Mr. Vishnu Bagri and Mr. Amar Kumar (Chartered Accountants, Singhvi, Dev & Unni LLP) discern the newly introduced regime for taxation of Virtual Digital Assets and discuss the accrual of income from crypto transactions and its characterization. They opine that “The characterization of the income is a debate, particularly in the context of VDAs qualifying as capital assets.” They are of the view that given the all-encompassing definition of VDAs, any digitally represented balance attributable to a specific user could be covered within the definition of VDAs such as cashback points in payment aggregator applications, loyalty points accumulated on membership cards specific to shopping outlets, credit card reward points, promotional balance and virtual coins provided to users in online games and other applications. The authors also discuss whether specific transactions such as generation of VDA, acquisition of NFT as collectibles, P2P sale of VDA and sale of VDA on centralized exchange, would tantamount to a transfer or raise further ambiguity. They are of the view, “...the Web technology is not limited to gains arising on account of high volatility in the Cryptocurrency markets. As the markets mature and technologies evolve further, the tax regime would need to address the peculiarities of the underlying technology and the new business models.”

“India Opens the Door to Crypto Tax Maze!”

The Finance Minister has introduced a new regime – Tax on income from Virtual Digital Assets (VDA), - on transactions involving Cryptocurrencies, which could also extend to other token-based transactions using the block-chain technologies. The introduction of the new regime is akin to entering a maze. As we discern the provisions, more questions arise, but we want to believe it’s moving towards the goal - tax certainty for the crypto world.

CHARGE OF TAX

Why are transactions in Crypto - income?

Income-tax is a levy on income. Under the Income-tax Act the liability to tax is attracted either on the accrual of the income or its receipt; but the substance of the matter is the income. If income does not result at all, there cannot be a tax, even though in bookkeeping, an entry is made about a hypothetical income, which does not materialize.[1]

Originally, the first Cryptocurrency i.e., bitcoin, came into existence through a decentralized and distributed ledger system gathering its value based on its demand and supply within the block-chain. Assuming the world did not accept the Cryptocurrency as a medium of exchange for a service or good which can be measured in “fiat currency”, it really would be no different from either an entry in a ledger or a coin in a video game!

Today, with the explosion of this new tokenized world, the transactions in the block-chain can be equated to some form of fiat currency or a commodity whose value is represented in fiat currency. It is in this backdrop that the transactions involving VDAs could be construed as real income, akin to a barter transaction where the money’s worth is the medium to measure.  

Is it a gain from a capital asset?

The characterization of the income is a debate, particularly in the context of VDAs qualifying as capital assets. VDAs should qualify as a capital asset, since the term ‘capital asset’ is defined to include property of any kind. On the contrary, doubts exist on it qualifying as an asset in light of its inherent volatility, its characteristics as a medium of exchange and concerns on enforceability of ownership rights.

The legislative intent appears to recognize VDAs as capital assets. The regulators have directly provided for a specific computation and rate of tax on the income arising from the transfer of any VDA. The term “transfer” has been defined in the Income Tax Act in relation to a capital asset. Further support for the view is found in the proposal on taxing gift of VDAs under Section 56(2)(x), which proposes to include VDAs under the definition of “property”, which in turn refers to capital assets.

This view would be relevant for the tax positions on historical transactions. The income from VDAs could be determined on principles as applicable to transactions involving sale of securities to determine whether it is trading income or capital gains.

After 31 March 2022, the characterization of the income arising from VDAs is not of much relevance, as there is a specific regime providing for a rate of tax, with no deductions or carry forward of losses, for all incomes arising from the transfer of a VDA. However, there are more turns in the maze which are to be navigated – What is a VDA? What is ‘transfer’ of a VDA? If not recognized by law, are there legally enforceable rights which are transferred?

WHAT IS A VDA?

The regulators have proposed a broad definition to the term VDA, and at times you would think it probably is beyond the Cryptocurrency transactions as well.

Characteristics of a VDA

The definition specifically includes non-fungible tokens (NFTs) and other tokens unless excluded through a notification.

An unintended ambiguity - will the wallets in retail apps, reward points & in-game coins be considered as VDAs?

Given the all-encompassing definition of VDAs, any digitally represented balance attributable to a specific user could be covered within the definition of VDAs. This may cover cashback points in payment aggregator applications, loyalty points accumulated on membership cards specific to shopping outlets, credit card reward points, promotional balance and virtual coins provided to users in online games and other applications. The foregoing is not an exhaustive list, and VDAs could cover any digital representation of any asset, property etc., if the characteristics discussed above are satisfied.

If the definition is to be construed narrowly, it could be contended that if the issuer of cashback points, reward points and tokens stipulates that these virtual points have no inherent monetary value and are not transferrable to any other user (apart from the initial accrual of the points for a user) and can only be used in-app or in-store to be eligible for a discount while making an eligible purchase, then these points would not satisfy the criteria of being transferred and being traded electronically, and consequently be outside the ambit of VDAs.

To address the above ambiguity, a clarification from the government would help allay the concerns regarding the probable unintended applicability of the VDA taxation regime.

WHAT IS TRANSFER OF A VDA?

The regulations propose to levy a tax, at the rate of 30%, on the income from the transfer of a VDA. The term transfer is defined in the Act, in the context of capital assets and typically represents a sale, exchange or relinquishment of the Asset or the extinguishment of any rights therein. In the context of the Cryptocurrencies, we look at select transactions to discuss whether they tantamount to a transfer or raise further ambiguity.

