How to do accounting & tax for liquidity pools?

How do accountants see liquidity pools? 

Imagine trying to explain to a traditional accountant what a liquidy pool is. In your explanation, you will need to approach it from an accounting perspective trying to emphasise transactions that are coming in and out of the pool and defining what a liquidity pool token means so they can classify it correctly in your accounting. 

In essence, a liquidity pool is a smart contract where tokens are locked for the purpose of providing liquidity for trading. Smart contracts are basically just a set of rules that dictate what happens in the liquidity pool like who gets paid, what amount and when. 

Now the smart contract is important for the accountant because it informs them what type of transactions should be classified as income and what type should be classified as capital gains. Depending on the classification, this will impact your year end results and therefore impact your tax obligation. 

Why do we need to provide liquidity to some tokens? 

A bit more context to understand liquidity pools so accountants can properly account for them. Some tokens are not as easily tradable because there just aren't enough of them where buying and selling prices are matched and so liquidity helps those tokens get traded. In return for providing liquidity, the liquidity providers need to get paid to have their assets locked. 

How do liquidity pools and decentralized exchanges work?

Liquidity pools are attached to exchanges that are decentralised also known as decentralised exchanges (DEXs). The DEX is where all the trading happens and they are able to dip into liquidity pools to help with that trading. 

The DEX is important for the accountant because that’s where transactions happen that potentially create revenue/income or capital gains for the liquidity pool provider.  

What is a liquidity pool token? How should I do accounting for a liquidity pool token? 

When a customer puts money into a liquidity pool, they get back what’s known as a liquidity pool token which represents their investment into that liquidity pool. 

A liquidity pool token is viewed as an asset similar to a building or car. The token will appreciate or depreciate in value but until it is sold there is no real impact to your accounting P&L. Now some accountants and clients may choose to value the liquidity pool token on a monthly basis and record this on their balance sheet but this is mainly for reporting purposes and not necessary for tax. It could be necessary for the liquidity pool provider to always have a month over month view of how his liquidity investment is doing. 

Typically companies value their liquidity pool token at year end to know how much tax they need to pay. Some do it on a quarterly basis because they want to report quarterly earnings and like to emphasise asset holdings. 

How do you value a liquidity pool token? 

There are not great tools out there on how to value a liquidity pool token but there are a number of manual methods you can use (statement dated Sep 2022). The primary approach is if you can find a market where those liquidity pool tokens are traded, then you can evaluate them by market price but this is typically unlikely for liquidity pool tokens since there is less trading hence the need to provide liquidity in the first place. 

Second approach is you could use underlying assets. For example, if you hold 1 liquidity pool token  and that 1 liquidity pool token is equivalent to 26 USDC to 0.1 BCT then your 1 LP token is worth those two assets combined. 

Do you get revenue fee income from liquidity pool tokens? 

Yes, liquidity pool tokens provide revenue in the form of fees in a number of ways. The first is you get revenue in the form of additional liquidity pool tokens on the decentralised exchange your liquidity pool is connected to each time a transaction in the liquidity pool occurs. 

So if your liquidity pool token is connected to a DEX like Sushiswap, you would get additional LP tokens in the form of a Sushiswap token. This technically should be recorded as revenue/income in the P&L even if it is not sold out of the liquidity pool. 

The second is you get a fee for each transaction that is equivalent to your liquidity pool holding in that pool. This fee is something provided automatically or the liquidity pool provider must claim it. 

When does an accountant record liquidity pool revenue or fees? 

You’re meant to record liquidity pool revenue or fees when they occur and not necessarily when they are claimed. So if you are holding a liquidity pool token and that token is generating fees even though those fees haven’t been claimed into your wallet, they should still be recorded as revenue or income on your P&L. 

Similarly if you receive fee or revenue via additional liquidity pool token, although you haven’t sold those tokens, they are still technically revenue or income and should be recorded on P&L on the transaction date. 

The reason you need to record liquidity pool fees with each transaction and not when they are claimed/harvested is because a firm can delay claiming the rewards from liquidity pool revenue to favour a poorer performing year so they can pay less in taxes. Think of it like an invoice which is recorded on your P&L account but you haven’t yet claimed the cash to clear your accounts receivable on your balance sheet. 

I recorded liquidity pool fee revenue and paid taxes on it but I didn’t get the amount I recorded when I claimed. What should I do? 

This is a grey area. Here it works similarly to stock options when you pay income tax on options which have not yet vested and the company goes bust. You don’t get a tax credit for this. Will keep you posted if any clarity comes out here on this from governments. 

How do you differ between liquidity pool gains and liquidity pool revenue or fees? 

So there is liquidity pool fee revenue which we discussed above and then there is the liquidity pool token capital gain. 

Liquidity pool token gains happen when you sell off the token and report the gains of that token or even the losses. This is recorded by showing the gain on your P&L and writing off the asset on your balance sheet considering you sold the entire asset otherwise just reducing the asset by the amount you sold. 

Is there software that helps with liquidity pool tracking? 

Unfortunately there is software that helps with liquidity pool portfolio tracking but no software helps with accounting such as distinguishing between liquidity pool revenue and liquidity pool gain. This is something Detof is working to build so please stay tuned. 

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