Canada's DeFi sector is booming, with a projected revenue of US$581.6 million in 2023 and an impressive 16.10% annual growth rate. Average revenue per user hits US$3,811.0, showcasing the financial impact on individual participants. While Canada advances, the global DeFi leader is the United States with US$8,673 million in 2023. Canada anticipates 189.60 thousand users by 2028, indicating a growing interest in decentralized finance. source

However, along with these gains come inevitable tax responsibilities. Yes, you read that right! Whether you're navigating through dexes, engaging in DeFi lending protocols, exploring liquidity mining, yield farming, or more, the Canada Revenue Agency (CRA) is keen to stay informed. It's essential to include your DeFi activities when filing your annual Income Tax return. In this guide, we will cover all the crucial details you need to know about managing DeFi taxes in Canada.

DeFi 101 - The Basics

DeFi, short for decentralized finance, encompasses a wide array of financial applications built on blockchain technology. Unlike traditional finance, which is bound by borders, regulations, and centralized control, DeFi operates in a decentralized and borderless manner. This means that anyone, anywhere, can access various financial applications without the need for extensive personal information, credit scores, or intermediaries.

How DeFi Works?

The core functionality of DeFi revolves around liquidity pools. 

These pools, where users stake their assets, serve as the backbone for various DeFi protocols. 

Smart contracts, automated pieces of digital code, facilitate transactions within these protocols, enabling activities such as trading, lending, and more.

The Well-known DeFi Protocols Out There

The DeFi space boasts a diverse range of protocols, each serving a specific purpose. Some notable DeFi protocols include:

• Decentralized Exchanges (DEXES): Platforms like Uniswap and PancakeSwap allow users to buy, sell, and trade crypto tokens.
• DeFi Lending Protocols: Aave and Compound enable users to loan and borrow crypto.
• DeFi Saving Protocols: Platforms like Anchor provide options for storing crypto and earning interest.
• Decentralized NFT Marketplaces: OpenSea and Rarible facilitate the buying, selling, and trading of NFTs.
• DeFi Insurance Protocols: Platforms like Armor and Unslashed offer insurance for crypto, NFTs, and other digital assets.
• DeFi Trading Protocols: Opyn and Lyra cater to options trading, derivatives, and other CFDs.
• DeFi Indexes: Set Protocol and Index Coop allow users to diversify and balance their crypto portfolios.
• DeFi Games: Axie Infinity and Decentraland provide gaming experiences where users can (P2E) play and earn crypto.
• DeFi Gambling Protocols: Platforms like Wink and SportX offer opportunities for crypto gambling.

How to Make Money with DeFi

With numerous DeFi protocols available, investors have various avenues to earn, including:

1. Buying, Selling, and Trading on DEXES: Similar to traditional exchanges, users can profit by trading crypto on decentralized exchanges.
2. Providing Liquidity to Pools: Users can stake their assets in liquidity pools and earn a share of transaction fees.
3. Staking: Participating in consensus mechanisms, such as staking BNB on the Binance Smart Chain, allows users to earn rewards.
4. Yield Farming: This involves leveraging the interoperability of protocols to maximize earnings. For example, providing liquidity on Curve and staking resulting tokens in Convex Finance.

How Does CRA View DeFi?

While the decentralized and often anonymous nature of DeFi platforms might suggest a degree of tax ambiguity, the Canada Revenue Agency (CRA) is keen on ensuring that DeFi users report their activities appropriately.

As of the time of writing, the CRA hasn't provided specific guidance on the tax treatment of DeFi transactions. This creates a challenge for investors who need to navigate the existing crypto tax guidelines in Canada and interpret how they apply to their DeFi activities.

The general principle in Canada is that crypto transactions can be subject to either Capital Gains Tax or Income Tax, depending on the nature of the transaction and the user's status—whether they are viewed as investors or engaged in business-like activities.

The CRA considers factors such as:

• Conduct for Commercial Reasons: If the user's crypto activities are deemed to be for commercial reasons.
• Promotion of a Product or Service: If there's evidence of promoting a product or service.
• Intent to Make a Profit: If the user demonstrates an intention to make a profit.
• Regular or Repetitive Crypto Activities: If the crypto activities are regular or repetitive.

Individual circumstances play a crucial role, and users with numerous DeFi transactions might be viewed by the CRA as taxpayers with business income. Seeking advice from experienced crypto accountants is advisable to navigate this intricate landscape.

