In decentralized financial markets (DeFi), crypto investors have a variety of ways to earn returns on their cryptocurrencies. Liquidity mining represents one of the most popular options.
How does liquidity mining work?
Liquidity mining is characterized by the fact that, by providing cryptocurrencies to a decentralized exchange (DEX), users receive a reward in return.
Specifically, crypto investors always submit two cryptocurrencies as a trading pair (e.g. BTC/DFI) to the liquidity pool of a decentralized exchange for this purpose. In return for providing liquidity in the form of cryptocurrencies, they receive tokens (rewards), among other things. Investors can withdraw their cryptocurrencies from the liquidity pool at any time.
Which tax rate applies to rewards from liquidity mining in Germany?
First and foremost – quite independently of liquidity mining -, there is the fundamental question of whether profits and losses from cryptocurrencies are allowed to be taxed in Germany at all. The courts of first instance are currently considering this issue, but a decision is still pending. Until then, crypto investors should always declare their profits to the German tax offices.
The tax classification of the rewards paid out through liquidity mining regularly presents crypto investors with major challenges in this regard. Because, as with so many topics in the DeFi world, the tax assessment of liquidity mining remains largely indeterminate.
While there are good reasons for classifying the rewards received from liquidity mining as capital income, similar to interest income, and thus taxing them at a flat rate of 25 percent capital gains tax (flat rate tax), the German tax authorities usually make a different classification.
Instead, the tax authorities generally consider it appropriate to classify the rewards as income from other benefits pursuant to § 22 no. 3 of the German Income Tax Act. In this case, crypto investors must pay tax on their rewards received at their personal income tax rate. The disadvantage: For the majority of investors, the tax rate will regularly be above 25 percent and may even be as high as 42 percent in the worst case.
How should rewards be reported on my tax return?
Option 1: Declare rewards as income from other benefits
Crypto investors can simplify this for themselves, declare their rewards from liquidity mining as other income and thus adopt the view of most tax authorities. Because, in this case, the tax office assesses liquidity mining income according to the personal income tax rate, crypto investors should, however, consider lodging an appeal against the tax assessment with the aim of suspending the proceedings due to the indeterminate legal situation. If, in the future, the Berman Federal Fiscal Court (Bundesfinanzhof, BFH) classifies the income as capital income in a way that is advantageous for the crypto investor, the crypto investor can reclaim the excess taxes paid. The disadvantage of this option is that the taxpayer must preemptively bear the higher tax burden for the moment.
Option 2: Declare rewards as capital income
In addition, crypto investors have the possibility, contrary to the view of the tax authorities, to declare their income as capital income, to disclose this to the tax office in their tax return and also to justify it for tax purposes. In the best case, this can result in an assessment as capital income by the tax office. Rewards from liquidity mining are then taxed at only 25 percent. However, there is a risk here that the investor will have to reckon with additional payments plus interest if the Federal Fiscal Court should decide in favour of the view of the tax authorities in the future.
Whichever of the two possible options crypto investors may choose always depends on the individual case. Consultation with an experienced tax advisor or attorney is strongly recommended. This is the only way to minimize the financial risks for the taxpayer and to jointly develop an optimal strategy.
WINHELLER advises on liquidity pool mining
Are you unclear about how your profits will be taxed in connection with liquidity mining? Please do not hesitate to come to us. Our experienced crypto tax law attorneys and tax advisors will find a solution for your concerns.