INTRODUCTION
What had long been considered ambiguous from a taxation perspective, the Indian income tax authorities formally brought cryptocurrency-related activities under the tax net with the Finance Act of 2022.
S. 2(47A) of the Income Tax Act, 1961, defines Virtual Digital Asset [“VDA” ]. S. 115BBH provides the general framework and the tax rates applicable to these transactions. For further monitoring of VDA transactions, Tax Deduction at Source [“TDS”] provisions were introduced under S. 194S, and S. 56(2)(x) was amended to include VDA in the definition of property.
Since then, the act has undergone a few more consequential amendments. The authorities have also issued a handful of circulars and notifications to provide clarity.
Although the Reserve Bank of India [“RBI”] warned investors about cryptocurrencies as early as 2013, the tax authorities did not establish a taxation framework for VDAs for nearly a decade. One would naturally think that since the taxation framework came out a long time after VDA activities picked up momentum in India, it would cover the most essential aspects of it. Unfortunately, that does not appear to be accurate, and the regulators seem to be preoccupied with only one aspect of VDAs.
NARROW FOCUS, MISSES SUBSTANCE
The existing framework related to VDAs largely seems to be based upon the assumption that VDA transactions are carried out through regulated intermediaries and exchanges, which are required to maintain various user details, including but not limited to name, address, and Permanent Account Number [“PAN”]. The current taxation framework seems to assume that for every trade, there will be a broker or some intermediary, like in the case of shares and other securities. This could be because the traditional perspective is not aligned with real-world scenarios or because of the uncertainty surrounding the practical implementation of these provisions. As a result, it appears the tax authorities have based the entire tax framework on the assumption that cryptocurrency transactions occur solely through trackable channels.
It must be accepted that most taxpayers have engaged with cryptocurrencies primarily for trading and short-term profits rather than their original intended uses. To that end, the revenue authorities have succeeded in expanding the tax base.
Conversely, when considering aspects beyond crypto trading through regulated intermediaries, it appears that the tax authorities have either failed to recognise the true nature of cryptocurrency transactions or have entirely overlooked those transactions conducted outside regulated exchanges.
These overlooked aspects of the taxation framework become evident when examining the fundamental reasons for the creation of cryptocurrencies and the way transactions are conducted in this domain.
This article seeks to understand transactions where the existing framework falls short and, if possible, to suggest remedies.
FINDING FMV – AN ELUSIVE EXERCISE?
Identifying FMV for VDAs is easier said than done. S. 56(2)(x) includes the term VDA in the definition of the Property. “Rule 11UA – Determination of Fair Market Value” provides the valuation methodology for property other than immovable property. However, Rule 11UA does not explicitly specify the valuation method to be applied in the case of VDA, as it does for jewellery, archaeological collections, drawings, paintings, sculptures, any work of art, and shares and securities.
If the cryptocurrency involved in the transaction is exchange-traded, then the reference to the trading price on the exchange can be made. On the other hand, it is often observed that cryptocurrency prices across exchanges differ. In that case, the question arises: which prices should be adopted? Also, which exchange rate should be applied—the SBI Telegraphic Transfer Rate, the RBI Rate or some other? The law is silent at the moment; hence, the taxpayer has to take a call. Things become further complicated when the cryptocurrency used in the transaction is not exchange-traded. Finding a comparable arm’s-length price for a similar transaction can be challenging. Additional complications may occur in the barter trade of VDA, especially when one of the VDA is a self-generated NFT.
The absence of a framework for determining FMV does not seem to be an arithmetic issue but rather a conceptual one. A taxpayer willing to pay the correct tax amount cannot do so because quantification without proper standards will result in highly subjective valuations, potentially leading to disputes between taxpayers and the revenue.
Until the law is settled on these issues, one will likely be exposed to litigation risks and should therefore remain consistent with the adopted FMV policy and retain all relevant documentary evidence.
BARTER OF VDA – A COMPLIANCE NIGHTMARE
Notification 75 of 2022 has made it clear that the transfer of an NFT that results in the transfer of an underlying tangible asset that is legally enforceable will fall outside the purview of VDA provisions. However, in practical terms, that is just half a story. What happens when, say, an NFT art is sold in exchange for cryptocurrency? Who is transferring what? From a taxation perspective, both the art seller and crypto payer are buyers and sellers of VDA at the same time. In this case, both are required to meet the compliance requirements under S. 194S. Couple this with practical difficulties in obtaining the counterparty’s PAN details, and we have a tax provision that is highly impossible to implement. The situation becomes even more complicated when the question of FMV arises, as there are no clear guidelines for ascertaining the FMV.
