The taxation of “virtual digital assets” is one of the most widely discussed announcements from the Finance Minister Nirmala Sitharaman’s Budget speech on February 1. A review of the Finance Act, 2022, shows that digital assets will cover cryptocurrencies and non-fungible tokens.

The Central government also has the authority to notify any other digital asset as a virtual digital asset. While NFTs have not as yet been defined through the Finance Act, the Central Government may issue a notification providing more clarity.

The government introduced broadly three measures on taxation of virtual digital assets. First, income from the transfer of virtual digital assets will be taxable at a flat rate of 30%, without the ability to offset it against any other losses. No deductions will be allowed and only the cost of acquisition will be allowed as deduction while computing income.

Second, it introduces the requirement for the tax to be deducted at source at the rate of 1% on payment to a resident on the transfer of virtual digital assets. Third, a gift of virtual digital assets will be taxable at the hands of the recipient.

This move has filled the crypto community with the hope that it signals the government’s acceptance of the NFTs and cryptocurrencies. In addition, it also marked the supposed legalisation of cryptocurrencies. Many commentators have already expressed their views about whether taxation does in fact lend legitimacy to cryptocurrencies.

Some argue that taxing virtual digital assets is not necessarily an indicator that they are legally recognised (here and here). While these discussions are important in their own right, there is a need for discussion on the potential effects of this policy decision on stakeholders and the ecosystem at large.

An obvious benefit that is clear through this official statement of the finance minister: “magnitude and frequency of these transactions have made it imperative to provide for a specific tax regime”. It means that the government, after having seen the increased scale of transactions taking place in this space, has decided to specifically tax transactions, as this provides it with an additional revenue source.

However, there may be more to this move than meets the eye.

Lack of information

The crypto community and specifically crypto exchanges have for long been lobbying for some form of regulation in the field. The ambiguity caused by the absence of regulations has hampered the growth of the field since more serious investors still continue to be wary. However, there has been a certain level of trepidation and uncertainty on the part of the government in introducing regulation to this space.

The government has also said that it does not have any crypto exchanges that are operational nor is it aware of the number of investors on these platforms. This means that it has inadequate information on this industry.

One of the reasons for this is the very architecture of these crypto-assets as largely global systems without heed to traditional national borders. The transactions on these systems, though publicly available for everyone to see (as in the case of bitcoins so to speak), do not provide any insight for the government on ownership or value or even location of a specific asset.

To a large extent, this creates opacity and paints a nebulous picture of this space at least in terms of determining policy. This makes it difficult for the government to determine the kind of transactions that flow out of and into India.

Of the three measures introduced on virtual digital assets that are being introduced, the second measure – a tax deduction at source on transfers of digital assets – will provide critical information that could inform the government about the nature and extent of transactions taking place in this industry.

It could especially provide data about the transactions between individuals who are resident in India.

These tax deductions at source requirements are only triggered for transactions above Rs 50,000 (in the case of specified persons) and those above Rs 10,000 in other cases. To be clear, the first measure of a 30% flat rate of taxation would also provide important information with regard to virtual digital assets. However, the requirement to file tax returns will only kick in from the next financial year 2022-’23.

A taxation regime becoming applicable on digital asset transactions provides the government with a window, albeit a small one, into the extent and nature of transactions taking place. This kind of data collection at a large scale might prove to be extremely valuable when the government does in fact decide to take a stance on crypto regulations.

However, it is also necessary for the government to provide much-needed clarity before the tax deducted at source requirement becomes effective on July 1. The global nature of cryptocurrency trade and the wide range of crypto exchanges that function in the market will significantly complicate the determination with regard to who would be allowed to deduct the tax at the source.

India is not the first country to introduce a crypto tax and certainly will not be the last. Nonetheless, in the absence of a suitable clarification from the government, compliance on the part of investors and exchanges could become increasingly burdensome.

Introducing caution

A major grouse for the government in the past has been the Wild West nature of trades on these markets. This is echoed by the exchanges’ claims that more serious investors continue to be wary of investing in these assets. However, the lack of concrete steps by the government to introduce regulation resulted in a Catch-22 situation.

By introducing a tax, especially one as high as 30% there is a possibility that this could be read as the government’s attempt at disincentivising crypto investors. Thus, attempting to bring in a certain degree of caution and prudence in making investments. However, only time will tell the long-term effect of such a decision.

What the industry desperately needs and has consistently demanded is the need for a clear set of regulations. The lack of clarity and the consequent hesitation could be very damaging to a fledgling industry. This is especially so at the scale at which the industry is operating and the sheer volume and value investments.

Therefore, the need of the hour is to develop a clear and sound regulatory framework after conducting transparent multistakeholder consultations with relevant stakeholders including crypto exchanges, consumer organisations and allied organisations.

While the substantive framework is important in itself, the initiation of an open democratic policy-making process will instil much-needed trust in the ecosystem.

Vishal Rakhecha is Associate, Regulatory and Policy Team, Saraf & Partners. He has a keen interest in the field of technology law, especially data protection and fintech.

Gangesh Varma is a Senior Associate with the Regulatory and Policy Team at Saraf & Partners. He has a decade of experience in the areas of internet governance, public and tech policy, international law, and data governance.

The views expressed by the authors are personal and do not reflect the opinion of their firm.