DEXES Taxes on Buying, Selling, and Trading

Decentralized exchanges (DEXES) play a pivotal role in the DeFi ecosystem, providing users with the ability to trade various cryptocurrencies. From a tax perspective, transactions on DEXES are subject to Capital Gains Tax.

If you're an individual investor, buying, selling, or trading crypto on DEXES incurs Capital Gains Tax on any profits realized from these transactions. However, if you engage in business-like activities, such as day trading, Income Tax might be applicable instead

Buying crypto with fiat currency like CAD is generally tax-free. Still, buying crypto with another cryptocurrency—even stablecoins—is considered a taxable transaction.

Taxes on Liquidity Pools and Liquidity Mining

Liquidity pools and liquidity mining are fundamental aspects of many DeFi protocols, providing users with opportunities to earn rewards by staking their assets. However, the tax implications vary depending on how these transactions are structured.

Liquidity Pools Tax

When you add liquidity to a pool, you typically receive a liquidity pool token representing your capital's share in the pool. This action, even though you're not disposing of your assets, might be treated as a crypto-to-crypto trade, subjecting you to Capital Gains Tax. The tax is triggered when you trade your liquidity pool token back for your initial assets, leading to a realized gain or loss.

For example, if you add BUSD and BNB to a PancakeSwap liquidity pool and receive a BUSD-BNB LP token, any increase in the LP token's value will be taxed when you trade it back for BUSD and BNB.

Liquidity Mining Tax

The rewards earned from liquidity pools depend on the protocol. In some cases, like PancakeSwap, your LP token's value increases with each trade in the pool. This value growth is considered a realized gain only when you remove your liquidity by trading the LP token back.

However, other protocols, such as Aave, reward users with new tokens in addition to the value increase of their LP tokens. This additional income is more likely to be viewed as regular income and may be subject to Income Tax based on the fair market value of the received tokens.

Tax on DeFi Lending

Participating in DeFi lending platforms introduces another layer of complexity in terms of tax implications. While lending your crypto or borrowing assets may not initially seem like a taxable event, the intricacies lie in the tokens received to represent collateral.

Lending on Platforms Like Compound

Let's take Compound, a popular DeFi lending protocol, as an example. When you deposit an asset into a lending pool, you receive cToken(s) representing your capital. These cTokens can be traded back for your initial asset, potentially incurring Capital Gains Tax.

Similarly, if you borrow crypto on Compound, you'll need to provide collateral, receiving cToken(s) in return. When you repay your loan, trading the cToken(s) back, this can be seen as a crypto-to-crypto trade, possibly subject to Capital Gains Tax.

However, the situation becomes more nuanced when considering interest. As you earn interest on your deposited assets, the value of your cToken(s) increases. In this scenario, you might not realize a gain until you remove your collateral, making it more likely to be considered a Capital Gains Tax event.

DeFi Lending and Interest Rewards

The interest earned on lending platforms like Compound often results in the distribution of platform-specific tokens, such as COMP tokens. While the profit from trading these tokens might incur Capital Gains Tax, the tokens received as interest could be treated as additional income.

If the platform rewards you with new tokens, it's likely considered income and subject to Income Tax based on the fair market value when received.

Yield Farming Tax

Yield farming is a concept that has emerged in the DeFi space, referring to the strategic deployment of assets across multiple protocols to maximize returns. As lucrative as yield farming can be, it introduces complexities in terms of tax implications due to the composability of protocols.

Earning Through Yield Farming

Yield farmers often earn through various mechanisms, such as providing liquidity, staking, and receiving governance tokens. The tax treatment depends on the nature of these earnings.

1. Providing Liquidity and Staking: When you provide liquidity to a pool or stake tokens, you may earn platform-specific tokens or other rewards. If these rewards are in the form of new tokens, they're likely considered income and subject to Income Tax based on the fair market value at the time of receipt.

2. Governance Tokens: Yield farmers often receive governance tokens, such as COMP or UNI, allowing them to participate in protocol governance. When you receive these tokens, they might be subject to Capital Gains Tax when traded, depending on whether you bought or earned them.

Complexities of Yield Farming

The complexity arises from the interconnected nature of DeFi protocols. For example, you might provide liquidity on one platform, receive LP tokens, stake those tokens on another platform, and earn additional tokens. Each step could have tax implications, and understanding the flow of assets is crucial for accurate tax reporting.

Taxes on Staking

Staking can refer to adding assets to a protocol or participating in consensus mechanisms, each having distinct tax considerations.

Staking in DeFi Protocols

1. Adding Assets to Protocols: When users stake assets to participate in liquidity pools or other DeFi protocols, the tax treatment depends on the nature of the rewards. If you receive new tokens as a reward, this is likely considered income and subject to Income Tax based on the fair market value at the time of receipt.

