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Liquidity Pools

What is a Liquidity Pool?

A liquidity pool is a crowdsourced pool of cryptocurrencies or tokens locked in a smart contract that is used to facilitate trades between the assets on a decentralized exchange (DEX) providing liquidity and convenience to the DeFi ecosystem.
When a user supplies a pool with liquidity, they are often rewarded with Liquidity Provider (LP) tokens in proportion to the amount of liquidity. When the pool facilitates a trade a fractional fee is distributed proportionally amongst the LP token holders.

Liquidity Pool Rewards

There is no HMRC guidance on liquidity pools or lending rewards in general, so you would need to examine the details of the transactions you are undertaking to determine the tax treatment.

Income Tax

Following HMRCโ€™s tax treatment of staking, it seems clear that rewards received in exchange for putting tokens into a liquidity pool will be taxable as miscellaneous income, subject to income tax.
The sterling value of the rewards (usually cryptoasset tokens) at the date of receipt will be the value of the taxable miscellaneous income.
If the taxpayer is a โ€˜financial traderโ€™ in cryptoassets these rewards may be treated as trading income rather than miscellaneous income.

Capital Gains Tax

The sterling value of the reward at the date of receipt is the capital gains tax acquisition cost of the tokens; to be deducted from the proceeds of a later disposal of the tokens (which is subject to capital gains tax).
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Liquidity Pool Movements

There is no HMRC guidance on liquidity pools, so you would need to examine the details of the transactions you are undertaking to determine the tax treatment.

Capital Gains Tax

Where the beneficial ownership of the cryptoasset tokens put into the liquidity pool is retained by the taxpayer, it seems clear that there is no disposal of these tokens for capital gains tax purposes. This is the same position as the tax treatment for staking, where HMRC do not treat tokens staked as a disposal for tax purposes.
Often two different types of cryptoasset tokens are added to a liquidity pool by the owner, but a different number of each type of token are withdrawn upon exit from the pool. For example, 5 ETH and 10 LNK are put into the liquidity pool; yet 3 ETH and 15 LNK are withdrawn from the liquidity pool. The most logical tax treatment is that upon the exit from the pool, there is a taxable disposal of 2 ETH and an acquisition of 5 LNK. The disposal proceeds being equal to the sterling value of 2 ETH and the acquisition cost being the sterling value of 5 LNK; both at the date of withdrawal of the tokens from the pool.

Income Tax

In the absence of HMRC guidance, it is expected that there are no income tax implications of adding cryptoassets to a liquidity pool or removing tokens provided as liquidity from the pool. See guidance above on Liquidity Pool Rewards for the tax position of rewards received in exchange for putting tokens into a liquidity pool.

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Next is an example to illustrate what we consider to be a reasonable tax approach for liquidity pools.
We have written to HMRC to seek clarification on the tax treatment of liquidity pools but we are awaiting a reply.
Last modified 1mo ago