Taxation of Cryptocurrency Yield Farming and Liquidity Mining
Published: December 16, 2022
Last updated: October 10, 2023
Introduction – What Is Liquidity Mining (or Yield Farming) for Cryptocurrencies?
You have effectively lent money to the bank when you put money in an account. The bank gives you interest as payment in exchange. By lending cryptocurrency to a new cryptocurrency platform looking to generate money, a practice known as liquidity mining (also known as "yield farming") takes place. Lenders sometimes earn interest payments or a portion of the platform's transaction fees in exchange for their services.
What's more crucial, though, is that the lender often gets to keep the platform's native cryptocurrency in the form of units or tokens. These tokens are an incentive for the lender for adding liquidity to the platform of a new cryptocurrency. Voting on the protocols of the cryptocurrency platform, such as value-capture methods, is possible with some reward tokens. The award tokens themselves can, of course, be traded. As a result, many lenders stake their loans on the prospect that the new platform would gain traction in the cryptocurrency markets, leading the platform's native cryptocurrency tokens to surge in value and enabling the investor to profit significantly from the sale of the reward tokens.
There are a lot of Canadian income-tax issues brought on by cryptocurrency liquidity mining and yield farming. The most fundamental question is: How does a Canadian taxpayer's income from yield farming and cryptocurrency liquidity mining differ from other types of revenue? Is it revenue from a business? revenue from investments? capital gains? Alternatively, how about a mix of all three? For each of these three types of income, there are specific tax laws under Canada's Income Tax Act. Without suitable crypto tax-planning advice from an expert Canadian crypto tax lawyer, Canadian liquidity miners and yield farmers will frequently be confused about how to properly declare their revenue to the Canada Revenue Agency, and run the risk of penalties and interest for incorrect filing.
This article intends to inform cryptocurrency investors and traders about the Canadian income-tax difficulties raised by yield farming and cryptocurrency liquidity mining. The first section of this article provides an explanation of the Canadian crypto tax laws that apply to the following three types of taxable income in Canada: company revenue, investment income, and capital gains. The second half of this article addresses the characteristics that set these three types of taxable income apart—specifically, the characteristics that help us determine whether a given receipt is revenue from a company, income from an investment, or income from a capital gain. This article first examines the legal framework before examining the consequences on Canadian income taxes of obtaining interest, fees, or reward tokens via cryptocurrency liquidity mining and yield farming. In order to help taxpayers who are cryptocurrency yield farmers and liquidity miners, this post then offers some professional Canadian crypto tax lawyer advice.
Canadian sources of taxable income: Section 3 of the Income Tax Act of Canada
Every tax resident of Canada is required to pay tax on "taxable income" according to Section 2(1) of the Income Tax Act of Canada.
The next sentence in subsection 2(2) states that a taxpayer's "taxable income" is equal to their "income for the year" less any deductions allowed by Division C of the Income Tax Act. (Division C includes a number of tax subsidies, tax-relief provisions, and policy-based deductions, such as the loss-carryover rules, the lifetime capital gains exemption or LCGE, the part-year-resident rule, which exempts offshore income earned while a taxpayer was a non-resident of Canada from taxation, and tax treaty exemptions.)
How to calculate a taxpayer's "income for the year" is explained in Section 3. In doing so, the section (in no way completely) lists the sources of revenue below:
- Property investment;
- Capital gains.
As a result, a person's taxable income is ultimately comprised of these kinds of income as well as any additional sources that section 3 does not specifically include.
The final three revenue sources—income from businesses, income from property investment, and capital gains—are the topic of this article.
Explanation of the Income Tax Regulations in Canada for Business Income, Investment Income, and Capital Gains
Each source of income is subject to a unique set of tax rules under the Income Tax Act of Canada. The term "source" refers to the type or nature of the revenue. As was already established, company revenue, investment income from property investment, and capital gains are among the sources of income listed in section 3 of the Income Tax Act. Division B of Part I of the Canada Income Tax Act contains the tax rules for each of these three sources. However, the tax provisions regulating capital gains are contained in subdivision c, whereas those governing business income and investment income are included in subdivision b.
