With a global market capitalization of around $2 trillion, cryptocurrencies (or virtual currencies—the expression in use recently for such assets) can no longer be ignored. The hunger for alternative investment opportunities fueled by pandemic-hit business sentiment has been a prominent reason for the astounding jump in crypto valuations in the past 12 months.
From a global tax perspective, this provides a massive tax opportunity for countries, and governments as well as international economic bodies have become more active and pragmatic in their approach towards cryptocurrencies. Though there are several macro-level policy issues and aspects—legal, regulatory, and taxation—that require clarity in this area, the underlying technology (i.e. the blockchain technology) needs to be leveraged and explored proactively to usher in the transition towards a digital economy.
India’s approach towards cryptocurrencies has been cautious and conservative, but it has certainly evolved over time. From a tax perspective, there is no official guidance from the Indian government yet on how crypto-related gains should be taxed and what should be the most appropriate characterization for cryptocurrencies. The taxation of crypto-related gains will therefore need to be examined in light of the existing taxation principles.
In this article we discuss some of the key technological concepts that surround cryptocurrencies and the evolving legal landscape as well as the income tax related implications related to cryptocurrencies in India.
Technological Aspects of Cryptocurrencies
Cryptocurrencies are usually defined as a digital representation of value which is secured using cryptographic methods and is recorded, transferred, or stored electronically using distributed ledger technology. Simply put, these are electronic peer-to-peer currencies.
This concept gained traction after the 2007–08 global financial crisis, with the introduction of a cryptocurrency named Bitcoin.
The core ideology behind cryptocurrencies was to create and move money without a central authority (i.e. a central bank of a country). Hence it was necessary to ensure that the underlying technology and infrastructure on which a cryptocurrency is based has an in-built trust mechanism and that the data/information entered on such networks remains immutable and tamper-proof.
In this regard, we outline below some of the key technological aspects:
- Distributed Ledger Technology (DLT): a distributed network of participants, using independent computers (also called nodes) which record, share, and synchronize information (essentially transactions or data) independently in their respective electronic ledgers. For ease of understanding, as an analogy, DLT can be understood as a WhatsApp group chat where the chat history (which contains the information) is the ledger which is distributed on every member’s phone (node/participant).
- Cryptography: the method of sending secured information between two or more participants. It essentially involves converting information that is available in plain ordinary text into unintelligible text (encryption) and vice versa (decryption). Cryptography in the realm of cryptocurrencies is used to secure and authenticate the information being recorded on a DLT. As the idea behind cryptocurrencies is to eliminate the need for a central authority, cryptographic methods are used to secure and authenticate the information relating to such cryptocurrency, to instil trust between the participants transacting in a cryptocurrency.
- Blockchain: A blockchain is a subset of DLT and one of the most commonly used forms of DLT. As the name suggests, it is essentially a chain of blocks with each block linked to the previous one. Each block consists of information on the transactions (timestamp, value, etc.) that have taken place on the blockchain DLT and which has been cryptographically authenticated by the participants on the DLT. According to the World Economic Forum, blockchain technology is being hailed as one of the seven revolutionary technologies that will revolutionize various aspects of human lives.
- Mining: As explained above, information related to transactions in a cryptocurrency is required to be authenticated using cryptographic methods before it is stored on a DLT. Thus, mining is deploying computers to cryptographically authenticate such information being recorded on a DLT. However, not every participant on the DLT may be interested in authenticating information and may merely be interested in transacting with the cryptocurrency. Therefore, to incentivize participants to authenticate such information, a reward in the form of the cryptocurrency itself is given to such participants. Participants who successfully authenticate such information using cryptographic methods are called “miners.”
Evolving Legal Landscape in India
Since Bitcoin and the concept of cryptocurrencies started gaining traction, the Indian government has consistently taken a cautionary approach, with the Reserve Bank of India (RBI) warning the Indian public about the uncertainties surrounding cryptocurrencies. In 2018, the RBI issued a prohibition on Indian banks facilitating any transactions in cryptocurrencies. Further, in 2019 an Inter-Ministerial Committee set up by the Indian government also recommended that all private cryptocurrencies, except any official digital currency issued by the state, be banned in India.
