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ATO subjects DeFi transactions to capital gains tax

ATO states that various DeFi interactions like lending, borrowing, liquidity provision, and wrapping tokens will typically result in a CGT event.

Christopher Lazzaro, CPA, MBA, Shehan Chandrasekera, CPA

December 12, 2023  ·  5 min read

ATO subjects DeFi transactions to capital gains tax

On November 8, 2023, the Australian Taxation Office (ATO) published guidance on how to treat decentralised finance (DeFi) and wrapping transactions. DeFi represents a shift in the traditional financial landscape, eliminating the need for intermediaries by operating on a peer-to-peer basis through the blockchain. While this advancement fosters financial inclusivity and innovation, it brings forth complex tax implications, specifically capital gains tax (CGT) events that vary depending on the DeFi activities.

The ATO states that various DeFi interactions like lending, borrowing, liquidity provision, and wrapping tokens will typically result in a CGT event. In addition, the ATO says that any interest or rewards earned from DeFi activities are assessable income. The taxation of these events is contingent upon the structure and nature of your arrangement. Considerations include involvement with another entity and if a trust relationship forms. Understanding the nuances of these activities and their tax implications is crucial for you to stay compliant.

Lending and borrowing with DeFi

The terminology in DeFi, such as “lending” and “borrowing,” don't always align with the traditional definitions for tax purposes. Therefore, these activities often lead to CGT events due to a change of beneficial ownership of crypto assets.

A CGT event occurs when you no longer have beneficial ownership of a crypto asset due to an arrangement. These arrangements usually involve trading one crypto asset for another or trading for a future right to receive an equivalent amount of the same asset.

To determine if a CGT event happens, you must analyze the terms, conditions, and operational aspects of the protocol. 

In essence, a CGT event occurs if you send a fungible crypto asset (for example, ether (ETH) or an ERC-20 compliant token) to an address that:

  • you don't control or,
  • you already have a balance of the same fungible crypto asset.

For example, Abe buys 100 X coins for $800 on January 1, 2023. On June 30, 2023, he lends (now worth $1,000) them to earn a 5% rate of return. Abe doesn’t maintain beneficial ownership based on the terms of the contract. Abe has a CGT event since there is a change in the beneficial ownership. Abe’s capital gain is $200 ($1,000 - $800).

Let's look at an example of a deposit into a wallet address with an existing balance. Blake buys 200 X coins for $1,500, and later lends them to a DeFi platform to earn rewards. The terms of the contract are unclear about whether Blake retains beneficial ownership of his X coins. The DeFi platform pools Blake’s X coins into the same address as other lenders' X coins. Since X coins are fungible and there is a balance of X coins in that wallet, a CGT event happens during the initial loan. By making this loan Blake has the right to receive 200 X coins from the DeFi platform at a future date. When Blake gets the right (makes the loan), his 200 X coins had a fair market value (FMV) of $1,200, so he has a loss of $300 ($1,200 - $1,500). Blake’s rights have a cost basis of $1,200.

Blake repays the loan four months later, and his rights to receive 200 X coins from the DeFi platform are satisfied when the 200 X coins get transferred to him. The FMV of the 200 X coins is $2,000 when they get transferred back. Blake has a CGT of $800 ($2,000 - $1,200), and the cost basis of his 200 X coins is $2,000.

Liquidity pools and providers

A liquidity pool is a smart contract that groups crypto users’ funds to provide liquidity for the market. Liquidity pools help facilitate decentralised crypto asset trading and lending. Liquidity Providers (LPs) generally receive a new crypto asset or rights representing their liquidity pool share. For doing so, LPs get rewarded with interest for locking their tokens. 

A CGT event happens when you deposit your crypto assets into the liquidity pool. Another CGT event occurs when you withdraw your crypto assets from the pool. In essence, liquidity pools are another form of lending, and LPs typically don’t control the wallet address of the pool, and their assets are pooled into a smart contract containing the same assets. 

For example, Cathy (LP) deposits 100 X coins into a liquidity pool. In exchange, she receives 20 liquidity pool tokens (worth $300) representing her share in the liquidity pool. Cathy acquired the 100 X coins two years ago for $100. The deposit of 100 X coins into the liquidity pool creates a CGT event. Cathy has a capital gain of $200 ($300 - $100). Since she held the X coins for over a year, only 50% of the gain is subject to capital gain tax. 

When Cathy returns the 20 liquidity pool tokens to the liquidity pool to redeem her 100 X coins, there will be another CGT event. For example, after six months, Cathy returns the 20 liquidity pool tokens and receives 100 X coins. The FMV of the X coins is$700 when she returns the liquidity pool tokens. This results in a capital gain of $400 ($700 - $300).  

Wrapped tokens

A wrapped token serves as a tokenised form of another cryptocurrency asset. Wrapped tokens allow for the use of one blockchain (like Bitcoin) asset to be used on a different blockchain (such as Ethereum) or represent a crypto asset of a specific standard as a different standard (such as converting ETH into an ERC-20 compliant version).

The process usually involves a smart contract that manages, verifies, or enforces contract terms without intermediaries. To wrap the tokens, you transfer the crypto assets to the smart contract's address. The contract then creates a wrapped version of the asset while the original is held in the contract's address until the wrapped token is redeemed. This locking mechanism prevents the double spending of the token's represented value.

Wrapping or unwrapping a crypto asset is an exchange between two assets, triggering a capital gain event. The capital proceeds from this event are equivalent to the market value of the wrapped token received at the time of the exchange.

For example, Dale bought one BTC for $20,000 in January 2023 that he wants to use on the Ethereum network. Dale wraps it through a smart contract and receives one wBTC in November 2023. The FMV of wBTC when he wrapped it was $50,000. A capital gain event happens when the smart contract wraps the BTC. Dale has a capital gain of $30,000 ($50,000 - $20,000). 

DeFi interest and rewards

Platforms often offer rewards for deposited assets, akin to interest income. These rewards are generally taxable and must be reported as assessable income based on the FMV of the received assets at the time of acquisition. These assets will be subject to CGT when they are disposed of in the future.

For example, Dale lends stablecoins to a platform to earn a rate of return. He periodically receives additional stablecoins as a reward throughout the year. These rewards add up to $50 based on their market value when received. The $50 of rewards is considered assessable income. If Dale sells the rewards for $110 a month later, he will have a capital gain of $60 ($110 - $50). 

How to stay tax-compliant

To stay tax-compliant, you must maintain detailed records of your transactions. The information you should keep includes:

  • Transaction records from exchange accounts and public wallet addresses, including:
    • Date
    • Value of the crypto assets at the time of each transaction
    • What is the transaction for, and who is the other party (or wallet address)
  • Costs that relate to managing your tax affairs (Accounting, legal, tracking software costs)

CoinTracker can maintain the transaction records to make your tax compliance easier. By default, CoinTracker will treat lending, borrowing, providing liquidity, and wrapping as CGT events and other rewards as assessable income. 

If you have any questions or comments, let us know on Twitter @CoinTracker.

CoinTracker integrates with 300+ cryptocurrency exchanges, 8,000+ cryptocurrencies and makes crypto tax calculations and portfolio tracking simple.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.

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