Investments in digital assets have been rising across the country. Due to the increase in the frequency and volume of transactions of Virtual Digital Assets, for the first time, the provisions for taxation of Virtual Digital Assets have been introduced in the Union Budget 2022

Mr. B.P. Sachin (Partner, Manohar Chowdhry & Associates) analyses the finer aspects of the scheme of tax on Virtual Digital Assets. He highlights that in case of a non-resident, “one has to take recourse to the general provisions under sections 4 and 5 of the Act. Thus, if the situs of the VDA is not located in India, its income may not be taxable in India.” He opines that the definition of VDA is very widely worded and thus it would imply that the Revenue desires to bring to tax digital assets in any form. He extensively analyses the cumulative conditions for any information or code or number or token to be considered as VDA and ponders over several interpretational issues arising therefrom such as whether points collected in e-wallets would be covered under VDA.

The author highlights that the proposed amendments do not explicitly mention the word ‘cryptocurrencies’ and opines that “not every transaction in cryptocurrencies may be a taxable transaction…. Revenue cannot subject to tax the transactions which are not otherwise taxable under the guise of the VDA regime.” He is of the view that the provisions should be amended to tax the transactions which are in the nature of investment / speculative transactions and the transactions where cryptocurrencies are being used as a medium of exchange should be specifically excluded from the purview.  He also provides a lucid comparison between NFTs and cryptocurrencies. He also ponders over the possibility of tax arbitrage through VDAs. While signing off, the author remarks that “The Revenue has rightly cleared its stance on the taxation of VDAs. However, the Revenue may be advised well to tread step-by-step on this path.”

“Taxation of Virtual Digital Assets – The Finer Aspects”

Background

The Reserve Bank of India had reportedly been pushing for a complete ban on all cryptocurrency transactions. In spite of these concerns, investments in digital assets have been rising across the country. Due to the increase in the frequency and volume of transactions of Virtual Digital Assets, for the first time, the provision for the taxation of virtual digital assets is introduced in Budget 2022, bringing Cryptocurrencies & Non-Fungible Tokens (NFTs) under the tax net.

Basic scheme of taxation under the Act

The Finance Bill, 2022 proposes to tax income from the transfer of Virtual Digital Assets (VDA or VDAs) under section 115BBH. Before any income can be taxed under the Income tax Act, 1961, one has to find out:

• Whether the assessee is an Indian resident or not?
• Whether the situs of the VDA is in India or outside?
• How to determine the situs of the VDA - depending on the residential status or citizenship of the assessee transferring the VDA or that of its miner / creator or based on the place where the exchange is registered or any other factor?

In the absence of guidance on these key aspects, the general provisions of the Act would continue to apply. This means that in the case of determining the taxability of a non-resident in India, one has to take recourse to the general provisions under sections 4 and 5 of the Act. Thus, if the situs of the VDA is not located in India, its income may not be taxable in India.

Having said that, we now proceed to analyse the definition of VDA as proposed by the Finance Bill, 2022. The scope of this article is restricted to the analysis of the definition of VDA under the proposed section 2(47A) and the plausible implications.

Definition of VDA

The proposed section reads as:

‘(47A) “virtual digital asset” means––

(a) any information or code or number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration, with the promise or representation of having inherent value, or functions as a store of value or a unit of account including its use in any financial transaction or investment, but not limited to investment scheme; and can be transferred, stored or traded electronically;

(b) a non-fungible token or any other token of similar nature, by whatever name called;

(c) any other digital asset, as the Central Government may, by notification in the Official Gazette specify:

Provided that the Central Government may, by notification in the Official Gazette, exclude any digital asset from the definition of virtual digital asset subject to such conditions as may be specified therein.

Explanation.––For the purposes of this clause,––

(a) “non-fungible token” means such digital asset as the Central Government may, by notification in the Official Gazette, specify;

(b) the expressions “currency”, “foreign currency” and “Indian currency” shall have the same meanings as respectively assigned to them in clauses (h), (m) and (q) of section 2 of the Foreign Exchange Management Act, 1999.’.

As one would observe, the definition of VDA is very widely worded. This implies that the Revenue desires to bring to tax digital assets in any form. For the sake of simplicity, let’s assume that we are analyzing whether ‘Gothic’ is a VDA or not.

