Context

The Finance Ministry recently proposed instituting an 18% goods and services tax (GST) on crypto trading. Though it’s not clear whether such a proposal will become law, but the government appears serious about pushing it.

Background

• Nearly twenty-five years ago, the internet disrupted the world and started a new era of technological supremacy.
• Today, with the rise of cryptocurrencies and its underlying technology, the world stands at the helm of another such revolution.
• Cryptocurrencies like bitcoin are decentralised, digital currencies relying on a peer-to-peer network which operates without the need for a third-party intermediary like the Reserve Bank of India.
• Coupled with lack of regulatory guidance, its unique technical aspects create huge complications in its taxation.
• The Indian government has been skeptical of cryptocurrency, vacillating between wanting to regulate cryptocurrencies and banning.
• While the government wishes to actively encourage blockchain technology, it has been resisting popular usage of cryptocurrencybecause once the unit of account of one of these transactions changes from rupees to any cryptocurrencies, then the possibility of recovery of tax would become farcical.
• So, if the government wishes to reap the revenues from blockchain transactions, it will have to recognize cryptocurrency, and not just INR, as a unit of account.  

Analysis

What are Virtual Currencies and Cryptocurrencies?

• A virtual currency is a digital representation of value that can be digitally traded and functions as:
  • a medium of exchange, and/ or
  • a unit of account and/or
  • a store of value, but does not have a legal tender status
• It fulfils the above functions only by agreement within the community of users of the virtual currency.
• It is not issued nor guaranteed by any jurisdiction.
• Cryptocurrency is a type of virtual currency that uses cryptography to secure transactions that are digitally recorded on a distributed ledger, such as a blockchain. 
• A transaction involving cryptocurrency that is recorded on a distributed ledger is referred to as an “on-chain” transaction; a transaction that is not recorded on the distributed ledger is referred to as an “off-chain” transaction.

Financial Action Task Force (FATF) on Cryptocurrencies Another vital definition given legal sanction in Indian laws by virtue of this judgment is that of Cryptocurrencies as defined by the FATF. Cryptocurrency, according to FATF, is a math-based, decentralized convertible virtual currency protected by cryptography by relying on public and private keys to transfer value from one person to another and signed cryptographically each time it is transferred.

How is virtually currency regulated in India?

• Currently, the regulatory mechanisms to govern virtual currencies are almost non-existent in India.
• Although bitcoins are not legal as yet, they have not been outrightly declared illegal either.
• Being a relatively unregulated form of currency, there is not much jurisprudence available which discusses the ability of the citizens in India to transact through bitcoins.

Reserve Bank of India, Government of India & Bitcoins: the trio

• Originally, RBI had issued a Press Release in 2017 cautioning the users, holders of Virtual Currencies that they are not recognised as legal tender. The Press Release also stated that the investors should avoid participating in them.
• RBI Circular prohibited entities regulated by RBI from dealing in Virtual Currencies (VCs) or provide services for facilitating any person or entity in dealing with dealing with or settling VCs.
• The Circular also instructed the entities which already provide such services to exit the relationship within three months from the date of the Circular. 
• After a series of Writ Petitions being filed in various High Courts and the Petition finally reaching the Supreme Court through transfer petitions, the matter was kept in abeyance as an Inter-Ministerial Committee was constituted and was deliberating on the issue.
  • The Inter-Ministerial Committee, on 28.02.2019 submitted a report along with a draft bill, namely, ‘Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019’.
• The Finance Minister in his budget speech on 01.02.2018 had also stated that the Government did not consider crypto-currencies as legal tender or coin and all measures to eliminate the use of these currencies in financing illegitimate activities or as a part of payment system will be taken by the Government.
• In April 2018, the RBI issued a circular banning regulated financial institutions from providing services to businesses dealing in exchange/trading of cryptocurrencies, which put the entire Indian cryptocurrency trading industry in turmoil.

What is Supreme Court’s view on virtual currencies?

