How Is Liquidity Mining (DeFi) Taxed in Germany?

A total of three points in time are relevant for the fiscal assessment with respect to crypto liquidity mining in Germany.

First, the contribution of the trading pairs into the pool is crucial for taxation. Adding trading pairs to a liquidity pool may constitute a sale of the pair for tax purposes. This is because in exchange for the deployment, the investor generally receives a liquidity pool token (LP token). This results in two sales within the meaning of Section 23 (1) sentence 1 no. 2 of the German Income Tax Act (Einkommensteuergesetz, EStG) - one for each currency. Profits are then taxable if the sale of the trading pairs is within the speculation period of one year. If the cryptocurrencies have already been held for more than one year, however, the gains are tax-free.

The regular profit distributions during the period of participation in the pool are also relevant for the assessment under German tax law. In this respect, various legal opinions are held. So far, there is no binding statement by the tax authorities. Since the emergence of liquidity mining, we have been of the opinion that regular rewards are income according to Section 20 (1) No. 4 EStG, i.e. capital income. They are thus subject to capital gains tax/withholding tax and not to the personal income tax rate.

Finally, the withdrawal from the pool has the consequence that the user receives back his contributed trading pairs in exchange for his LP token. When re-purchasing the trading pairs against the contribution of the LP token, the investor generally does not receive the currencies back in the same proportion as he contributed them to the pool because of the changes in value that have occurred in the meantime. For the LP token, the investor does not receive, for example, 50 A-Coins and 50 B-Coins, which he originally put into the pool, but, for example, only 40 A-Coins, but 60 B-Coins. These are two disposal or acquisition transactions according to § 23 EStG. The holding period for the reacquired cryptocurrencies starts again.

The above illustration is not the only way to treat the contribution and withdrawal of coins into a liquidity pool for tax purposes. Indeed, it assumes that an LP token is a separate token with its own underlying legal quality. It is therefore a separate asset that changes hands in exchange for the contribution of the currency pair. This is supported by the fact that LP tokens can also be used themselves on some platforms to generate income (staking/farming). However, this is not always the case.

LP tokens are often not tradable. The relevant pricing tools (Coingecko, etc.) do not show market prices for this reason. If this is the case, an LP token is possibly only a kind of receipt or entitlement certificate that represents the investor's share in the pool. In this case, the token only represents a mathematical quantity for the loan granted by the currency pair to the pool.

And indeed, in an individual decision, a tax authority in Hesse expressed this latter opinion: "The contribution of the trading pairs to the liquidity pool constitutes a deposit of the assets which continue to be owned by the contributors. The token received is only an 'entitlement certificate'."

This legal opinion is based on BFH case law on securities lending: At least if the notice period is less than three days, there is no transfer of beneficial ownership of the borrowed securities in the case of securities lending. However, this is a prerequisite for a sale under Section 23 EStG.

This idea can be transferred to the lending of cryptocurrency pairs: The currency pair is only lent and the repayment is also made in the crypto values lent, although possibly in a different denomination. The economic ownership, however, remains with the investor all the time, who, by the way, continues to bear the price risk and the risk of the so-called impermanent loss. In most cases, the investor can also terminate the crypto liquidity mining at any time; a notice period often does not exist.