2. Consensus Mechanism Staking: Proof of Stake (PoS) blockchains, common in the DeFi space, allow users to stake their assets and earn additional coins as rewards. This is generally treated as income, and Income Tax applies to the fair market value of the newly earned coins.

Taxes on Margin Trading, Derivatives, and Other CFDs

The DeFi space offers opportunities for margin trading, derivatives, and other contracts for difference (CFDs). While these financial instruments provide additional avenues for profit, they introduce complexities in terms of tax implications.

Individual Investor vs. Day Trader

The tax treatment largely depends on whether the user is viewed as an individual investor or is engaging in day trading as a business.

• Individual Investor: If you're seen as an individual investor, Capital Gains Tax is applicable. Profits from closing positions are taxed at the point of closure, while margin fees may be tax-deductible.

• Day Trader: If your DeFi activities are deemed as business-like, Income Tax applies to profits when closing positions. Liquidation events are considered dispositions, and any resulting profit is subject to Income Tax.

Given the absence of specific guidance on DeFi margin trading and derivatives, users should align with their perceived status and seek professional advice for accurate tax reporting.

(P2E) Play-to-Earn Taxes

Play-to-Earn (P2E) crypto gaming has gained popularity, offering players the chance to earn cryptocurrency through in-game activities. While the Canada Revenue Agency (CRA) hasn't issued specific guidance on P2E gaming and taxes, certain principles can be applied based on existing crypto tax frameworks.

Minimal Earnings vs. Regular Income

The tax treatment may vary based on the scale and frequency of earnings:

1. Minimal Earnings (Hobby Mining): If users earn minimal amounts through P2E gaming, similar to hobby mining, the tax liability may be deferred until they sell, trade, spend, or gift the earned coins or tokens. In such cases, Capital Gains Tax would apply.

2. Regular or Significant Earnings (Income): For users earning larger amounts regularly, akin to a consistent income, Income Tax is likely applicable. The fair market value of the received crypto at the time of receipt would determine the taxable amount.

Given the evolving nature of P2E gaming, users should stay informed about any updates or specific guidance from the CRA.

Taxes on NFTs

Non-Fungible Tokens (NFTs) have become a prominent part of the DeFi landscape, representing unique digital assets. Despite their non-fungible nature, NFTs are treated similarly to other cryptocurrencies for tax purposes in Canada.

Buying NFTs

1. Buying with Crypto: Purchasing NFTs with cryptocurrency incurs Capital Gains Tax when selling the NFT. The taxable event occurs at the time of selling the NFT, and the tax liability is based on the profit realized from the sale.

2. Buying with Fiat Currency: Buying NFTs with fiat currency is generally tax-free, as it doesn't involve the disposal of cryptocurrency.

Selling and Trading NFTs

1. Selling NFTs: Capital Gains Tax is applicable when selling an NFT that was previously purchased. The tax liability is based on the profit realized from the sale.

2. Trading NFTs: Similar to selling, trading NFTs incurs Capital Gains Tax. The taxable event occurs at the time of the trade, and the profit from the transaction is subject to taxation.

Is GAS FEES Taxed?

The aspect of gas fees in the DeFi space brings a unique challenge when it comes to taxation. Gas fees, which are transaction fees paid for the computational work involved in processing and validating transactions on the blockchain, can have varying tax implications.

Transaction Fees and Tax Deductibility

1. Gas Fees as Cost Basis: Transaction fees, often associated with executing various DeFi activities, can be added to the cost basis of the transaction. This means that the fees can be considered part of the overall expense of the transaction, potentially reducing the taxable gains.

2. Transfer Fees: However, not all fees are treated the same way. Transfer fees, which are distinct from transaction fees, may not be eligible for addition to the cost basis. Instead, they might be treated as a disposition and subject to Capital Gains Tax.

Tax on Wrapped Tokens

Wrapped tokens play a crucial role in facilitating interoperability between different blockchains within the DeFi space. However, the tax treatment of wrapping tokens involves considerations similar to crypto-to-crypto trades.

Crypto-to-Crypto Trade and Capital Gains Tax

When you 'wrap' a token, exchanging one token for another, it could be treated as a crypto-to-crypto trade. While this might trigger Capital Gains Tax, the taxable event's outcome often depends on the specific circumstances

1. Equivalent Value: If the tokens exchanged are of equivalent value, the realization of a gain or loss might be minimal. In such cases, there may be no substantial taxable event.

