DeFi has exploded in popularity across the world, including Canada - but with great gains come great tax bills. Thatâs right, if youâre using dexes, DeFi lending protocols, liquidity mining, yield farming and more, the Canada Revenue Agency wants to know about it. Youâll need to report your DeFi activities as part of your annual Income Tax return. Weâre looking at everything you need to know about Canada DeFi tax in our guide.
DeFi stands for decentralized finance. Itâs an umbrella term for a huge variety of financial apps built using blockchain technology. Weâve got a great in-depth guide on all things DeFi already if youâd like to learn more, but in brief DeFi is looking to solve the many problems that traditional finance has.
Itâs easiest to understand DeFi by looking at what it isnât. Traditional finance is limited by markets, regulations, borders, internal policies and a select few corporations who decide who has access to finance and, conversely, who doesnât.
DeFi on the other hand is decentralized and borderless. Anyone, anywhere can access the various financial apps without needing to provide extensive personal information, a credit score, proof of income and more. There are no centralized third parties taking their cut or limiting access - like a bank or a traditional crypto exchange.Â
So how does it all work if thereâs no bank or third party?
By utilizing liquidity pools.
Almost all DeFi protocols rely on liquidity pools in order to function. This is where investors stake their assets in order to earn rewards in return. This liquidity is then used to finance the various transactions that may happen on the DeFi protocol - like trading, lending or more.
All transactions on a DeFi protocol are automated by smart contracts - pieces of digital code that set the terms of the transaction.Â
Smart contracts can be used to automate pretty much anything you can think of - provided you can code it. Letâs take a look at some of the most popular DeFi protocols and projects.Â
As we mentioned above, there are a huge variety of financial applications in the DeFi space, each with their own purpose. Some of the most popular DeFi protocols include:
With so many different kinds of DeFi protocols available, investors have a lot of new opportunities to earn through them. Some of the most common ways include:
As well as this, many investors seek out specific liquidity pools in order to earn specific tokens. For example, if you deposit liquidity to the new WETH.e pool on the Aave Avalanche, youâll get WAVAX tokens, as well as fees, letting investors earn more. This is known as liquidity mining.
Yield farming is another term thatâs sprung up out of the DeFi space and refers to the composability of protocols. In other words, the way different protocols work together, letting you earn on earnings. For example, if you provide liquidity on Curve, you get CRV tokens as your reward. You can then stake these CRV tokens in Convex Finance to earn rewards on your reward.Â
No matter how youâre earning through DeFi - one thing is sure. The CRA are going to want to know about it.Â
Letâs start with the obvious - the Canada Revenue Agency hasnât issued any guidance on the tax treatment of DeFi yet.Â
That doesnât mean you wonât pay tax on your DeFi transactions though. You need to look at the current guidance on crypto tax in Canada and infer how that would apply to your DeFi transactions.Â
Weâve got a great guide on Canada crypto tax for the full story, but in brief, crypto is either subject to Capital Gains Tax or Income Tax depending on the specific transaction.
Whenever you sell, trade, spend or gift crypto - youâll pay Capital Gains Tax on any profit you make as a result of that transaction. However, if youâre seen to be trading as a business (like a day trader), youâll actually pay Income Tax on this instead.
Whenever youâre seen to be making an income - like through mining, staking, bonuses or selling NFTs you create - youâll pay Income Tax instead.
With all this in mind, to figure out Canada DeFi tax, we need to look at the specific transaction and how the CRA are likely to view it. So letâs break it down.
This one is nice and straightforward as there is clear guidance from the CRA. Provided youâre seen as an individual investor and not a business - youâll pay Capital Gains Tax on any profits you make as a result of selling or trading crypto on dexes.
Buying crypto with fiat currency like CAD is tax free. Buying crypto with another cryptocurrency - even stablecoins - would be viewed as a trade and taxable transaction.Â
If youâre seen to be conducting business-like activities - like a day trader - youâll pay Income Tax on any profits you make as a result of selling or trading crypto on dexes instead.