DECENTRALISED FINANCE – DEFI-NG THE MIDDLEMAN
DeFi stands for decentralised finance, in which lending and borrowing of cryptocurrency, amongst other transactions, take place. In a nutshell, here, (mainly) banking activities are carried out without intermediaries.
The question may arise as to how borrowing and lending of cryptocurrency through DeFi platforms are seen through the lens of the Income Tax Act. As per section 115BH, it has to be an income from the transfer of VDA for it to be a taxable event. Without a proper mechanism to distinguish whether cryptocurrency received in one’s wallet is a loan or income, this may pose a challenge when dealing with the authorities. Also, the TDS mechanism practically fails in such scenarios, as the parties know only each other’s wallet addresses and nothing else. Hence, obtaining the lender’s PAN and other details for TDS compliance is technically impossible.
Additionally, uncertainty exists regarding the allowability of interest paid on these loans, and the applicable conversion rate—SBI TT, RBI, or otherwise—remains undefined. Further, in the absence of tax deduction at the time of payment, how will the authorities assess the allowability of the expenses? This situation is, unfortunately, administratively impossible to implement but legally inescapable. This will require clarity and the additional reporting clauses in the ITR forms to disclose the categorisation of cryptocurrencies in one’s portfolio.
MINING AND VALIDATION – A BUILT-IN DOUBLE TAX
As cryptocurrencies run on a decentralised mechanism, for every transaction to get permanently embedded on the blockchain, it has to pass either the mining or validation process. In the case of mining, the person (literally, the computer) who first solves the mathematical code verifying the transaction earns a significant portion of the reward pool/transaction fees in the same cryptocurrency used to execute the original transaction. Since he has not paid anything in literal terms to earn this cryptocurrency, in the eyes of the law there is no cost of acquisition under s. 115BBH. Essentially, the whole earnings of the miner are taxable under s. 56(2)(x) at the slab rate. When the miner trades the same currency in the future, the entire sale proceeds will again be taxed at a flat rate under s. 115BBH.
In validation, validators stake their own coins and are randomly selected by the system to verify transactions. The validator proposes the transaction for inclusion in the block. Once validated by the others, the validator earns the rewards, and so do the others who confirm the transaction, albeit marginally less than the original validator. The issue mentioned in the miners’ case applies equally here.
Although the above working mechanisms are oversimplified, the issue remains loud and clear. The income from VDA is taxed twice, and TDS compliance is impossible under this mechanism, as no party knows the other; hence, obtaining PAN and other details is impossible.
GAS FEES – A CORE COST THAT THE LAW PRETENDS DOES NOT EXIST
For every transaction executed, the person incurs transaction fees, called gas or network fees. These gas fees are the essential part of the transaction; however, these are not permitted as an expenditure in connection with the transfer under s. 115BBH. The regulators seem to have overlooked the nature of the actual crypto mechanism again.
For every crypto transaction in this domain, gas fees are an embedded, non-compromising cost charged by the platform itself, yet the tax authorities arbitrarily segregate them from the main transaction for taxation purposes. One wonders whether it is deliberate or mere shortsightedness on the part of authorities to classify every cryptocurrency transaction as akin to a transfer of a capital asset or property, in which the original consideration and ancillary costs can be separated. At one end, the authorities are charging notional gains with double taxation in many parts, and at the other end, they are completely ignoring the platform-mandated costs. Such selective taxation amputates the original structures for the widening of the tax base (at least on paper).
STABLECOINS – THERE IS STILL A TAXATION CHAOS
Recently, stablecoins have become prominent in the crypto world, offering stability and better protection against market volatility, which has become synonymous with other cryptocurrencies. It is achieved by linking the cryptocurrency to tangible real-world assets, such as US dollars or precious metals like gold. This stability has enabled stablecoins to be widely used as a transaction medium for the exchange of goods and services in Western countries. Many prominent companies have begun accepting payments in stablecoins.
However, Indian tax law does not distinguish between regular cryptocurrencies and stablecoins, placing them in the same basket. If a person uses these stablecoins to pay service providers, the law does not provide any mechanism to treat those payments as an expenditure. The law still treats it as a transfer of VDA and completely turns a blind eye towards the essence of the transaction.
THE JURISDICTION ISSUE
As cryptos lack physical existence, they create their own issues that are largely unaddressed at the moment.
Generally, the asset’s physical location plays an essential role in cross-border transactions. In the crypto framework, there is no practical way to determine whether the parties to a transaction fall under the same tax jurisdiction. Assuming that it is a cross-border transaction, identifying the location of crypto is a futile exercise as crypto essentially exists nowhere and yet everywhere. This raises the question of which jurisdiction has the right to tax income generated from crypto.