Coverage

As per the definition, Gothic would be considered as a VDA if it is covered under any of the clauses (a), (b) or (c) above. This means that it may be either:

a. An information or code or number or token meeting the other conditions; or

b. A non-fungible token (NFT) or any other token which is similar to NFT – Explanation to section 2(47A) provides that NFT is a digital asset which is notified by the Central Government; or

c. Any other digital asset as notified by the Central Government.

It implies that if Gothic is not notified under clauses (b) and (c), it may still be covered under clause (a).

Characteristics of VDA for the purpose of clause (a) of section 2(47A)

If Gothic is not a VDA under clauses (b) or (c) of section 2(47A), it may still be considered as a VDA under clause (a). For this purpose, Gothic must be considered as any information or code or number or token which cumulatively satisfies the following conditions:

Cryptocurrencies

The proposed amendments do not mention or define the word ‘cryptocurrencies.’ As per the Merriam-Webster’s dictionary:

“Cryptocurrency means: any form of currency that only exists digitally, that usually has no central issuing or regulating authority but instead uses a decentralized system to record transactions and manage the issuance of new units, and that relies on cryptography to prevent counterfeiting and fraudulent transactions”

In real life, cryptocurrencies may be simply used as an investment asset. They are also being accepted as a valid currency in the virtual world. They are being used to:

• Make low-cost and quick money transfers across the globe;
• Make private investments in companies;
• Buy and sell goods or services;
• Play online games or buy new features of the games; or
• Travel worldwide (being considered as a universal currency) etc.

This means that cryptocurrencies can be used as a medium of exchange apart from being considered as an investment or a speculative asset. Thus, not every transaction in cryptocurrencies may be a taxable transaction (eg. NRIs using cryptocurrencies to remit money to Indian relatives). Yet, it may be taxable considering the current drafting of the proposed provisions. It is pertinent to note that the Revenue cannot subject to tax the transactions which are not otherwise taxable under the guise of the VDA regime.  Hence, the provisions should be amended to tax the transactions which are in the nature of investment / speculative transactions; the transactions where cryptocurrencies are being used as a medium of exchange should be specifically excluded from the purview.

NFT vs Cryptocurrencies

It may be worthwhile to note that non-fungible token (NFT) and cryptocurrencies are two different things. As per the Merriam-Webster’s dictionary:

Non-fungible token means

a: a unique digital identifier that cannot be copied, substituted, or subdivided, that is recorded in a blockchain, and that is used to certify authenticity and ownership (as of a specific digital asset and specific rights relating to it)

b: the asset that is represented by an NFT

A preliminary analysis of the definition indicates that cryptocurrencies and NFTs are two characteristically different things.

NFTs lead to the creation of digital assets like designs, paintings, graphic characters etc. Digital geeks and students have developed innovative digital designs known as NFTs which have a booming market.  The creator owns these assets (akin to patents). These NFTs can be sold outright or retained by the owner to earn royalty from allowing others the 'right to use'. The fact that NFTs can be traded or transacted in cryptocurrencies does not mean that NFTs are cryptocurrencies.

Besides, as the definition of NFT stands today u/s 2(47A), an item may be considered NFT only if it is notified by the Central Government. There are millions[5] of NFTs being traded in the virtual world and new NFTs are constantly being invented. It may not be possible for the Government to notify all these NFTs or the new ones being created. This may lead to unintended consequences of tax arbitrage (explained later in this article) amongst NFTs that are notified and those which are not. Rather, the Government may consider adding NFTs like any other tangible physical assets and the tax treatment accorded must be the same as other tangible assets.

Exclusions from VDA

Proviso to the section provides that the Government may also notify certain digital to be specifically excluded from the purview of VDA. Thus, if Gothic is specifically excluded from the definition of VDA, it will not be taxable under the proposed section 115BBH. This does not mean that it is automatically exempt. It simply means that income from Gothic would be taxable under the normal provisions of the Act which provide for:

• Categorization of income as business income, capital gains or income from other sources
• Benefit of deductibility of expenditure incurred on such income
• Benefit of set-off of losses and carry-forward of losses
• Benefit of slab rates of tax

It may be worthwhile to think whether the proposed definition is opening up the possibility of tax arbitrage by determining whether an asset can be taxed as a VDA or under any other provision of the Act which may prove to be more beneficial.

Virtual digital asset vs digital asset

The definition of VDA uses two terms – “virtual digital asset” and “digital asset”. Usage of 2 different terms would leave open a room for future litigation in the matter.

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