However, the legal landscape and the perception in India of cryptocurrencies has evolved, and the RBI prohibition described above was set aside by the Supreme Court of India in 2020. Arguably, this was a watershed moment in India’s cryptocurrency ecosystem. However, the statements made by the government and regulators from time to time still indicate that the future of cryptocurrencies from an Indian regulatory perspective may be uncertain.
Key Taxable Events
The foundational step for imposing any tax on cryptocurrencies is their characterization. It remains open whether cryptocurrency should fall under the definition of a “currency” or whether it should simply be classified as an “intangible asset.” This question has become even more interesting recently as El Salvador has recognized Bitcoin as its legal tender and therefore it may be argued that Bitcoin falls under the definition of a “foreign currency.”
The taxable events in relation to cryptocurrencies can be broadly divided into two categories—events which lead to the creation or generation of a cryptocurrency, and events which relate to the secondary disposal of a cryptocurrency. The possible Indian income tax implications of such events are discussed below.
Creation of Cryptocurrencies
- Mining: If the activity of mining is carried out with the intention of earning profits (i.e. as a business), then the rewarded cryptocurrency should be taxable as business income. However, if mining is carried out as a casual activity or a hobby, it needs to be evaluated whether the rewarded cryptocurrency will be characterized as ordinary income or as a non-taxable capital receipt. For it to be characterized as ordinary income, the relevant test will be whether cryptocurrency falls within the ambit of a “security.” This is because under Indian income tax law, receipt of a “security” for nil or inadequate consideration triggers a taxable event for the recipient.
- Initial Coin Offering (ICO): Similar to an initial public offering by a company, an ICO refers to an event where a new cryptocurrency is issued in exchange for one of the existing major cryptocurrencies (for example, Bitcoin, Ether) or in some cases even in exchange for fiat currencies. An ICO is a commonly used method for raising funds for a new project in the cryptocurrency space. In the absence of any specific taxing provision for such events in relation to cryptocurrencies, it seems that the existing provisions of Indian income tax law relating to primary issuance of shares will not be attracted in the case of an ICO.
- Airdrop: This refers to an event where cryptocurrency is given or distributed, without any consideration, to a select few people (such as influencers, celebrities, or other public figures) to increase awareness of the cryptocurrency. This method is generally adopted by new cryptocurrencies upon their launch in the market. A recent example of airdropping occurred when more than 50% of the Shiba Inu (a relatively new cryptocurrency launched in 2020) in circulation was donated to Vitalik Buterin, the co-founder of Ethereum. In the case of influencers and celebrities, the receipt of cryptocurrencies via an airdrop is likely to be taxable in the same manner as fees received for promoting brand awareness, i.e. as business income. However, in the case of public figures (such as Buterin), who are not in the business of carrying out brand awareness or marketing activities, and to whom cryptocurrencies are airdropped without any expectation of service in return, the receipt may be taxable as an ordinary income, provided that the cryptocurrency falls within the ambit of a “security.”
Secondary Disposal of Cryptocurrencies
- Mined coins: Where the secondary sale relates to mined cryptocurrencies, the gains arising upon disposal of such mined coins should be taxable as business income, if mining activities were carried out with the intention of earning profits. In any other case of a mined coin, the gains arising upon disposal of mined coins should be taxable as capital gains. However, it may be argued that no capital gains tax should be levied in the case of mined coins, as the cost of acquisition of such assets is not determinable, thereby resulting in failure of the machinery provisions for computing capital gains. However, the tax authorities may want to argue that the computing costs, electricity costs, etc., incurred in relation to cryptocurrency mining should form the cost base for computing such capital gains.
- Other than mined coins: In other cases, it needs to be evaluated whether the gains arising from such secondary disposal would be taxable as business income or capital gains, as may be applicable according to the facts of the case.
- Exchange for goods/services: Where cryptocurrency was held for a period of time, during which its value increased/decreased, and thereafter it was exchanged in return for any goods or services, the gains earned or the losses incurred during the holding period (i.e. the increase or decrease in the value of the cryptocurrency since its acquisition) before the cryptocurrency was exchanged for goods or service will result in a taxable event. The tax implications in relation to such gains should be the same as in case of a secondary disposal, as discussed above.
