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How Is Liquidity Mining (DeFi) Taxed in Germany?

What is decentralized finance (DeFi)?

Parallel to the growing interest in cryptocurrencies among the general public, decentralized financial markets (DeFi) are becoming increasingly popular. The boom is fueled not least by the bankruptcies of central trading platforms such as FTX, but also Mt.Gox and others.

DeFi represents new alternatives to traditional financial markets. While traditional financial sectors require a central actor (e.g. a bank or stock exchange) to regulate and control all transactions and services, in DeFi this function is performed by a decentralized autonomous organization. This is an organization based on blockchain technology that makes use of smart contracts (computer codes that can automatically execute certain specified rules) to be able to self-direct operations in the virtual financial market. Ideally, this represents a tamper-proof and transparent financial system.

One particularly popular decentralized financial innovation is liquidity mining.

How does liquidity mining work?

One way for investors to make a profit on decentralized exchanges (DEX) is through so-called liquidity mining. This refers to a mechanism in which investors invest their cryptocurrencies in a pool and make them available to a decentralized exchange (DEX). For making the cryptocurrencies available, the providers are rewarded by, for example, being paid a portion of the fees incurred on the marketplace through transactions. In addition, however, there may also be a distribution of governance tokens from various platforms as a reward. Governance tokens allow holders participation rights within a DeFi platform (e.g. voting rights on the future development of the platform). These rewards can in turn be used to generate further profits on various DeFi platforms. Meanwhile, there are many different DeFi platforms for liquidity mining, such as Uniswap, Synthetix, Nexus Mutual or Compound.

Liquidity mining in the example of Uniswap

Users of the DeFi/liquidity mining platform Uniswap provide trading pairs in the form of different cryptocurrencies to the liquidity pool (e.g. ETH/USDC, ETH/DAI, ETH/wBTC). Each time liquidity is contributed to a pool, governance tokens (UNI tokens) are distributed to the investor in proportion to the amount of liquidity contributed to the pool. In addition, fees are charged each time a trade is made by the platform and are distributed proportionately to all liquidity providers. The user can claim the fees as soon as he withdraws his trading pairs from the pool again.

Three relevant times for taxation of liquidity mining in Germany

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

1. Contribution of the tokens

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.

2. Regular distribution of profits

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.

3. Withdrawal from the pool

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 surrender 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.

Alternative tax consideration: LP tokens as receipts or certificates

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.

Regional Tax Office: No taxable transaction upon entry into the liquidity pool

And indeed, in an individual decision, the OFD Hesse (Higher Fiscal Authority in Frankfurt/Main) 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'."

Absence of transfer of beneficial ownership

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.

Legal consequence: No disposal upon entry into and exit from the pool

If one follows this alternative interpretation, one comes to the conclusion that the transfer of the currency pair into the pool does not constitute a sale, but merely the transfer of a loan similar to a securities loan, i.e. a special form of lending. Upon termination of the loan and return of the LP token, there is thus also no exchange. Instead, the return of the LP token is merely the repayment of the loan granted.

It is obvious that the change in the denomination at the repayment represents a sale between the given currencies in the sense of § 23 EStG. However, even this is not 100 percent certain. This is because there is at least no conscious decision on the part of the investor to sell.

Your experts for the taxation of Liquidity Mining (DeFi) in Germany

We support crypto investors in determining profits from liquidity mining in conjunction with relevant software, such as CoinTracking, and take on the representation of interests vis-à-vis the German tax office, e.g. with regard to the classification of rewards as capital income or the tax exemption of the contribution to and withdrawal from the pool. Your contact persons are

Benefit from our many years of experience in the taxation of cryptocurrencies. Contact us via telephone (+49 69 76 75 77 80), via e-mail (info@winheller.com) or via our contact form for the taxation of cryptocurrencies.

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