Is Generation of a VDA a transfer?

For a Cryptocurrency miner, by convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block, which is an incentive for miners to support the network, and it provides a way to initially distribute coins into circulation, since there is no central authority to issue the Cryptocurrency.

A mining transaction does not involve a transfer of VDAs from one person to another (staying true to the peculiar characteristic of a decentralized network). As such, the coins are created or mined by the miner and enter circulation. There is no ‘transfer’ of the mined cryptocurrency to the miner.

It appears that the intent of the legislature is to introduce a transitory regime for taxation of VDAs by placing the trigger of taxation at the stage of conversion of VDAs to fiat currency or conversion to another VDA having reference to the fiat equivalent of such VDAs. A clarification from the board would help, considering the technological attributes specific to VDAs. Currently, it is ambiguous if the receipt of cryptocurrency by the miners will trigger a tax under Section 56(2)(X) and how the same could be valued.

Acquiring a NFT say Collectibles; is it a transfer?

Several brands have started offering NFTs to its users under a direct sale or by an auction. These NFTs are minted using smart contracts and they are tracked and stored on the Blockchain.

Typically, in the context of Collectibles the rights of the Collector/Owner appear to be limited to the use of the Collectible in defined scenarios e.g. for the purpose of sharing or promoting on social media platforms, blogs, digital galleries, or other digital media; or  within decentralized virtual environments, virtual worlds, virtual galleries, virtual museums, or other navigable and perceivable virtual environments, including simultaneous display of multiple copies of the Works within one or more virtual environments. 

Another emerging transaction model pertains to the merging of a NFT art with the exclusive physical commodity. This would typically involve sale of NFTs of 3D artwork featuring the tangible underlying (for ex. Footwear). In exchange for payment, the user is granted the NFT ownership with a future option to redeem the NFT for the underlying physical object (subject to applicable terms and conditions imposed by the issuer of the NFT).

Acquiring a NFT does not generally result in an acquisition of all the underlying intellectual property rights by the user. The acquisition of the NFT merely is the right to sell an authenticated NFT, or the right to display such NFT in a suitable environment (e.g., the metaverse).

Does the acquisition of a NFT tantamount to a “transfer” or is it a grant of a right? The proposals do provide the legislature with the powers to exclude certain types of NFT / tokens from the definition of VDA. It would augur well to have immediate clarifications for this fast-emerging segment.

Sale of VDA - Peer to Peer (P2P) transactions

Several platforms enable users to use fiat currency funds in exchange for certain Supported Cryptocurrencies with other Users on the platforms in so-called “P2P transactions.” In a P2P transaction, usually the platform will hold the digital currency in escrow between the two counterparties until payment in fiat currency funds between the buyer and seller is confirmed by the respective parties. Such Supported Cryptocurrency is released to the wallet of the buyer as soon as the payment is confirmed. The platform typically does not take custody or facilitate transfer of the fiat currency funds in this model, and the transfer of the fiat currency funds is solely between Users.

In a P2P transaction, the resident seller being the transferor of the VDA, as envisaged under the proposal, is liable to tax on the appreciation in value of the VDA. The buyer is required to deduct tax at source under Section 194S of the Act at the rate of 1%.

The reporting of these transactions and the liability of the non-resident seller / resident buyer would need further clarification.

Sale of VDA – On a centralized exchange

Centralized exchanges (‘CEX’) commonly facilitate trades between users by maintaining an order book. An order book is a collection of buy and sell orders posted by traders. Orders are requests to buy or sell a certain amount of a specific cryptocurrency at a certain price. CEXs aggregate orders from their users and then use special software to match and execute the corresponding buy and sell orders.

CEX users do not actually exchange crypto or fiat currencies with each other. Instead, when they deposit their funds onto an exchange, the exchange takes over the custody of those assets and issues a corresponding amount of IOUs to the trader. The exchange tracks every user’s IOUs internally as they change hands in trades and only converts them into actual currency upon withdrawal of funds.

The tax implications will be like a P2P transaction; however, on the TDS, the person responsible for deduction of tax is likely to be the CEX.

LOOKING AHEAD

The introduction of a taxation regime for Cryptocurrency is a welcome move. While the intent for the same appears to be to bring to the tax net the gains made in the Cryptocurrency markets, a broad-brush approach of classifying and taxing the transfer of Cryptocurrencies and NFT’s may lead to a disconnect between the evolving business models and the taxation regime.  

It should be acknowledged that the Web3 technology is not limited to gains arising on account of high volatility in the Cryptocurrency markets. As the markets mature and technologies evolve further, the tax regime would need to address the peculiarities of the underlying technology and the new business models.

Further, the interplay of The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (‘Crypto Bill’) (yet to be introduced), which was initially intended to prohibit all private cryptocurrencies in India, while allowing for certain exceptions to promote the underlying technology of cryptocurrency and its uses, with the taxation regime remains to be seen. More clarity on the legalization of Cryptocurrencies and technology relating to NFTs, smart contracts is expected once the Crypto Bill is introduced.

-------------

[1]  Maharajkumar Gopal Saran Narain Singhv.CIT [1935] 3 ITR 237 (PC) = [TS-5001-SC-1935-O]