How is Liquidity Mining (DeFi) taxed in Luxembourg?

How is Liquidity Mining (DeFi) taxed in Luxembourg?

What is Decentralized Finance (DefI)?

Along with the growing interest in cryptocurrency, Decentralized Finance (DeFi) is becoming increasingly popular. DeFi refers to a special ecosystem in the blockchain space that enables digital financial services. An explosion of DeFi cryptocurrency has been seen since February 2021 with several thousand percent increases in value.

Mostly based on the Ethereum blockchain, decentralized applications (DApps) can be created which are specifically targeted at the financial sector and which are executed using so-called smart contracts (automated computer codes). Most recently, there has also been a very strong rise on the Binance Blockchain for DeFi.

The unique feature here is that these DApps can be programmed as required. Different blocks can be put together like in a Lego box. Once the DApp is implemented on the blockchain, it runs independently and decentrally, depending on its design.

The DeFi boom results also from the very strong popularity of liquidity mining.

How does Liquidity Mining work?

One way for investors to make a profit on decentralized exchanges (DEX) is through liquidity mining. This is a mechanism whereby investors invest their crypto currency in a pool and make it available to a decentralized exchange (DEX). The providers are rewarded for making the crypto currency available, for example, by 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 owners 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. There are many different DeFi platforms for liquidity mining now, such as Uniswap, Curve, or Aave.

Liquidity mining based on the example of Uniswap

Users of the DeFi platform Uniswap provide trading pairs in the form of various cryptocurrencies to the liquidity pool (e.g. ETH/USDC, ETH/DAI). Each time liquidity is contributed to a pool, governance tokens (UNI tokens) are distributed to the provider proportional to the amount of liquidity contributed to the pool. In addition, fees are collected each time a trade is made by the platform and are distributed proportionally to all liquidity providers. Users can eventually claim the fees when they withdraw their trading pairs from the pool.

There are three relevant periods for the taxation of liquidity mining

Due to the novelty of liquidity mining, there is neither a clarifying jurisdiction nor a statement from the Luxembourg tax administration on the tax treatment of liquidity mining at this point in time. Therefore, the tax treatment in Luxembourg is linked to the tax treatment in Germany and will be discussed in more detail below.

1. Dedication of the tokens

First of all, the dedication of the trading pairs into the pool is crucial for taxation. Adding trading pairs to a liquidity pool constitutes a sale of the pair for tax purposes. This results in a sale within the meaning of Section 23 (1) sentence 1 no. 2 EStG in Germany. Profits are taxable here if the sale of the trading pairs is within the speculation period of one year. If the crypto currency has already been held for more than one year, the profits are tax-free. If this tax approach were to be applied analogously for Luxembourg, then a sale within the meaning of Article 99 in conjunction with Article 99bis Luxembourg Income Tax Act (LEStG) would have to be assumed. A Luxembourgish tax treatment would have to be considered according to the Luxembourgish speculation period of 6 months.

2. Participation in the distribution of profits

The profit distributions during the period of participation in the pool are also relevant for the tax assessment. Different legal opinions are held with regard to the tax classification for the profit distributions during the participation in the pool. This is due to the fact that liquidity mining is a new trend and the tax courts have not yet dealt with the tax classification. The German Federal Ministry of Finance (BMF) has also not yet issued a statement on this issue. Profit distributions in Germany from participation in the liquidity pool will have to be treated as capital income and will therefore be subject to German capital gains tax at a rate of 25%.

This view could also be taken in Luxembourg by the Luxembourg tax administration and, in accordance with Article 97 LEStG, it could be taxed at the Liquidity Provider’s personal tax rate.In the worst case, at the top tax rate of 42% in Luxembourg. Here, the impermanent loss in the DeFi Space will not be discussed in more detail, as these are unrealized and therefore irrelevant for tax purposes during the holding period in the Liquidity Pool.

3. Withdrawal from the pool

Ultimately, the withdrawal from the pool has the consequence that the user receives his contributed trading pairs back. The repurchase of the trading pairs can take place in different amounts compared to the time of the contribution of the tokens. The holding period for the recovered cryptocurrencies starts from zero after obtaining the coins. The gains or losses (realization of the impermanent loss) due to the withdrawal from the pool are also income from capital assets, which would be taxable in Luxembourg pursuant to Article 97 LEStG.

Assuming that the Luxembourg tax administration denies the capital income, it would be possible to sell the Liquidity Token in Luxembourg tax-free after a 6-month holding period. In this respect, there is a tax risk to exit within 6 months.

The interesting question that emerges is the additional receipt of Governance Tokens. Are these received governance tokens treated in the same way as received tokens from airdrop or staking?

The aforementioned information is in no way a substitute for legal or tax advice due to the complexity of the subject matter.

The information has been compiled with the utmost care. However, jinfa S.à r.l. does not assume any liability for the correctness of the information. We are grateful at any time for suggestions for improvement, relevant information and ideas.

Your tax advisor in Luxembourg for Cryptocurrency



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