Many of the sections governing income taxes apply to both business and investment income. For instance, Subsection 9(1) codifies that costs associated with producing revenue are deductible for determining business income and investment income. This is accomplished by defining business revenue and investment income as the taxpayer's "profit" from those particular sources. In other words, a taxpayer's investment income, which the Income Tax Act refers to as "income from property," comprises the taxpayer's "profit from that property," whereas a taxpayer's business income is made up of the taxpayer's "profit from that business." So, for each, the computation of profit or net income serves as the foundation. As a result, income from businesses and income from investments are eligible for many of the same deductions.
The two types of revenue, however, are separate sources of income: business income and investment income. This leads to some significant disparities in their tax treatment. A few illustrations:
- Only the investment income of a private corporation is subject to Part IV tax; business revenue is not subject to Part IV tax.
- Investment income, but not business income, is subject to the tax attribution requirements in section 74.1.
- Only the business income of a private corporation under Canadian-controlled private corporations is eligible for the small-business deduction tax credit under Section 125. Investment income received by the private corporation under Canadian-controlled private corporations is often not eligible for the tax credit.
In spite of this, the overall tax treatment of the business and investment income is comparable.
On the other hand, the capital gains provisions for Canadian income tax purposes are completely another beast. For instance, only half of a capital gain is included in taxable income, although company revenue and investment income are both completely taxable. Similarly, only half of a capital loss is deductible, and the acceptable component of a capital loss is often only able to be used to offset the taxable portion of a capital gain. Business losses and investment losses are both completely deductible against any source of income.
Which of the following best describes your income: business income, investment income, or capital gain?
The term "income from property" or "investment income" refers to the yield on a piece of property. Dividends are paid on shares, for instance. Interest on bonds is paid. There are royalties from intellectual property. Rent is a result of real property. and so forth. In other words, investment income is passive income that results from the simple act of owning property and doesn't need a major expenditure of time, effort, or attention. For instance, a person doesn't need to put up any more work to buy public shares and receive dividends. Therefore, the dividends are revenue from investments. Income from property, often known as investment income, is the yield on a piece of property.
Organization, methodical effort, and some level of engagement are required for business revenue, in contrast. An investment dealer, for instance, might actively manage and buy shares of public companies for a portfolio. The proceeds from the portfolio dealer's investment company, which she runs, are her sources of income. A "business" is defined as "a profession, vocation, trade, or endeavor of any sort," according to Subsection 248(1) of the Income Tax Act of Canada. "An adventure or concern in the nature of trade" is also referred to as a "business." Consequently, the term "business" denotes activity and a desire for profit. Activity, enterprise, entrepreneurship, and commercial risk are examples of a business's representative traits. The pursuit of profit is what a business is about above everything else. In fact, what separates a business from a simple leisure or pastime is the desire for profit (Stewart v Canada, 2002 SCC 46).
The degree of activity involved in earning the revenue determines the difference between business income and income from investments. To put it another way, the kind of revenue a property generates is not always determined by its mere usage. As an illustration, a taxpayer who leases a basement flat and another taxpayer who actively operates a hotel both make use of the same property and earn rent payments. But whereas the homeowner makes money through investments or rents from their house, the hotel management makes money from his or her business.
Despite the fact that the use of property may result in either business or investment income, the Income Tax Act's subsection 9(3) clearly distinguishes between investment income and capital gains. This subsection makes it clear that a gain from the disposal of an income-producing asset is not included in income from the property. (It further stipulates that a loss resulting from property excludes a loss arising from the disposition of that property.) To put it another way, the profit you get by selling a property isn't considered investment income for tax reasons; instead, it's either a capital gain or business income.
The disposal of the investment that is a "capital property" results in a capital gain. For tax purposes, only two major categories of property are recognized by the Income Tax Act of Canada:
- capital assets, the disposal of which results in a capital gain or loss; and
- inventory, which is taken into account while calculating business income.
Whether a piece of property is a capital asset or inventory depends on the kind of revenue it produces when it is sold, such as capital gains or business income. To put it another way, characterizing the property comes first, followed by establishing the type of revenue, not the other way around.
