grow your crypto investments automatically.
- Gamble and bet crypto.
With all these different transactions comes different taxation.
How does HMRC tax DeFi?
HMRC has finally released guidance on how they plan to tax DeFi. But it's not exactly straight forward. It all comes down to whether your crypto is viewed as income or a capital. This means it all comes up to how your specific DeFi protocol works.
From a tax perspective - the 'nature of the transaction' defines the tax treatment. So if it has the nature of capital, it's subject to Capital Gains Tax. Meanwhile, if it has the nature of revenue, it's subject to Income Tax.
To try and simplify this a bit more, a lot of your DeFi trades are going to be seen as disposals now. This includes adding/removing liquidity, staking crypto and in some instances the rewards you receive from DeFi protocols - if you receive that reward in one large sum (like if you traded a liquidity pool token that had increased in value).
Meanwhile, returns may be seen as income in some instances. HMRC say this is more likely if:
- The return to be received has been agreed - as opposed to speculative and unknown.
- If the return is paid by the borrower/DeFi platform.
- If the return is paid periodically throughout the period of lending/staking.
So if you're earning new tokens or coins on a periodic basis through your DeFi activities - this is more likely to be seen as income and subject to Income Tax.
Income or capital asset
HMRC views crypto in one of two ways and subjects them to two different types of tax. In the UK DeFi trades are either seen as income and subjected to Income Tax or seen as a capital asset and subjected to Capital Gains Tax.
The lines on what is considered income can get quite blurry. However, some crypto transactions are clear cut. For example, the following investments are seen as income and subject to Income Tax:
- Getting paid in crypto - known as ‘money’s worth’ and subject to Income Tax and National Insurance contributions.
- Mining crypto - depending on the degree of activity.
- Staking crypto - depending on the degree of activity.
- Airdrops - in most instances.
Capital Gains Tax, on the other hand, only applies when you sell, swap, spend or gift your crypto (excluding to your spouse). This is known as a ‘disposal’ of an asset’. It’s important to note that even when you pay Income Tax on a crypto asset, you’ll also pay Capital Gains Tax when you later dispose of your crypto asset. Similarly even if you didn’t pay Income Tax on your crypto asset, you’ll still pay Capital Gains Tax when you dispose of it.
Crypto transactions which are subject to Capital Gains Tax in the UK include:
- Selling your crypto for fiat currency.
- Swapping your crypto for another cryptocurrency.
- Spending your crypto on goods or services.
- Gifting your crypto (excluding gifting your crypto to your spouse or civil partner).
With this in mind - we’ll look at the common types of DeFi transactions and how HMRC is likely to view them under the slightly confusing new guidance.
DeFi lending tax UK
HMRC have just released extensive guidance around lending and borrowing crypto through DeFi protocols.
For the lender, when you loan out crypto - you make a disposal which is subject to Capital Gains Tax. If you know the amount of crypto you're receiving in return for the loan - you should include this in your capital gains calculations. If you don't you can calculate this later. When you receive your crypto back after the loan, your capital is treated as an acquisition - but any return is not. Your return may be subject to Income Tax or Capital Gains Tax - depending on how you receive it.
For borrowers, a loan is treated as an acquisition - and any loan interest payments are an allowable expense. When they pay back the loan, this will be treated as a disposition which is subject to Capital Gains Tax.
Staking tax UK
This one is pretty clear cut because although staking exists within DeFi, it also existed long before, so HMRC has specific guidance.
Rewards from staking are viewed as miscellaneous income and they’re subject to Income Tax. You’ll also have to pay Capital Gains Tax when you later dispose of the asset.
In addition to this, new HMRC guidance states that crypto you stake is subject to Capital Gains Tax as they view this transaction as a disposal.
Yield farming tax UK
Yield farming is big news in DeFi right now. Speaking broadly, it refers to any crypto assets strategically invested to yield the greatest returns - hence the name. You can earn different kinds of yields - for example, tokens, interest or by being paid the transaction fee. The whole purpose of yield farming is to strategically stack different crypto investments on top of each other to yield the largest rewards.
You can refer to the different sections within this guide to identify how each would be treated from a tax perspective.
Liquidity mining tax UK
New HMRC guidance states that adding and removing liquidity is subject to Capital Gains Tax. The liquidity pool token you receive in return inherits the cost basis of your added capital.
You will pay tax on the rewards earned - and it depends on how you earn them. If you receive new tokens or coins in return for your capital, you'll likely pay Income Tax. Whereas if you receive liquidity pool token(s) in return for your capital that increase in value - but that value is not realised until you remove your capital - this is more likely to be seen as a capital gains transaction.
Crypto CFD trading tax UK
HMRC has no specific guidance on CFD trading options in the crypto market like derivatives, margin trading and leveraged trading. However, they have a lot of guidance available on how these are taxed in traditional financial markets.
The advice on traditional finance markets is pretty straightforward - these will normally be seen as individual investments, except in extraordinary circumstances where they may be viewed as a trading. For individual investments, you’re only liable to pay Capital Gains Tax on any profits when your position closes.
Of course, there are some instances where your contract liquidates, in these instances this would be viewed as a disposal and you’d similarly be liable to pay Capital Gains Tax on any profits.
It’s important to note that because there is no specific advice on crypto CFD trading, you should still speak to a UK tax advisor for specific guidance on your crypto tax for these transactions.
Gas fees tax UK
HMRC has clear guidance on allowable expenses when calculating transaction or gas fees. Transaction fees are an allowable expense, so you can add them to your cost basis. Transfer fees are also an allowable expense in most instances.
Wrapping tax UK
In some instances, you’ll need to ‘wrap’ coins before you can deposit them into a smart contract. A good example of this is when you want to use BTC on an Ethereum based platform, you can ‘wrap’ BTC and exchange it for an ERC-20 token of an equivalent value that does work within the platform.
HMRC does not have clear guidance on this just yet. However, as you’re swapping one coin for another, it is very possible that they would view this as a kind of disposal and subject to Capital Gains Tax. So even if you make no gain or loss (because you’re swapping something for equivalent value), you may still need to declare this on your tax return.
How to calculate UK crypto taxes with Koinly
Koinly helps UK crypto investors calculate their crypto income, capital gains and losses and expenses. All you need to do is import your crypto transactions from your wallets to Koinly through CSV or API. Once your transactions are imported, Koinly will calculate your crypto taxes for you. All you need to do is head over to the tax reports page, where you’ll see a simple summary of your crypto taxes. Below this, you’ll find a variety of tax reports you can download and submit to HMRC when filing your annual Self Assessment Tax Return.
You can find more great information about filing your UK tax reports in our UK crypto tax guide and you can find the UK Capital Gains Tax and Income Tax rates in our UK Tax Rates guide.
- DeFi is an umbrella term for a variety of different financial apps for crypto investors.
- HMRC is yet to issue specific guidance on DeFi taxes for UK taxpayers.
- But there is guidance on crypto tax that already broadly applies to many DeFi transactions.
- Your crypto will be taxed in one of two ways - as income or as a capital asset.
- Income will be subject to Income Tax (and sometimes National Insurance contributions).
- Capital assets will be subject to Capital Gains Tax.