Another traditional tax assumption is that each transaction can be identified as to where it accrued or arose, and taxed in that jurisdiction first, unless a DTAA provides to the contrary. The mining or staking rewards the person receives are code-driven and do not have a specific location where they are generated.
As of now, none of the tax treaties have any specific article that addresses crypto activities. Also, since the Indian tax law treats VDA as its own category, rather than as business income or capital gains, it does not fall within any treaty article; hence, the person may not be able to take advantage of any treaty benefits.
LIMITATIONS OF THE TAXATION FRAMEWORK
The current taxation framework suffers from fundamental flaws since it applies conventional tax principles in a decentralised transaction environment. It may be argued that these flaws are a byproduct of misalignment between how lawmakers view the transactions and how the world practically treats them.
– Absence of middleman o The framework looks at every VDA transaction with an assumption that it will always have a middleman on whom the responsibility may be cast to collect the appropriate taxes. The inception of cryptocurrency itself is built on the principle that transactions ought to be carried out peer-to-peer rather than through any intermediary. This fundamental difference in perspective leads to misalignment with reality.
– Assumption of “transfer” o S. 115BBH relies on the transfer for the whole tax mechanism to work. The law assumes there must be a transfer between the parties for it to be taxed. However, it can be seen in examples such as staking rewards, yield farming, or payments through stablecoins that there is no transfer in the traditional sense, or a relinquishment, as envisaged by the definition of transfer. The person continues to own the cryptocurrencies, yet he stands to gain from them through the inherent crypto mechanism or by participating in the activities. This may leave these activities outside the scope of taxation, which, in turn, does not serve the purpose of tax collection.
– Valuation Framework Absence o As discussed previously, the law does not provide any guidance on the valuation of VDAs, which essentially is a minefield for future litigation and disputes between tax authorities and VDA users.
– Inadequate and Impractical Compliance Mechanism o Even if one wanted to be a compliant citizen, a person cannot obtain the identifiable information from the opposite party regarding their name, PAN, jurisdiction, etc. This practical difficulty is essentially a result of an inherent assumption about crypto transactions’ privacy-first approach that the law overlooks.
– Blind eye towards real-world use cases o The law essentially treats crypto as an asset on which gains are generated upon transfer. However, in the real world, cryptos are used for far more purposes than that. The expenditure incurred through cryptocurrencies does not find a place in the current tax structure.
– Burdening the compliant o Since the existing tax framework primarily focuses on the exchange-traded crypto activities, it effectively shoulders more responsibility on the law-compliant participants
and overlooks a plethora of decentralised activities. This does not result in neutral enforcement of tax provisions.
A LOOK AROUND
Before discussing the possible steps regulators can take, it would be helpful to understand how cryptocurrency taxation works elsewhere
United States
The nation that arguably rules the world economy through its currency seems more open to cryptocurrencies than many others.
The US allows cryptocurrency to be classified under income heads such as salary income, business income, capital gains – short-term, and long-term.
It also allows for the inclusion of fees, commissions, and other expenses incurred in acquiring the cryptocurrency.
The US IRS also provides a general framework for identifying the FMV of crypto under various circumstances, including when an exchange serves as an intermediary or in peer-to-peer transactions. The taxpayer is also allowed to adopt any other value as fair market value, provided they can establish that the adopted value is an accurate representation of the value.
OECD – Crypto Asset Reporting Framework
The OECD has developed a framework to bring cryptos under the standardised framework for the exchange of information between jurisdictions. India has endorsed the framework, and recent reports suggest it may adopt it with effect from April 1, 2027. Though this is a welcome move to increase transparency, the key point is that this framework primarily focuses on exchanges, custodians, and other regulated entities that will be required to collect transaction data and share it with tax authorities. This will help increase transparency in reporting and information sharing across borders.
Yet, one gets the feeling that despite adapting to it, it will be the case of putting more light in the already lit room, while ignoring the blind spots surrounding it, as India’s crypto reporting framework for transactions carried out through exchanges is already quite robust through the introduction of s. 285BAA.
A PAUSE BEFORE THE WAY FORWARD
The cumulative effect of the inherent limitations of the existing tax framework results in practical implementation impossibilities. The tax law remains on paper in most cases, resulting in inefficiency in achieving its intended objectives.
When the cost of compliance in terms of implementation, time spent in understanding the structure, and possible penal consequences far outweighs the revenue collection, the law fails in the real world. This deadweight results in businesses focusing on compliance rather than on productive output.
