In the Union Budget 2022, a new asset class, known as virtual digital assets (VDA) was recognized. Though, VDA has made rapid proliferation across geographies and industries, from tokens to stablecoins to NFTs, Metaverse, there’s little practical guidance available for businesses, to understand the tax implication of such VDAs. The legal framework on VDAs is still in a formative stage. One of the key challenges for the administration is that VDAs bypass the existing long established financial systems of intermediaries and have challenges in traceability on account of its decentralized nature. The anonymous nature of the assets and its transactions is creating a blind spot for the tax authorities.

In December 2013, Reserve Bank of India (RBI) issued press releases to caution the users, holder and trader of virtual currencies that it has not issued any license / authorization to operate or deal in virtual currencies. Thus, one should deal in virtual currencies at their own risk. Thereafter, in April 2018, RBI issued a circular prohibiting, commercial and co-operative banks, payment banks, small finance banks, NBFCs and payment system providers, from dealing in virtual currencies and instructed the regulated entities to exit the relationship within three months. Post this, crypto exchanges were unable to access the banking services in India. In March 2020, the Supreme Court struck down RBI’s ban on virtual currencies and held that Circular issued in April 2018 was unconstitutional.

Govt clarity

The Government took the first step on bringing clarity on taxation of VDA such as cryptocurrencies and Non-Fungible Tokes (NFTs) from a direct tax perspective, by recognizing them as new asset class and including them in the tax framework. Finance minister Nirmala Sitharaman announced in the Union Budget for 2022-23, that the Reserve Bank of India (RBI) will introduce the Central Bank Digital Currency (CBDC) as India’s official digital rupee in 2022-23. Thus, Government has clarified its intention to keep the CBDC distinct from any private cryptocurrency.

Tax authorities are struggling to come to grips with the dynamic nature of VDAs and its exponential growth and adaptability with consumers. This makes it difficult for the tax authorities to understand how VDAs could be included in the traditional definitions and concepts of taxes. One of the key aspects to be identified from GST perspective is the classification of VDAs into goods or services. We often equate VDAs with cryptocurrencies such as Bitcoin, Ethereum. But crypto-assets actually covers much more than just crypto-payments.

There are following broad archetypes of crypto assets/token:

a) Payment / Exchange token – Such token are means of payment for goods / services. Globally, most regulators are of the view that payment tokens cannot be assimilated with fiat currency because they are not issued or backed by a central bank. Their value solely depends on the trust/value that user places in them.

b) Security token – Such token provides to the holder, the ownership of assets and entitlement to use them. Such tokens are more similar to financial instrument than to mode of payment.

c) Utility token – Such token provides token holder with access to a function, use or participation in an event, service or product. In some aspect such tokens are akin to a voucher.

d) Hybrid token – Such tokens may fall into several categories

Tax definition

The tax definition of VDAs also include non-fungible token (NFT). NFTs are mostly rare collectibles / interesting arts, music, video and in-game products or similar digital content that can be bought and sold on the NFT marketplace and the original creator of NFT sometimes may earn royalty for each re-sale.

Chairman, CBIC has acknowledged that there are more than one aspect of crypto-currency that require detailed examination from GST perspective. He mentioned that CBIC is in the process of examining these aspects and there will be some finality in due course. GST authorities have been seeking information from the key players in the VDA space to understand business nuances and operations and identify the transactions.

GST treatment

Under GST the tax treatment is dependent on the location of the service provider and service receiver. In a typical VDA transaction, the parties may be identified based a digital wallet rather than a physical address. Given the anonymity of the buyer, seller, and the underlying assets, it becomes equally challenging to determine if the VDA transaction would qualify as a domestic (inter/intra state) or a cross-border transaction (export/import).

The first possible taxable event is created when a VDA is created. This process is also known as mining in common parlance. As an established principal, for a supply to be taxed, there should be two persons, one of them being the service provider undertakes an activity for the service recipient for a consideration. Tax authorities are finding it challenging to tax this event, as it is difficult to establish for whom did the miner (i.e., service provider) undertake the activity of mining.

Further, in most jurisdictions, the activities by exchanges who are providing a platform to trade in VDAs are considered as taxable. However, it is challenging for the tax authorities to track all transactions, as VDAs can also be traded in a decentralized manner (i.e., the peer-to-peer). Further, there is no foreign exchange reference rate comparable to the ones published in respect of fiat currencies which help in determining the value on which tax is to be levied. Also, such exchanges do not maintain the details required by the tax authorities.

Under the Indian GST Law, there is a provision for digital services provider to undertake compliance in India in case of ‘online information database retrieval” (OIDAR) service. However, it would have to be analyzed if exchanges could be considered to be covered under the OIDAR concept or as E-commerce operator.

The increased volume of transactions enabled by VDA is also creating a complex world of barter transactions and causing entire ecosystems to come into existence without ever reverting back to fiat currency.

The settlement for a VDA transaction is often made through a ‘smart contract’. The challenge with a smart contract is that it is written in a technical code rather than a language and hence it becomes difficult to understand and comprehend. Further, other issues relating to legality, enforceability, etc still persist. The accounting for digital assets for business transactions will also play a pivotal role in bringing clarity from a tax perspective.

Policy makers need to be cognizant of the fact that all VDAs are not created equal and small distinction can make a big impact on their tax treatment. The tax treatment should be coherent with the industry needs and broader regulatory framework.

Gandhi is Partner, Chaturvedi is Director, and Gada is Manager at Deloitte Haskins & Sells LLP