Cryptocurrency is surging in popularity in India as an investment and, increasingly, a means of payment by companies for their products and services. This brings in the question of how to pay taxes on those types of transactions.

While the Reserve Bank of India has not granted legal tender status to Bitcoin and other cryptocurrencies, there is no escape from paying tax on cryptocurrency investment gains. The Indian government is planning to compartmentalise virtual currencies and their tax treatment on the basis of their use cases – payments, investment, or utility, according to the Economic Times.

“Cryptocurrency gains could happen from multiple ways such as mining, staking, farming, or conventional buying and selling,” said Edul Patel, co-founder and CEO of San Francisco-headquartered cryptocurrency trading platform Mudrex. Gains from trading digital assets could be categorised under “business income”, while other activities would likely fall under “income from other sources”. Bringing in additional rules or amendments would needlessly burden the taxpayer, Patel said.

High-powered computers “mine” Bitcoin by solving complex mathematical puzzles that result in a Bitcoin reward. Similarly, cryptocurrency staking provides a token reward for determining whether a transaction conforms to certain protocol requirements. Yield farming, which typically takes place using the Ethereum ecosystem, involves lending out crypto assets in return for a payment.

While it is not yet clear that the Indian government will set out a regulatory framework for virtual assets, it has provided some provisions for transparency.

In March, the Indian government made it mandatory for companies dealing with virtual currencies to disclose profit or loss incurred on crypto transactions and the amount of cryptocurrency they hold in their balance sheets. The amendments made in the Companies Act came into effect on April 1 this year.

The then-minister of state for finance, Anurag Singh Thakur, clarified that “the gains resulting from the transfer of cryptocurrencies/assets are subject to tax under the head of income, depending upon the nature of holding of the same”.

The important bit is to assess the nature of these investments.

The Reserve Bank of India has not granted legal tender status to Bitcoin and other cryptocurrencies, Photo credit: Vivek Prakash/ Reuters

Classification of crypto

A digital token is deemed to be a capital asset if it is purchased for investment, which means it is bound to be taxed under capital gains. These investments are categorised into long-term or short-term capital gains, depending on the holding period.

Any gains after holding a cryptocurrency for 36 months or more would be taxable as long-term capital gains, while gains accrued during a shorter period would be categorised as short-term capital gains. These gains are taxable as per the slab rates applicable to a taxpayer, while long-term capital gains are taxed at the flat rate of 20% with the benefit of indexation, according to Harsh Bhuta, partner at accounting firm Bhuta Shah & Co. Bhuta says “much clarity” is still required on how to treat the different types of gains and income.

The tax rate under the long-term category can decline once the indexation benefit is applied, which allows the investor to adjust for inflation during the period these investments were held. Every year, the Central Board of Direct Taxes releases the cost inflation on which these assessments are done.

On the other hand, if a trader carries out cryptocurrency transactions frequently, any profits thereon would be taxable as business income.

Cryptocurrency Bill

Many countries already have a taxation system for cryptocurrency gains in place, but India’s frigid response to the virtual currency ecosystem makes it tough for investors to file their tax returns. Indians had parked nearly $6.6 billion (Rs 49,189 crore) in cryptocurrencies as of May this year, as compared to around just $923 million until April 2020, according to blockchain data firm Chainalysis.

As cryptocurrency regulations in India remain ambiguous, a growing number of Indians are accessing digital tokens by buying and selling on foreign platforms, which may have better features and customer service. If Indian authorities warm to the crypto token market, however, that could pull some of that business back to domestic crypto exchanges.

The Indian government may levy the 18% Goods and Services Tax on transactions on foreign cryptocurrency exchanges in order to level the playing field with domestic ones, according to reports in July. India has also reportedly considered a 2% equalisation levy on transactions with foreign crypto exchanges. For Indian cryptocurrency exchanges, the 18% GST is charged as the trading fee to customers, which is similar to the setup for stock brokerages.

Market players are now biting their nails ahead of the winter session of the Indian Parliament, when the country’s first cryptocurrency legislation is likely to be presented. The Cryptocurrency and Regulation of Official Digital Currency Bill is expected to contain disclosure requirements for income tax returns for crypto holdings in India as well as on foreign crypto exchanges by Indian residents.

This may allow the government to regulate cryptocurrency transactions, and the legitimacy provided to digital tokens could give investors more confidence in the sector. Many cryptocurrency enthusiasts believe that regulating cryptocurrency will generate tax revenues for the Indian government as well.

Bhuta expects the Indian government may introduce special income tax rates to tax profits from cryptocurrency transactions and may identify such transactions through recognised platforms only.

“It would be a massive source of revenue for the government, which is currently burdened with a large fiscal deficit,” Patel said. “The government realises the importance of employment opportunities in the several new startups that have sprawled up around the crypto ecosystem. The government should likely focus on creating a robust taxation framework that is easy to understand and simple to implement.”

This article first appeared on Quartz.