The distinction between selling an investment, which results in a capital gain, and trading, which generates business revenue, has been a contentious issue for Canadian tax courts, which have produced a substantial body of case law. When considering whether to classify a transaction's gains or losses as on an account of capital or income, courts consider a variety of variables. These elements might consist of:
- Transaction frequency—for instance, a trend of frequent cryptocurrency buying and selling or a high rate of cryptocurrency unit turnover may point to a business;
- Duration of ownership—for instance, keeping cryptocurrencies for short periods of time indicates commercial activities rather than capital investments;
- Understanding of cryptocurrency marketplaces, for instance, more knowledge or expertise with cryptocurrency markets favors a business categorization;
- Relationship to the taxpayer's other employment; for instance, if cryptocurrency trades (or similar activities) are a component of the taxpayer's employment or other business, it indicates toward business;
- Time invested—for instance, there is a higher chance that the taxpayer will be classified as operating a business if a significant portion of their time is spent researching potential acquisitions, analyzing cryptocurrency markets, or actively managing their cryptocurrency portfolio;
- Financial support—for instance, leveraged cryptocurrency transactions signify a business; and
- Advertising—for instance, a greater chance that the taxpayer's cryptocurrency company would be characterized as one if he has done so.
In the end, the taxpayer's purpose at the time of purchasing the property is the most crucial factor that courts take into account when deciding whether the transaction resulted in a capital gain or business income. A tax court will pay attention to the objective circumstances surrounding both the acquisition and sale of the property in order to determine a taxpayer's purpose. To put it another way, the criteria mentioned above will be considered by tax courts when determining a taxpayer's purpose.
In conclusion, a property can create commercial revenue, investment income, or capital gain depending on how a taxpayer uses it, and two Canadian taxpayers with comparable digital-currency portfolios may have different tax consequences. If the property itself produces a profit, that profit may be made from a business or from investments (i.e., income from property). The degree of activity involved in earning the revenue determines the proper tax classification: earning income from a business indicates work; earning income from investments suggests passivity. If the revenue is the result of selling the asset, it may be either a capital gain or revenue from a business. If the taxpayer bought the property with the intention of trading, that will determine the right tax classification in this situation.
Income from Cryptocurrency Liquidity Mining and Yield Farming in Canada: Tax Implications of Interest, Fees, and Reward Tokens
The conclusion drawn from the aforementioned analysis is: Under the Income Tax Act of Canada, the kind of income affects how it is taxed. Therefore, in order to understand the Canadian income-tax effects of cryptocurrency liquidity mining and yield farming, we must first ask: What is the nature of the money that you make when participating in cryptocurrency liquidity mining and yield farming?
We must make a distinction between two methods of cryptocurrency liquidity mining and yield farming revenue generation before we can respond to this topic. The first is any interest, charges, or incentive tokens you could be given by the cryptocurrency platform in exchange for the cryptocurrency you lent as part of the liquidity-mining or yield-farming agreement. The second is any profit you could make by selling the reward tokens themselves.
Interest, fees, and reward tokens from cryptocurrency liquidity mining and yield farming as Characterized by Canadian Income-Tax
Our skilled Canadian crypto tax lawyers begin by examining the tax characterization of the interest, fees, or reward tokens that a liquidity miner or yield farmer receives for staking cryptocurrency in order to characterize the Canadian tax treatment of cryptocurrency liquidity mining and yield farming. The majority of liquidity-mining and yield-farming agreements take the form of a loan or investment, more specifically, a loan or investment made by the liquidity miner in the form of cryptocurrency to a cryptocurrency platform in need of funding. This is how these agreements are typically described. In return, the liquidity miner or yield farmer gets compensated, similar to how a lender is compensated with interest payments or an investor is compensated with dividends. (For the purposes of this article, the distinction between lenders and investors isn't significant. The taxation of interest received by a lender and the dividend received by an investment is comparable. The distinction between lenders and investors doesn't really matter in terms of taxes from the viewpoint of the liquidity miner or yield farmer.) In other words, the liquidity miner or yield farmer stakes a property—specifically, the cryptocurrency that was invested in or lent to the capital-seeking cryptocurrency platform—and that property subsequently generates income in the form of interest, fees, or the platform's native cryptocurrency tokens. As a result, when a liquidity miner or yield farmer receives interest, fees, or reward tokens in exchange for staking cryptocurrency, it is plausible that these payments qualify as investment income (or "income from property," as it is known under the Income Tax Act).
Even yet, the investment-income description might not always be accurate. As was already established, if a taxpayer utilizes cryptocurrency property to create revenue, the right tax characterization will still depend on the degree of activity involved in earning that money. Therefore, if you engage in cryptocurrency liquidity mining or yield farming and your operation exhibits entrepreneurship, commercial risk, and the pursuit of profit and necessitates a significant commitment of time, labor, and attention—for example, regularly researching cryptocurrency markets, pursuing a number of strategic cryptocurrency-platform targets, using leverage to fund your ventures, immediately selling or collateralizing—your receipts may qualify as business income.
