💧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
Income Tax
Income rewards
The new HMRC DeFi guidance on lending and staking indicates that lending rewards (including those from liquidity pools) may not always be income rewards. It is necessary to consider if the nature of the rewards is capital or income.
Income 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 reward tokens at the date of receipt will be the value of the taxable miscellaneous income.
If the taxpayer is a ‘financial trader’ in cryptoassets these rewards may be treated as trading income rather than miscellaneous income.
Capital rewards are subject to capital gains tax and are not treated as miscellaneous income subjected to income tax - see below.
Capital Gains Tax
Capital rewards - CGT charged upon entering liquidity pool and upon receipt of reward
The new HMRC DeFi guidance on lending and staking indicates that lending rewards (including those from liquidity pools) may not always be income rewards. It is necessary to consider if the nature of the rewards is capital or income.
Capital rewards are subject to capital gains tax and are not treated as miscellaneous income subjected to income tax.
A capital gain is realised on the capital reward upon adding tokens into the liquidity pool (based on the estimated present value of the future capital reward). This gain upon entry is then re-assessed upon receipt of the capital reward (usually upon exit), based on the value of the reward when received.
Upon entering the liquidity pool, when the capital reward is subjected to capital gains tax, there is also an acquisition of a ‘Marren v Ingles right' to receive the future capital reward. The acquisition cost of this ‘Marren v Ingles right' is the estimated present value of the future capital reward at the time of entering the liquidity pool.
There is a disposal of this 'Marren v Ingles right' upon receipt of the capital reward (usually upon exit from the liquidity pool). The disposal proceeds are the sterling market value of the capital reward tokens received. The acquisition cost is the estimate of the future capital reward that was made upon entry. There is a capital gain where the estimation upon entry was too low, or a capital loss where is was too high. It is possible to make an election to carry back a loss from a 'Marren v Ingles right' against the capital gain upon entry.
See our detailed guidance on the tax position of capital reward upon entering a liquidity pool and upon receipt of the capital reward.
If the taxpayer is a ‘financial trader’ in cryptoassets these rewards may be treated as trading income rather than capital rewards.
Acquisition cost of reward tokens
The receipt of cryptoasset tokens as a liquidity pool reward is an acquisition of those tokens for CGT purposes, regardless of whether it is taxed as an income reward or a capital reward. The sterling market value at the date of receipt is the CGT acquisition cost. The acquisition of tokens is in not a CGT event.
When these tokens received as rewards are later disposed of, there may be a capital gain or capital loss depending on the change in value since acquisition and the application of the share matching rules, dictating which cost is offset against a disposal.
Liquidity Pools - entry and exit
Principal tokens added to and removed from pool
HMRC guidance confirms that the capital gains tax position of the principal tokens locked away needs to be considered at the time of adding your cryptoassets to the liquidity pool and again at the time of removing them. There are no income tax implications for the principal tokens.
The tax treatment depends on whether or not beneficial ownership of the tokens locked away has been transferred to another party. This is a very complex decision and please see our further guidance on this, but ultimately seek expert help from a tax professional or legal advice on this matter.
Our analysis of the tax position is different depending on whether the rewards are income or capital in nature:
If NO beneficial ownership transferred
The new HMRC DeFi guidance on lending and staking does not cover liquidity pools in a situation where there is no transfer of beneficial ownership of the tokens added to the pool.
Where there is no change in beneficial ownership when the tokens are added to the pool, there is no requirement to realise a capital gains tax disposal of the tokens added.
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.
It is unclear in the absence of HMRC guidance how to account for the changes in the number of tokens held upon exit from the 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.
Example - where there is NO beneficial ownership transferred
Next is an Example - Liquidity pool to illustrate what we consider to be a reasonable tax approach for liquidity pools where there is no transfer of beneficial ownership of the tokens added to the pool.
We have written to HMRC to seek clarification on the tax treatment of liquidity pools where there is no transfer of beneficial ownership, but we are awaiting a reply.
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