It may also be argued that mere amendments to these sections will result in temporary fixes, which may again be laid bare by technological advancements and innovations in the crypto world. The solutions sought should not be activity-oriented but purpose-driven for effective implementation. In the ideal scenario, regulators should aim to build a broader framework that seriously considers how the decentralised structure of cryptocurrencies operates, rather than arbitrarily creating laws that prevent genuine taxpayers from using these mediums for legitimate activities.
As the former chief executive of Niti Aayog succinctly put it, “India’s regulatory environment places a very high compliance burden … Regulation should not ‘stifle innovation and job creation’, and should rather play a role where it enables growth … We need regulation that enables, not controls.”
WAY FORWARD
The gaps arising from non-alignment can be addressed through the following considerations.
DUE CONSIDERATION TO “ACTIVITY” RATHER THAN “TRANSFER”
The current tax regime seems to focus heavily on the event of “transfer” in the traditional sense, which may or may not happen as intended in the definition in the decentralised environment. Although all activities and their taxable events cannot be practically incorporated into tax laws, the overarching framework explaining the activity or event that gives rise to a tax incidence can be laid down. Coupling this with the substance of the transaction, rather than mere visibility, could also ease the interpretational issues to a great extent.
SELF-REPORTING AND TRUST-BASED TAXATION
The practical difficulties arising from the implementation of the TDS mechanism in transactions carried out through a medium other than a regulated exchange can be addressed through a self-reporting mechanism. The trust-based taxation is the keystone of the existing ruling regime. This could be further built upon by providing a separate schedule in the ITR that allows the taxpayer to report the movement of VDAs from their wallets. The honest taxpayers can be served greatly through such a mechanism.
VALUATION MECHANISM
The mere addition of the VDA to the definition of property has not, in practice, served anyone, as the valuation rules do not provide a methodology for valuing VDAs. Again, the honest taxpayer suffers in the absence of clarity surrounding valuation. The regulators should consider valuation practices used in other countries, such as the US.
ALLOWING INCIDENTAL EXPENSES
The gas fees, mining fees, and other inherent expenses incurred when transferring the VDA from one wallet to another should be included in the cost of acquisition or allowed to be deducted from the sales consideration.
EXPENDITURE INCURRED THROUGH STABLECOINS
The use of stablecoins to incur genuine business expenditure is not a dystopian scenario anymore, when many prominent organisations around the world are accepting them in exchange for services or products provided by them. These are the genuine business transactions in the real world. Due regard should be given to these scenarios when deciding the tax treatment of VDA transfers.
SIMPLIFIED TAX CALCULATORS AND TOOLS
The section of taxpayers engaging in VDA transactions is often not the one that can digest and act on the various nuances of tax laws. The pilot projects providing simplified tax calculators and FAQ sections could be made available on the relevant portals so that honest taxpayers can meet their tax liabilities with greater clarity.
PROVIDING THRESHOLD FOR VDA TAXABILITY
Rather than taxing VDA transactions outright, the regulators may consider a threshold limit after which the VDA transactions will be brought under the tax net, while at the same time making it mandatory to report each VDA transaction undertaken during the year. This may enable casual persons indulging in VDAs to be well-versed in the tax consequences. At the same time, the regulators may obtain better information surrounding VDA transactions undertaken by taxpayers.
VDA IS HERE TO STAY
The most significant mindset shift that regulators can adopt is that VDAs are here to stay. While most of the world was wary in the early stages of the VDA, the consensus seems to be shifting toward the view that VDAs are now a noticeable part of the economy, if not already an integral part. The current tax regime in India appears to be built on the presumption that VDA activities should be prohibitive, and every tax provision seems to be structured to discourage their use.
Granted that regulators may have their own reservations about encouraging the adoption of VDA as an alternative to fiat currencies; however, the approach of treating every VDA transaction through the same tinted glass may warrant further introspection.
It would be worth noting that the Hon’ble Madras High Court recently held that crypto is property, even though it is neither tangible nor currency.
CONCLUSION
Every story has different sides, and quite rightly so. The regulators, for obvious reasons, have reservations about wider adoption of VDAs in trade and industry. The scenarios of foul play by people using VDAs for illegal or criminal activities cannot be ruled out; hence, to the extent that these regulators’ reservations about VDAs may be justified. However, unfortunately, it could also be noted that such activities are still undertaken with fiat currencies.
The regulations should not be so severe as to hinder the development of new technologies, avenues, or innovations.
As the Hon’ble Finance Minister was recently quoted as saying, “Our government remains steadfast in reducing regulatory burdens and enhancing trust-based governance … one where businesses are free to focus on innovation and expansion, and not paperwork and penalties.” The jury’s still out.