Interest, fees, and reward tokens from cryptocurrency liquidity mining and yield farming: Canadian Income-Tax Treatment
In any case, the general tax treatment of company revenue and investment income is very similar. Therefore, regardless of whatever tax classification is eventually accurate, if you get interest, fees, or reward tokens through cryptocurrency liquidity mining or yield farming, those receipts are fully taxable under subsection 9(1) as your profit from a business or an investment, as the case may be. When determining your taxable income for the year of receipt, which is the calendar year for a person or the fiscal year for a corporation, you must include the entire amount of any interest or fees you receive. If you obtain a reward token or if your interest or fees are paid in cryptocurrency, you must factor in the fair market value of the cryptocurrency when figuring out your taxable income. This value is stated as the cryptocurrency's worth in Canadian dollars at the time you received it.
Additionally, under Subsection 52(1) of the Income Tax Act, you will increase the tax cost of the cryptocurrency in accordance with the fact that you have declared the value of the reward token (or other cryptocurrencies) as taxable income. Double taxation is avoided when you eventually dispose of the reward token or other cryptocurrency due to the higher tax on space. For instance, you may participate in a liquidity-mining agreement where you lend cryptocurrency to a platform. You receive incentive tokens, which are equivalent to two units of the cryptocurrency platform's native currency, in return. The award tokens are now valued at $500.00 at the time of issue. According to subsection 9(1) of the Income Tax Act of Canada, you must declare the $500 as either business income or investment income (depending on the appropriate tax characterization). You will pay taxes on $500 in income as a result of the incentive tokens, per subsection 52(1).
When the prize token is disposed of, your taxable income will be determined by the $500 tax cost. For example, if you subsequently sell the reward tokens for $8,000 (or exchange them for other cryptocurrency units for $8,000), your $500 tax cost translates to a $7,500 profit that you must declare as income or capital gains. Once more, the proper tax characterization will determine the precise tax treatment of this income.
Canadian Income-Tax Characterization of Profits from the Sale of Reward Tokens from Yield Farming and Liquidity Mining of Cryptocurrencies
We now evaluate the tax treatment of a liquidity miner's gain from selling the reward tokens that the liquidity miner got in exchange for staking cryptocurrency. As was already indicated, depending on the amount of activity involved, income from the use of property can be classified as either investment income or business revenue. The Income Tax Act, however, precludes classifying a profit from the sale of a property as investment income. The profit that results from this is thus either a capital gain or company income. As a result, any profits made by liquidity miners from the sale of reward tokens must be declared and subject to taxation as either business income or capital gain.
According to the cryptocurrency liquidity miner's goals, there is a difference between capital and revenue. The main concern is if the taxpayer participated in yield farming or cryptocurrency liquidity mining with the goal of selling the reward tokens for a profit. The profit then counts as business income. The selling profits, however, will be placed on a capital account and subject to capital gain taxes if the taxpayer can prove that they intended to invest rather than trade by citing a number of objective facts. For example, if the taxpayer can show that they were solely interested in liquidity-mining contracts that offered reward tokens that gave them voting rights over the platform's protocols because they wished to run a new cryptocurrency platform, they may be able to justify capital treatment.
The wealth of tax case law evaluating the many aspects that affect the capital/income distinction may be found throughout Canada's income tax jurisprudence. Case law can be complicated, fact-specific, and inconsistent. These verdicts demonstrate, if anything, that the necessary legal analysis necessitates counsel from a Canadian crypto tax lawyer with experience in cryptocurrencies.
Treatment of Income from the Sale of Reward Tokens from Cryptocurrency Liquidity Mining and Yield Farming for Canadian Income Tax Purposes
For business income and capital gains, respectively, the Income Tax Act of Canada establishes two completely separate tax systems. Reward tokens are considered inventory if you trade them to generate money for your business; as a result, you must pay full taxes on your cryptocurrency trading gains. When calculating your taxable income for the year in which you sold your reward token, only one-half of the gain is taken into account if your reward token qualifies as capital property since you bought it for investment reasons.