Other Tax Considerations
The Indian income tax law imposes an additional tax of 2%, the equalization levy (EL), on the consideration received by an offshore entity which manages, operates, or owns an electronic facility or platform, for online sale of goods or online provision of services or both.
Thus, for offshore cryptocurrency exchanges providing cryptocurrency-related services to Indian residents or to any person using services from an Indian IP address, the possible application of the EL should be evaluated.
Similarly, the application of the EL in the case of an offshore entity providing online wallet services for cryptocurrencies should also be evaluated.
Tax Deducted at Source (TDS)
Under the Indian income tax law, if sale of goods by an Indian resident is facilitated through an electronic facility or a platform owned, operated, or managed by an entity (whether offshore or onshore), TDS at the rate of 1% needs to be deducted by such entity. Thus, cryptocurrency exchanges will need to evaluate the applicability of this provision to their business models for facilitating the sale of cryptocurrencies held by an Indian resident.
However, as the term “goods” is not defined under Indian income tax law, it is necessary to evaluate on a case-by-case basis (depending upon the sale of cryptocurrency being facilitated by the exchange) whether cryptocurrencies will fall under the definition of “goods.”
It is relevant to note that the definition of “goods” under the Indian Sale of Goods Act has wide import and includes movable property of every kind which is sold for monetary consideration.
Global Tax Considerations and Implications
The Organization for Economic Cooperation and Development (OECD) in its report titled “Taxing Virtual Currencies: An Overview of Tax Treatments And Emerging Tax Policy Issues” has noted that countries have different approaches in their characterization of cryptocurrencies for tax purposes.
While many countries have characterized cryptocurrencies as merely an intangible asset, some have gone further and classified them as a financial instrument or a virtual commodity. Certain countries such as Italy, Belgium, and Poland have also classified them as “currency.”
While a majority of countries is yet to formulate specific laws and regulations to govern the cryptocurrency space, some, like the U.S., U.K., and Singapore, have released detailed guidance in relation to the income tax treatment of cryptocurrencies. The approach taken by the U.S. and the U.K. is to treat mining as the first event of taxation; whereas in Singapore, mere mining of cryptocurrencies will not lead to any tax implications, and it is only upon secondary disposal that tax implications arise.
Another notable difference is that while Singapore has provided clear implications in the case of different types of ICOs, the U.S. and the U.K. have not provided any guidance in relation to the tax implications in case of an ICO. The U.K. has provided further guidance with respect to determination of the situs of the cryptocurrencies as well for tax purposes.
The Indian government has on various occasions clarified that cryptocurrency-related gains will be taxable depending upon the nature of the holding of such cryptocurrency. A clear road map and official guidance are keenly awaited on critical aspects such as what should be the first taxable event and the valuation mechanism, and who should have the obligation to report cryptocurrency trades.
In recent years, the Indian income tax authorities have also issued notices to cryptocurrency holders and exchanges seeking details about their cryptocurrency dealings.
It thus remains to be seen how the Indian government develops regulations in the crypto space. If regulated properly, this asset class could reap huge tax revenues for the government which could be used to meet its planned objectives in relation to the development of the country.
Further, with talk gaining momentum that the Indian government is considering a phased introduction of a Central Bank Digital Currency, it will be imperative to embrace the underlying blockchain technology.
The environmental impact of cryptocurrency mining will also need to be weighed by governments when deciding their next course of action in this field—for instance, it has been reported that the electricity consumed in mining Bitcoins represented about 0.59% of global electricity consumption, and in May 2021, the Iranian government imposed a four-month long ban on cryptocurrency mining operations amid major power blackouts in many cities.
The views of the author(s) in this article are personal and do not constitute legal/professional advice of Khaitan & Co. For any further queries, please contact us at firstname.lastname@example.org.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Bijal Ajinkya is a Partner, Raghav Kumar Bajaj is a Principal Associate and Milind Hasrajani is an Associate at Khaitan & Co.