Introduction
Yield farming has become a widely used strategy in Decentralised Finance (DeFi), allowing investors to earn passive income by staking, lending, or providing liquidity. However, while it offers high potential rewards, it also comes with risks—particularly regarding tax compliance.
HMRC's stance on DeFi taxation remains a topic of discussion, with industry professionals highlighting the complexity of its guidance. Despite this, investors must adhere to current tax laws and report all DeFi activity accurately.
This article explains how yield farming works, its potential risks, and the tax implications for UK investors.
What Is Yield Farming?
Yield farming is a way for cryptocurrency holders to earn rewards by contributing their assets to DeFi platforms. These rewards typically come from transaction fees, interest, or additional tokens distributed as incentives.
How Does Yield Farming Work?
Yield farming is carried out through smart contracts on DeFi platforms. Investors deposit their crypto into liquidity pools or lending platforms, which are then used for various financial activities.
-
Lending: Investors lend crypto to borrowers through platforms like Aave or Compound and receive interest in return.
-
Borrowing: Users provide collateral to borrow another asset, often using the borrowed funds to reinvest and earn more rewards.
-
Staking: Users lock up their crypto to support a blockchain network and receive staking rewards.
-
Liquidity Pools: Users contribute tokens to decentralised exchanges like Uniswap to facilitate trading and earn a share of transaction fees.
Risks of Yield Farming
Despite the potential for high returns, yield farming has its risks:
-
Impermanent Loss: If the price of tokens in a liquidity pool fluctuates significantly, investors may end up with fewer assets than they initially deposited.
-
Protocol Risks: DeFi platforms rely on smart contracts, which can be vulnerable to bugs, exploits, or fraud.
-
Market Volatility: Cryptocurrency markets are highly volatile, affecting the value of staked or borrowed assets.
-
Regulatory Uncertainty: The evolving regulatory landscape means tax rules may change, requiring investors to stay updated.
How Is Yield Farming Taxed?
The taxation of yield farming depends on the type of activity and whether it generates income or capital gains. HMRC's guidance states that investors must assess whether their transactions involve a change in beneficial ownership and classify their rewards accordingly.
Income Tax on Yield Farming Rewards
If yield farming rewards are classified as income, they are taxed as miscellaneous income at their fair market value (FMV) when received. This means that each reward is assessed for taxation at the time of receipt, regardless of whether the asset's value increases or decreases later.
Capital Gains Tax on Yield Farming
If rewards are considered capital in nature, capital gains tax (CGT) applies. Additionally, CGT may be triggered at the following stages:
-
When entering a yield farming position: If HMRC determines that beneficial ownership has changed, depositing assets into a DeFi protocol could be considered a disposal.
-
When exiting a yield farming position: If beneficial ownership is transferred back, another disposal occurs, triggering CGT on any gains or losses.
-
When selling or exchanging rewards: Any subsequent disposal of tokens received as rewards is subject to CGT. The taxable gain is calculated as the difference between the FMV at the time of receipt and the disposal value.
How to Track Yield Farming Taxes
Given the complexities of tracking DeFi transactions, proper record-keeping is essential. Investors should maintain:
-
A record of all transactions, including deposits, rewards, and withdrawals.
-
The FMV of rewards at the time of receipt.
-
Any costs or fees incurred in yield farming activities.
-
The valuation method used to determine gains and losses.
Conclusion
Yield farming offers attractive earning opportunities but comes with significant tax obligations. Investors must determine whether their rewards fall under income tax or capital gains tax and assess whether beneficial ownership changes apply to their transactions.
Staying compliant requires accurate record-keeping and a thorough understanding of HMRC’s current guidance. Since tax regulations for DeFi remain complex and subject to change, consulting a crypto tax professional can help ensure proper reporting.
If you have any questions or require further assistance, our team at Block3 Finance can help you.
Please contact us by email at inquiry@block3finance.com or by phone at 1-877-804-1888 to schedule a FREE initial consultation appointment.
You may also visit our website (www.block3finance.com) to learn more about the range of crypto services we offer to startups, DAOs, and established businesses.