2. Realized Gain or Loss: The determination of Capital Gains Tax will depend on whether the exchange results in a realized gain or loss. This is calculated based on the difference in value between the tokens at the time of the exchange.

Token Rebases Tax

Token rebases, a mechanism employed by certain tokens to maintain a consistent value with an underlying asset, present tax considerations similar to stock splits. While the Canada Revenue Agency (CRA) hasn't provided specific guidance on token rebases, some parallels can be drawn from existing frameworks.

Token Rebase as a Non-Taxable Event

Drawing inspiration from the treatment of stock splits, which the CRA deems as non-taxable events, it's reasonable to assume a similar approach for token rebases.

1. Adjustment in Coin Supply: Token rebases involve adjustments to the coin supply based on price fluctuations. If the rebase results in an increase or decrease in the number of tokens without an accompanying disposition, it might be considered a non-taxable event.

2. Comparison to Stock Splits: Given the similarity to stock splits, where the number of shares changes without altering the overall value, token rebases could be viewed in a similar light from a tax perspective.

Example: 

Initial Value: Imagine the initial value of 1 RBC (Token) is pegged to $1 USD, and the total supply of RBC is 1 million tokens.

Price Fluctuations: Due to market dynamics, the price of RBC starts to fluctuate. If the market price rises above $1, a rebase occurs.

Rebase Event: To realign the value, a rebase might increase the total supply of RBC. For instance, a 10% positive rebase could add 10% more tokens to each holder's balance.

Before Rebase: 1 RBC = $1

After 10% Positive Rebase: 1.1 RBC = $1.1 (to maintain the $1 value)

Inverse Scenario: Conversely, if the market price drops below $1, a negative rebase reduces the total supply, aiming to restore the $1 value.

Before Rebase: 1 RBC = $1

After 10% Negative Rebase: 0.9 RBC = $1 (to maintain the $1 value)

Best Crypto Tax Software for DeFi

Navigating DeFi taxes can be TRICKY and requires a robust tool to streamline the process and ensure accurate reporting. Several crypto tax software solutions are available, and choosing the right one is crucial for effectively managing your tax obligations.

Kryptos Crypto Tax Software

Kryptos stands out as a comprehensive crypto tax software that caters to the intricate nature of DeFi transactions. Here are some key features:

1. Transaction Tracking: Kryptos enables you to sync wallets, exchanges, or blockchains, providing a centralized view of your crypto transactions.

2. Automated Labeling: The software employs automated labeling to identify different types of DeFi transactions, ensuring accurate tax treatment.

3. Customization Options: Kryptos offers customization options, allowing users to control the level of conservatism in their crypto tax reporting.

4. Tax Reports: Once transactions are imported, Kryptos generates detailed tax reports suitable for submission to the CRA. Reports can also be tailored for specific tax applications like TurboTax.

5. User-Friendly Interface: With an intuitive user interface, Kryptos simplifies the process of calculating and managing DeFi taxes.

FAQs

1. How does DeFi yield farming impact my taxes in Canada?

Yield farming in the decentralized finance (DeFi) space introduces complexities in tax implications. Earnings from providing liquidity, staking, and receiving governance tokens may be subject to Income Tax, and understanding these dynamics is crucial for accurate tax reporting.

2. Are gas fees incurred during DeFi transactions taxable in Canada?

Gas fees, which represent transaction costs on the blockchain, have varying tax implications. While transaction fees may be added to the cost basis and considered tax-deductible, transfer fees could be treated as a disposition, subject to Capital Gains Tax.

3. What is the tax treatment for Play-to-Earn (P2E) crypto gaming in Canada?

Play-to-Earn (P2E) gaming earnings are subject to tax in Canada, with the treatment depending on the scale of earnings. Minimal amounts may incur Capital Gains Tax upon selling, trading, or gifting, while regular or significant earnings may be treated as income, taxed based on the fair market value at receipt.

4. How are Wrapped Tokens taxed in the Canadian DeFi landscape?

Wrapped tokens, facilitating interoperability between blockchains, are subject to tax similar to crypto-to-crypto trades. The exchange of tokens may trigger Capital Gains Tax, depending on the value and nature of the tokens exchanged.

5. Is there a tax liability for token rebases in Canada's DeFi space?

Token rebases, aimed at maintaining value with an underlying asset, are likely treated as a non-taxable event in Canada, drawing parallels with stock splits. While the Canada Revenue Agency hasn't provided specific guidance, users should stay informed and seek professional advice due to evolving interpretations.

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