Navigate the complexities of crypto taxes in the Netherlands with our comprehensive guide. From reporting obligations to deductions, learn how to minimize your tax liability and maximize your crypto gains.
De-Fi adoption has seen an astronomical rise in the past few years. According to Dune Analytics, the number of unique addresses using De-Fi applications has skyrocketed to 4 million since May 2020, and the total value locked across De-Fi protocols stood at $78 billion, a 10X multiple of what it was back in 2020, according to Defi Pulse.
While this has been lucrative for startups and investors in the space, the sheer volume of transactions has mandated regulators across the globe to issue guidelines for Defi taxes, and regulate the space to protect investors from fraud and unsolicited legal complications. And the UK is no exception to this, the HMRC has issued guidelines to categorize De-Fi transactions and offers clarity on their taxation.
If you don’t have the time to read the entire HMRC taxation report on De-Fi transactions, here’s a summary of the doc in a more digestible format.
What is De-Fi?
De-Fi is an alternative financial infrastructure offering all traditional financial services via a decentralized ledger using cryptocurrencies, removing the need for traditional intermediaries like banks, insurance companies, and brokerage firms. Decentralized finance lowers the barrier to entry for people and makes it easier for them to access basic financial services like loans, payments, brokerage, and investments.
It is an umbrella term to describe all crypto transactions that involve a decentralized service provider. De-Fi is not defined in UK regulatory or tax laws, and the terms used in the industry are primarily created by industry participants.
Understanding De-Fi Lending and Staking
De-Fi lending is a pretty straightforward concept. It refers to the lending of crypto assets you own to others either directly through P2P lending, or through lending platforms like Crypto.com, Binance, and Celsius. The liquidity providers or the owners of crypto assets are rewarded for lending their assets(a form of interest paid using platform-native tokens). Users can also seek loans from these platforms for which they might have to provide collateral.
Staking is different in the context that the crypto assets are added to a liquidity pool created by a De-Fi platform by accumulating assets from users called liquidity providers in return for a reward, often referred to as “staking reward” in the De-Fi space. Since both staking and lending involve transferring ownership although temporarily in some cases, it is considered as a disposal of crypto assets and attracts capital gains tax. And any recurring returns from staking or lending are considered an income and therefore attract income tax liabilities.
UK Governments Lending and Staking Models
The HMRC has issued clear guidelines listing the existing lending and staking models. As the market evolves, new models will be added to organize the taxation of De-Fi transactions.
- When an individual lends out their tokens directly to a borrower without the involvement of a De-Fi platform and transfers control of the tokens to the borrower.
- If an individual gives tokens to a De-Fi lending platform temporarily, which pools the tokens with others to create a liquidity pool.
- A person lends tokens to a De-Fi platform in exchange for different crypto assets or NFTs, which the platform pools and gives back different tokens or NFTs as a reward.
How are De-Fi Transactions Taxed as per HMRC Guidelines?
No new legislation has been passed to accommodate the taxation of De-Fi transactions, the HMRC has issued guidelines to group De-Fi transactions under the current taxable categories. De-Fi transactions are not taxes based on the nomenclature, but rather the nature of transactions.
The transaction involving De-Fi has three main elements that need to be considered for tax purposes.
- Lending tokens or making tokens available for staking
- Rewards received as a result of lending or staking
- Withdrawing tokens from liquidity or repayment of a loan
Income Vs Capital Assets
As mentioned earlier, De-Fi transactions are taxed based on the nature of transactions. De-Fi transactions are categorized into two sections according to the HMRC’s notifications, if the crypto asset is disposed of or exchanged for some other token, then it is counted as a capital asset disposal and attracts capital gains tax.
In the event of recurring rewards from staking, or lending crypto-assets, either from an individual or from a De-Fi platform, the gains will be considered as income and will be taxed under the income tax laws.
Lending and Staking Taxes in the UK
Depending on the nature of the De-Fi transaction, the gains are taxed according to the following rules:
- If the return is considered income, it will be subject to income tax (or corporation tax for companies) when it is received. Generally, the return is considered income if it is based on a percentage of the tokens that were lent or staked, such as a 5% per year return for 2 years on staked crypto-assets.
- If the return is considered capital in nature, it will be subject to Capital Gains Tax when received. Determining whether a return is capital in nature can be complex. Still, it is generally considered capital if it is obtained through the sale of a capital asset or if the return is based on the increase in value of a capital asset.
Liquidity Mining Taxes in the UK
Adding or removing liquidity from liquidity pools is a taxable event according to the new HMRC guidelines. Defi mining attracts capital gains tax in the UK. The tokens received in exchange for lending or staking crypto-assets inherit the cost basis(amount paid for acquiring the assets) of the assets staked or pledged as a lender.
