Updates to the ATO Guidance on DeFi

If you're trading crypto in Australia, you may not be aware that the Australian Taxation Office (ATO) updated its website guidance in November 2023 with respect to decentralised finance (DeFi) arrangements. We’ve put together a short article that helps you navigate these new changes and how they could affect your tax obligations.

Lending and borrowing

When you lend your crypto assets to a third party, you trigger a CGT event because you lose the “beneficial ownership” of the token. Under that lending arrangement, you can either receive a token back immediately or you may get a “right” to receive tokens back. This “right” is a separate capital gains tax (CGT) asset and can affect your CGT calculations. It’s important to be aware that multiple CGT events can occur within a single lending transaction.

Example of CGT events

1. Tax on lending: When Mika lends 100 ZYX coins to a DeFi platform, she disposes of 100 ZYX coins in exchange for a “right” to reclaim those ZYX coins in the future. As a result, a CGT event occurs, with the market value of the “right” forming part of her capital proceeds.

The value of each ZYX coin at the time of disposal is $9, so the 'right' Mika holds is valued at $900 (100 coins × $9). However, Mika originally purchased the coins for $1,000. This difference between the original purchase price and the current value of the right results in a capital loss of $100 ($900 - $1,000).

The 'right' to receive the coins back now has a new cost base of $900.

1. Repayment of the loan: When Mika exercises her right to reclaim her ZYX coins, she triggers another CGT event. This time, it’s a CGT event relating to the end of her “right” to reclaim the ZYX coins. Remember that this right has a cost base of $900. At the time of repayment, each ZYX coin is valued at $10. Therefore, the total value of the 100 coins is now $1,000.

Mika has a capital gain of $100 ($1,000 - $900). Therefore, Mika now owns 100 ZYX coins with a new cost base of $1,000, reflecting the value of the coins at the time of repayment.

This shows how:

1. A CGT event happens when you “lend” crypto.

2. The “right” to reclaim tokens is treated as a separate CGT asset.

3. Exercising the “right” to reclaim tokens triggers another CGT event.

4. Multiple gains or losses can occur, even if you end up with the same number of coins.

This approach more accurately reflects the complexity of DeFi lending and borrowing from a tax perspective, showing how you can incur tax liabilities even when you might not expect to.

Liquidity pools

When you deposit tokens into or make withdrawals from a liquidity pool, a CGT event happens. Often, the liquidity pool will also issue a unique token to contributors to reflect their share of the liquidity pool. The value of these assets at the time of the transaction will determine the capital proceeds for tax purposes.

Example of CGT events

1. Initial deposit: Martha deposits 1 ETH into an ETH/XA liquidity pool, which triggers a CGT event. In return, she receives 20 XA tokens, which represent her share of the liquidity pool. Martha originally acquired the 1 ETH for $2. At the time of the deposit, the 20 XA tokens have a market value of $20.****

As Martha originally acquired the ETH for $2, and the capital proceeds are valued at $20, her capital gain is $18.

1. Increase in XA tokens: Over time, the liquidity pool generates a profit from its staking activities. As a result, Martha is given an additional 5 XA tokens, representing her share of the rewards from the staking protocol. Under the interest and rewards guidance, the market value of the 5 XA tokens at the time of issuance will form part of her ordinary income. Let’s say that 5 XA were valued at $1. That value will also be the cost base for those tokens in the event of a future disposal.

2. Withdrawal from the liquidity pool: As highlighted above, Martha now holds 25 XA tokens, which are worth $30. She decides to exchange her 25 XA tokens for the equivalent value held by the liquidity pool. She receives 1.2 ETH upon withdrawal (also valued at $30), due to additional ETH earned from fees in the pool. The exchange of her 25 XA tokens triggers a CGT event.

The cost base of the 25 XA is $21 (20 XA with a $20 cost base, and 5 XA with a cost base of $1). As Martha received 1.2 ETH valued at $30, her capital gain is $9 ($30 - $21).

This shows how:

1. A CGT event happens when you deposit crypto to a liquidity pool.

2. Any tokens representing your share of the pool are treated as separate CGT assets.

3. Exchanging tokens to withdraw your share triggers another CGT event.

4. Engaging in these transactions gives rise to capital gains tax and income tax events.

Interest and rewards

When you receive interest or rewards from DeFi transactions, the gross receipts are treated as ordinary income (like salary and wages) rather than capital gains. This means you must report the market value of the crypto asset reward or interest at the time of receipt. This market value will also be the cost base for that crypto asset in the event you dispose of it in future.

Example of taxing points

1. Initial deposit: Craig lends 100 newly created stablecoin tokens (AUDP) to the DeFi platform Compound Finance. Each AUDP is valued at $10, so his total lending is worth $1,000. The platform offers a return rate of 1% in the form of newly issued AUDP tokens.

Further to the lending guidance above, a CGT event happens when Craig lends his 100 AUDP but likely gives rise to no capital gain or loss because the cost base and capital proceeds of the AUDP is $10 ($10 - $10 = $0).

1. Receiving rewards: After a month, Craig receives 1 AUDP as a reward for lending his 100 AUDP. At the time of receipt, a single AUDP token is still worth $10. As the AUDP was a reward for lending his 100 AUDP, Craig must declare the market value of the 1 AUDP ($10) as part of his ordinary income.

2. Future CGT implications: The newly received token has a cost base of $10 (its value when received). If Craig later sells this token, he'll calculate any capital gain or loss based on this $10 cost base.

This shows how:

1. Interest and rewards are treated as ordinary income, not capital gains.

2. The entire reward is taxable, regardless of whether it's sold or held.

3. Rewards have a new cost base, which is relevant if sold in future.

4. You should keep records of when rewards are received and their value at that time.

Wrapped tokens

When you wrap a token (e.g., wrap BTC into WBTC) or unwrap a token (e.g., convert WBTC to BTC) a CGT event occurs. According to the ATO view, this is because you are exchanging one crypto asset for another: the unwrapped token in exchange for the wrapped token, or vice versa.

The capital proceeds from the CGT event will equal the market value of the token you receive at the time of the exchange. If you are wrapping a token, you are disposing of the original token in exchange for the wrapped token. Therefore, the market value of the wrapped token is relevant. If you are unwrapping a token, you are disposing of the wrapped token in exchange for the original token and the market value of the original token is relevant.

Example of CGT events

1. Wrapped: Kal decides to wrap his Bitcoin to use it on the Ethereum network. Kal bought 1 BTC for $30,000 in January 2023. In April 2023, Kal wrapped his 1 BTC for 1 WBTC, which triggers a CGT event. At the time of wrapping, the market value of WBTC is $45,000, resulting in a $15,000 capital gain.

2. Unwrapped: Kal decides to unwrap his WBTC back to BTC, which triggers a CGT event. The cost base of Kal’s WBTC is equal to $45,000. At the time of unwrapping, the market value of BTC is $50,000, resulting in a $5,000 capital gain.

This illustrates how:

1. Wrapping and unwrapping tokens trigger CGT events.

2. Each wrapping and unwrapping changes the cost base of the wrapped / original tokens.

3. You can incur capital gains (or losses) even if the value of the underlying asset hasn't changed, due to market fluctuations between wrapping and unwrapping.

4. You must keep detailed records of when you wrap/unwrap tokens and the market values at those times.

Additional consideration:

If Kal used the WBTC on other DeFi platforms (e.g., as collateral for a loan), those actions might trigger additional CGT events, compounding the complexity of his tax obligations. This approach demonstrates how the seemingly simple act of making a token compatible with another blockchain can have significant tax implications, potentially creating taxable events even when you might not expect it.