Pro Tax Tips: Record-Keeping for Taxpayers Engaging in Liquidity Mining or Yield Farming for Cryptocurrencies, Legal Opinion on Appropriate Cryptocurrency Tax Reporting, and Voluntary Disclosures Program for Unreported Cryptocurrency Income
If the Canada Revenue Agency decides to conduct a CRA cryptocurrency tax audit, a liquidity miner who doesn't keep accurate documents would perform poorly (which is becoming far more prevalent). Taxpayers who participate in cryptocurrency liquidity mining and yield farming must maintain records of any cryptocurrency transactions they make as well as any interest, charges, and reward tokens they get from cryptocurrency platforms.
In order to prevent losing their transaction data, taxpayers who are engaged in cryptocurrency liquidity mining and yield farming should routinely download and export their data. The following records concerning any cryptocurrency transactions should be kept as well:
- The time of every transaction;
- A copy of any cryptocurrency-related invoices or transfers;
- The cost of the cryptocurrency in Canadian dollars at the time of the transaction;
- Addresses for cryptocurrencies and digital wallet data;
- A summary of the deal and the other party (such as the other party's cryptocurrency address);
- The records of the exchange,
- The records of the exchange, the legal terms, and conditions of the agreement,
- The records of any accounting and legal fees, and
- The records of any software fees for managing your cryptocurrency and tax affairs.
In order to prevent the Canada Revenue Agency (CRA) from accusing you of misrepresenting the information in your tax returns, charging you with gross negligence penalties, or, worse yet, prosecuting you for tax evasion, our Certified Specialist Canadian tax lawyer can give guidance about record-keeping and proper reporting of your cryptocurrency profits.
A tax memorandum examining whether the interest, fees, and reward tokens that taxpayers receive from cryptocurrency platforms should be reported as investment income, business income, or as a combination of both may be useful for taxpayers who engage in cryptocurrency liquidity mining and yield farming, in particular. As well as the question of whether their profits should be recorded as business income, capital gains, or a combination of the two if they have exchanged their reward tokens.
The privacy that cryptocurrency users believed they formerly enjoyed is coming to an end due to developments and the cooperation of tax officials. With unreported earnings from cryptocurrency trades, this should undoubtedly worry Canadian taxpayers. Although cryptocurrency liquidity mining and yield farming are still relatively new, taxpayers who participate in these activities should be equally apprehensive. You run the possibility of not only being subject to monetary fines, such as gross-negligence fines but also being charged with crypto tax evasion if you submitted Canadian tax returns that failed to disclose or underreported your cryptocurrency income.
According to the CRA's Voluntary Disclosures Program, you could be eligible for relief (VDP). The CRA will forego criminal prosecution and remit fines for gross negligence if your VDP application is approved (and may reduce interest). However, a voluntary disclosure application must be submitted quickly. If an application is not "voluntary," the CRA's Voluntary Disclosures Program will reject it and hence refuse relief. This effectively implies that before the CRA contacts you about the non-compliance you intend to reveal, the Voluntary Disclosures Program must receive your application for a voluntary disclosure or tax amnesty. Our knowledgeable Canadian tax lawyers have helped many Canadian taxpayers with unreported cryptocurrency transactions by drafting several memoranda that categorize cryptocurrency trading as either business income or capital gains. Your application for voluntary disclosure can be carefully planned and quickly prepared. In addition to improving your chances of receiving tax amnesty from the CRA, a properly prepared disclosure application also paves the way for a legal request for judicial review to the Federal Court in the event that the Canada Revenue Agency wrongfully rejects your voluntary disclosure application.
Schedule an appointment for a professional, confidential consultation with one of our knowledgeable Canadian crypto tax lawyers to find out if you are eligible for the VDP. Information that is shielded by the solicitor-client privilege cannot be required to be produced by the Canada Revenue Agency. Solicitor-client confidentiality prevents the CRA from discovering the legal counsel you obtained from your Canadian crypto tax lawyer, to put it another way. However, none of your conversations with an accountant are secure. Therefore, you should first contact our Canadian tax lawyers if you need tax guidance but don't want the CRA to know. If you need an accountant, we can retain them for you while maintaining the solicitor-client privilege.
"Only general information is provided in this article. Only as of the publishing date is it current. It hasn't been updated, therefore it could no longer be relevant. It cannot or ought not to be relied upon since it does not offer legal advice. Each tax circumstance is unique to its facts and will be different from the instances described in the articles. You should speak with a lawyer if you have particular legal inquiries."