Liquidity pools all work in a similar way, no matter the specific protocol youâre using.Â
When you add liquidity to a given pool, youâll get a liquidity pool token in return that represents your capital in the pool. When you want your capital back, youâll trade your liquidity pool token back. For example, letâs say you added BUSD and BNB to a liquidity pool on PancakeSwap. Youâd get a BUSD-BNB LP token in return.Â
Even though youâre not disposing of your asset - itâs likely this would be viewed as a crypto to crypto trade which is a taxable event under Capital Gains Tax. Youâll need to pay Capital Gains Tax on any profit from this transaction.
When it comes to the rewards youâre paid out from liquidity pools, it all depends on how youâre paid your rewards. Liquidity pools tend to work in one of two ways. Letâs look at two examples.
Youâve added BUSD and BNB on PancakeSwap and got your BUSD-BNB LP token(s) in return. You donât earn new LP tokens on PancakeSwap whenever someone makes a transaction, instead the value of your liquidity pool token increases whenever someone makes a trade. Itâs only when you remove your liquidity by trading your BUSD-BNB LP token(s) back that youâll have a realized gain. In this example, youâd pay Capital Gains Tax on any profit at the point you realize your gain by removing your liquidity.
But not all liquidity pool rewards are paid out like this. Letâs say you deposit ETH to an Aave lending pool instead. Youâll get aTokens at a 1:1 ratio to represent your capital in the lending pool. However, your rewards are similarly paid out at a 1:1 ratio. This is far more likely to be seen as income because youâre earning new tokens. So while you may pay Capital Gains Tax on any profits when you trade your crypto for aTokens, itâs more likely the rewards you get as a result would be subject to Income Tax instead. Youâd pay Income Tax based on the fair market value of your aTokens at the point you received them.Â
Weâve touched on this above with our Aave example, but itâs worth expanding on it as DeFi lending can get complicated from a tax perspective.
Though loaning your crypto or borrowing crypto doesnât seem like a taxable event - because you often receive tokens in return to represent your asset or collateral, it may well be. This is easier to understand with an example.
Compound is a popular lending protocol. When you deposit an asset to loan, you add it to a lending pool (which is just another word for a liquidity pool). Youâll get cToken(s) in return representing your capital. When you want your capital back, youâll trade your cToken(s back. This could be viewed as a crypto to crypto trade and therefore any profits subject to Capital Gains Tax.
Similarly, when you want to borrow crypto on Compound, youâll need collateral. When you add collateral, youâll get cToken(s) in return. When youâre done with your loan, you can remove your collateral by trading your cToken(s) back. These transactions are likely to be seen as a crypto to crypto trade which means any profits would be subject to Capital Gains Tax.
But what about interest?
Again, this all comes down to how your specific protocol works. In the Compound example, as you earn interest, the value of your cToken(s) increases the longer itâs in the lending pool. So in this instance, you donât realize a gain until you remove your collateral. This is more likely to be seen as a Capital Gains Tax event as youâre not earning new coins.
However, when you lend or borrow on Compound, youâll be rewarded with COMP tokens as a result. These are new tokens you can claim at any point. This would be viewed as additional income and youâd pay Income Tax based on the fair market value of your COMP tokens at the point you received them.Â
In short, earning new tokens is likely to be seen as Income and subject to Income Tax, while the value of tokens increasing is likely to be subject to Capital Gains Tax.
When it comes to paying interest - the tax implications are convoluted. Spending crypto is subject to Capital Gains Tax as itâs seen as a disposition. However, if youâre borrowing crypto to âbuy incomeâ - like investing in another DeFi platform that generates rewards - then interest paid may be deductible against that income.Â
Yield farming can refer to a huge variety of different activities - so itâll all depend on how youâre being paid out. Letâs look at an example of SushiSwap yield farming.
Youâve added liquidity on SushiSwap and got SushiSwap LP tokens (SLP tokens) in return. You can then stake your SLP tokens to earn SUSHI tokens.
You can harvest these SUSHI token rewards at any point. You're earning new tokens, which would be seen as income and you'd need to pay Income Tax on the fair market value of your SUSHI tokens at the point you received them.
You can also then stake your SUSHI tokens to increase your rewards. However, when you stake SUSHI tokens, you'll get XSUSHI tokens in return. You don't earn new XSUSHI tokens, instead your XSUSHI tokens grow in value and you'll only realize your gain when you unstake your SUSHI tokens by trading your XSUSHI tokens back. This is more likely to be subject to Capital Gains Tax as you're trading crypto, not earning new tokens.
