Yield farming has quickly become one of the most popular strategies in Decentralised Finance (DeFi). By locking in or staking cryptocurrency in exchange for rewards, investors can earn additional income on their assets. Yield farming offers exciting opportunities but also comes with risk and complexities - especially when it comes to tax reporting. HMRC’s DeFi consultation is ongoing, with initial guidance getting a lot of scrutiny from the industry over how inappropriate and challenging it is to apply. Whilst we hope positive changes to the tax rules are incoming, you must still report DeFi activity on the tax return as per current HMRC guidance.
In this article, we’ll cover how yield farming works and the potential risks as well as how it is taxed in the UK.
This guide is intended as a generic informative piece. This is not accounting or tax advice that can be relied upon for any UK individual’s specific circumstances. Please speak to a qualified tax advisor about your specific circumstances before acting upon any of the information in this article.
What is yield farming?
Yield farming is a strategy in the DeFi ecosystem where cryptocurrency holders earn rewards by lending, staking, or providing liquidity to decentralised platforms. It’s a way to generate passive income by putting your crypto assets to work rather than letting them sit idle in a wallet, incentivising liquidity and participation in DeFi protocols.
How does yield farming work?
Typically, yield farming involves depositing crypto into a smart contract on decentralised exchanges (DEXs). These contracts direct the funds into activities like lending, borrowing, staking, or providing liquidity, supporting the blockchain and enabling the smooth functioning of DeFi platforms, earning rewards in return.
Lending: By lending cryptocurrency through DeFi platforms like Compound or Aave, users earn interest as a reward. Borrowers deposit collateral to secure the loans, mitigating default risks.
Borrowing: Users deposit collateral to borrow a different asset and then stake or farm with the borrowed funds. This strategy leverages the borrowed assets for additional returns.
Staking: Staking involves locking cryptocurrency in a blockchain network to support its security and operations. In return, participants earn rewards, typically in the form of native tokens. Popular staking protocols include Ethereum 2.0 and Polkadot.
Liquidity Pools: Liquidity providers deposit pairs of tokens into decentralised exchanges like Uniswap or SushiSwap. Liquidity pools facilitate trading and reward liquidity providers with transaction fees or platform tokens.
What are the risks of yield farming?
While yield farming can offer high returns, it comes with significant risks:
- Impermanent loss: When the price of tokens in a liquidity pool changes, you may face losses compared to if you held the tokens outright.
- Protocol risks: Smart contract vulnerabilities, platform hacks or even scams like rug pulls can lead to financial losses.
- Fluctuating returns: Token rewards and APYs are highly volatile, and returns may diminish over time.
- Regulatory uncertainty: The evolving legal landscape for DeFi and crypto also poses challenges.
How is yield farming taxed?
Both income tax and capital gains tax could apply to yield farming depending on the scenario. HMRC's DeFi guidance is complex and has been met with criticism by the crypto industry, specialist accountants and tax professionals, for not addressing the unique nature of DeFi. We are currently waiting for the outcome of HMRCs DeFi consultation. While the final stance may evolve, it’s crucial to stay tax compliant based on their current guidance, as outlined below.
To determine how tax rules apply to your yield farming activity, you need to assess whether there has been a change in beneficial ownership and whether the rewards you earn are considered capital gains or income. Due to the wide variety of platforms, different mechanisms and terms and conditions, there is no definitive tax outcome which can make this challenging. We highlight different considerations and outcomes in our Technical Crypto Tax Guide but recommend getting advice from a crypto accountant if you are unsure.
Income tax on yield farming
Where it is decided that rewards earned through yield farming are income in nature, the taxable amount is based on the fair market value (FMV) of the rewards when received. These must be declared as part of your annual income tax return.
Capital gains tax on yield farming
When the rewards are deemed capital in nature, the tax application is more complex because you also need to consider whether there was a change in beneficial ownership.
Take a read of our Technical Tax Guide for suggestions on determining the correct tax application - we also highly recommend getting advice from a tax professional.
Don’t forget when you eventually dispose of tokens earned through yield farming - whether by selling, trading, or using them - you may also be liable for capital gains tax. The taxable gain is calculated as the difference between the disposal proceeds and the FMV of the tokens when acquired.
Find out more detail in our DeFi Tax Guide or take a broader look at the taxation of digital assets in our UK Crypto Tax Guide.
How to track yield farming taxes
Tracking yield farming taxes requires meticulous record-keeping, including:
- Asset and protocol names (it’s also useful to keep a copy of the T&C’s as they can change)
- Dates of acquisition and disposal
- Proceeds from disposals
- The cost basis of the asset
- Gains (losses)
- Pricing valuations and sources
Given the complexities of tracking these details, crypto tax software like Recap can help. Recap automates record-keeping, calculates your tax liability, and ensures you stay compliant with HMRC regulations.
Calculate your yield farming taxes with Recap
Recap makes tracking and calculating DeFi taxes simple. With our software, you can:
- Easily import and reconcile your DeFi transactions
- View detailed breakdowns of your income and gains
- Access real-time insights of your crypto portfolio and tax position
- Automatically generate HMRC compliant tax reports.
Sign up for Recap today and take the stress out of your UK crypto tax calculations!