The taxes will depend on the way they are obtained. Income Tax will apply if you receive new tokens or coins as a result of your contribution, while Capital Gains Tax is more likely to apply if you receive tokens from a liquidity pool that increases in value, but the gains are realized only when you withdraw assets from the liquidity pool.
Crypto Futures and Derivatives Taxes in the UK
Crypto futures and derivatives are advanced financial instruments that are offered by De-Fi platforms. These transactions are simply viewed as simple open/close positions by the HMRC and attract capital gains tax in the UK.
If the futures contract liquidates or you close your position, any capital gains incurred from the event are taxed under capital gains tax rules. It's worth mentioning that as there is no specific guidance on taxes for trading crypto CFDs, it is advisable to consult a UK tax advisor for personalized advice on how these transactions will affect your crypto taxes.
Yield Farming Taxes in the UK
Yield farming is one of the most popular avenues for earning steady returns on a volatile asset like crypto, primarily because of the lower risk profile of the method. It simply refers to the strategic approach of stacking crypto transactions on top of each other to receive the highest returns possible on the investment. The returns may be tokens, NFTs, or interest paid for staking tokens.
Depending on how you club your investments, the taxation may vary. You can club the tax rules for the type of rewards you receive and calculate the taxes owed on the transactions.
Gas Fees Taxes in the UK
The HMRC guidelines offer a list of allowable expenses that can be added to your cost basis to reduce your taxable income. Transfer fees and transaction fees are both categorized as allowed expenses and therefore can be added to your cost basis.
Taxes on Wrapped Tokens
Wrapped tokens are simply crypto tokens that are wrapped with blockchain-based representations on another blockchain, which makes it easier for them to travel across the decentralized financial chain.
Wrapping assets makes it easier for De-Fi protocols to send or receive them, which might not have been practically possible if they were not wrapped. A good example would be how gold as a physical asset is non-transferrable across the decentralized chain, but if gold is wrapped, it can be easily transferred across the De-Fi space.
HMRC has not provided specific guidelines on the taxation of wrapped assets yet. However, based on the nature of swapping one cryptocurrency for another, it is likely that any resulting gain would be considered disposal and would therefore be subject to Capital Gains Tax
How to Calculate your De-Fi taxes Instantly?
Tracking all De-Fi transactions across platforms and calculating your cost basis for every transaction is a tedious task and that’s why filing crypto taxes can be intimidating for a lot of people.
One smart way to keep track of all your De-Fi transactions is to use crypto tax software like Kryptoskatt, that auto-fetches all your transactions across the De-Fi space and creates a legally compliant tax report based on your location.
All you need to do is add all your active profiles across De-Fi exchanges on the website and hop in the back seat while Kryptoskatt does the job for you.
Frequently Asked Questions(FAQs)
- How do Defi projects earn money?
Defi platforms make money through multiple avenues and it’s nearly impossible to list every income stream here. However, here are some of the primary ones.
- Transaction fees: Many Defi protocols charge small fees for transactions on their platforms, such as trading fees or lending fees.
- Liquidity provision: Some Defi projects allow users to provide liquidity to trading pairs on their platform, in exchange for a portion of the trading fees. These are known as liquidity providers.
- Yield farming: Yield farming is a form of liquidity provision that allows users to earn returns on their assets by lending them to other users. These returns can be in the form of interest, trading fees, or even new tokens.
- Governance: Some Defi projects offer token holders the ability to vote on protocol changes, which can affect the overall value of the token.
- How are Defi loans taxed?
The taxation of decentralized finance (Defi) loans can vary depending on the jurisdiction and the specific details of the loan. However, in general, Defi loans may be subject to income tax, capital gains tax, or both.
Income tax: If a Defi loan is structured as interest-bearing, the interest earned on loan may be considered taxable income and subject to income tax.
Capital gains tax: If a Defi loan is structured as a collateralized loan, and the value of the collateral increases while it is being held as collateral, the borrower may be subject to capital gains tax when the loan is repaid and the collateral is returned.
- Can you avoid taxes on Defi?
It is not advisable to avoid taxes on decentralized finance (Defi) transactions as it is illegal in most countries. Tax laws vary by jurisdiction and it's important to consult with a tax professional or check with the relevant tax authority to understand the tax implications of your Defi transactions.
It's important to note that tax evasion, which is the illegal non-payment or underpayment of taxes, can result in significant fines or even criminal charges. It is important to report all DeFi-related income to the tax authorities.
- What are some disadvantages of De-Fi?
There are several disadvantages of De-Fi. Some of them are listed below:
- High complexity
- Lack of regulation
- Smart Contract Risks
- Lack of insurance
- Complex taxation
- Lack of customer support