Overall, your yield farming will be subject to either Income Tax or Capital Gains Tax depending on whether youâre earning new tokens or your tokens are increasing in value.Â
Staking in the DeFi world can actually refer to two different transactions so letâs cover both.
Many investors use the phrase staking to refer to them adding an asset to a given protocol - like staking SLP tokens to earn Sushi. This could be subject to Income Tax if youâre earning new tokens, or Capital Gains Tax if the value of your tokens increases but you donât receive new assets.
Staking is also used to refer to staking as part of a consensus mechanism. There are a number of Proof of Stake (PoS) blockchains in the DeFi space including ADA and AVAX. There are many non-custodial wallets you can use to stake as part of a PoS blockchain in order to earn rewards - for example, you can use Yoroi or Daedalus to stake ADA. As youâre earning new coins, this is likely to be seen as income and subject to Income Tax.Â
Thereâs no specific guidance on the tax treatment of crypto margin trading, crypto derivatives trading or other crypto CFDs for either centralized or decentralized exchanges.
But this will all come down to whether youâre seen to be acting as a day trader (like a business) or as an individual investor.
If youâre seen to be trading as an individual investor, youâll pay Capital Gains Tax on any profits at the point you close a position. Margin fees are tax deductible provided they relate to your crypto trading, while liquidation is seen as a disposition and any profit subject to Capital Gains Tax.
Meanwhile, if youâre seen to be acting as a day trader, youâll pay Income Tax on any profits at the point you close a position.Â
The CRA hasnât issued any guidance on play-to-earn crypto gaming and tax just yet, but itâs all going to come down to how you earn and how your earnings are viewed.
If youâre earning minimal amounts (like hobby mining), itâs likely youâd only need to pay Capital Gains Tax when you later sold, traded, spent or gifted any coins/tokens youâve earned through DeFi games.
If youâre earning larger amounts, regularly - like an income - youâre likely to pay Income Tax on your crypto, based on the fair market value at the point you receive it.Â
Of course, many DeFi games are using NFTs - so weâll cover NFT taxes below.
Despite being non-fungible, these tokens are treated the same as any other cryptocurrency from a tax perspective. In short:
Weâve got a whole article on gas fees and taxes but in brief, transaction fees can be added to your cost basis and are therefore tax deductible while transfer fees likely cannot be added to your cost basis and should be treated as a disposition.Â
Wrapped tokens allow for interoperability between various blockchains - for example, WETH or WBTC.Â
When you âwrapâ a token, youâre exchanging one token for another. This could be seen as a crypto to crypto trade and subject to Capital Gains Tax. However, as the two tokens are of equivalent value, youâll often have no realized gain or loss.
Some tokens need to maintain a consistent value with an underlying asset - for example, Lidoâs stETH is tied to the value of ETH. To maintain this value, these tokens have whatâs known as a rebasing function. Rebases adjust the supply of coins according to price fluctuations.
For example, if a token is supposed to be worth $1 but the price is rising above that, the number of coins in circulation would increase. Similarly, if the price dropped below $1, the number of coins in circulation would be reduced. In other words, you might end up with more or less tokens due to rebases - especially rebases that happen daily.Â
The CRA doesnât have guidance on token rebases. However, we can liken these to a stock split, which they do have guidance on. The CRA states that stock splits are not seen as a disposition and therefore a non-taxable event. It would be reasonable to assume token rebases would be seen in a similar way.
Koinly crypto tax software calculates all your crypto taxes for you, including DeFi taxes. All you need to do is sync the wallets, exchanges or blockchains you use with Koinly through API or import a CSV file of your crypto transactions.
From here, Koinly will identify your different crypto transactions and apply the relevant taxes. Your data should be labeled automatically, but if it isnât you can tag your DeFi transactions as a loan interest, received from pool or a reward for deposits. For withdrawals, you can tag your DeFi transactions as cost, interest payment or sent to pool.
We give you complete control over how conservative youâd like to be with your crypto tax reporting. In our settings, you can choose whether to realize gains on liquidity transactions, whether to treat other gains as capital gains and whether to treat transfer fees as disposals.
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 youâll see a simple summary of your crypto taxes. Below this, youâll find a variety of tax reports you can download and submit to the CRA, as well as reports for specific tax apps like TurboTax and more.Â