• The Supreme Court in the caseInternet and Mobile Association of India v. Reserve Bank of India, deliberated on cryptocurrency and struck down the 2018 circular.
• The Supreme Court analyzed the role of RBI in the economy as a central bank to manage currency, money supply and interest rates and recognized that the maintenance of price stability as an objective of RBI.
• The Supreme Court noted that cryptocurrency is capable of being accepted as valid payment for the purchase of goods and services, and payment systems can be regulated by the RBI.
• This verdict gave a thumbs-up to the crypto exchanges and crypto as an asset class, as indirectly they have not been found violating any other law of the land.

Taxation of cryptocurrencies

• The power to levy taxes is prescribed under Article 246 which grants power to the Parliament as well as state legislatures to impose taxes.
• Article 265 provides that no tax can be imposed or collected without the authority of law.
• By virtue of Constitution (One Hundred and First Amendment) Act, 2016, the Parliament made several amendments with respect to the imposition of Goods and Services Tax (‘GST’) including Article 246A, wherein exclusive power was given to the Parliament to make laws with regard to interstate trade and commerce.
• Furthermore, Schedule VII lists the subject matters where Parliament and state legislatures can impose taxes.
• Broadly speaking, any transaction involving virtual currency could be analysed from two viewpoints – income and expenditure.
• Depending upon the nature and parties to the transaction, it may be taxable under
  • the Income Tax Act, 1961 ('ITA') (in case of income), or
  • Central Goods and Services Tax Act, 2017 ('Act') and
  • other laws (in case of expenditure)
• Since the regulatory framework regarding cryptocurrencies is uncertain, the taxation (or non-taxation) can be analyzed by considering them as both goods and currency.
• With this, two major approaches currently prevalent across the world.

1. Treatment under Indirect Tax:
   • GST was implemented with effect from July 1, 2017, across India. GST subsumes most of the indirect taxes, barring few.
   • Treatment of cryptocurrencies as goods/property would mean that supply of bitcoins is a ‘taxable supply’ and hence subject to GST.
2. Treatment under Direct Tax:
   • The treatment of cryptocurrencies under direct tax regime is mainly governed by the ITA in India.
   • Till date, the Income Tax Department (‘ITD’) has neither issued any guidance regarding taxation of digital currencies nor do any disclosure requirements exist in relation to such income earned.
   • bitcoins are considered as ‘currency’, they would not be susceptible to tax under ITA.

The European Court of Justice ruled in 2015 that trades involving cryptoassets should be exempt from GST (also known as VAT in certain jurisdictions), while nations like Singapore have in fact reversed previous laws where exchanges involving crypto were subject to GST/VAT.

International Practices

• United States: The USA FinCEN (Financial Crimes Enforcement Network), being at the forefront of regulation of cryptocurrencies, issued a guidance on regulating decentralised virtual currencies bringing them within the ambit of the Bank Secrecy Act, 1970.
  • As per the US Internal Revenue Service (‘IRS’), cryptocurrencies are treated as property for the purpose of federal tax.
• Germany: Germany formally recognised bitcoins as units of account allowing them to be used for tax and private trading purposes throughout the country.
• United Kingdom: In the United Kingdom (UK), they are classified as an asset or private money, on which capital gains tax is applicable, but VAT is exempted.
• Australia: In Australia, digital currencies were previously considered ‘intangible property’ and were therefore subject to GST.
• China: Although no regulation governs cryptocurrency in China, the Government has taken an aggressive stance towards digital currencies. Recently, the People’s Bank of China conducted on-site inspections of bitcoin exchanges and plans to impose penalties on these exchanges for violating upgraded norms related to anti-money laundering.

Wrapping Up

Given the monumental rise in digital currency and its significant role in financial technology in the coming years, the question is not whether India should adopt a regulatory framework or not; the relevant question is which regulatory framework would be best suited to India and its underlying need for economic growth and financial inclusion. The country should regulate these transactions in a manner that permits a reasonable balance between consumer security and legitimacy. This sandbox approach will ensure financial innovation and transparency and give a boost to economic growth, all of which are primary objectives of the Government.