LOOPHOLES IN THE TAXABILITY OF VIRTUAL DIGITAL ASSETS

by Aryan Patwari *

INTRODUCTION

Nowadays, the increase in the use and trade of Virtual Digital Assets (VDAs) has been a debatable issue with respect to the tax regimes. A long-awaited need for a particular legislation towards taxability of VDAs was fulfilled by the government when the Finance Minister, Nirmala Sitharaman, introduced the concept of taxability of Virtual Digital Assets in the Union Budget 2022. The government has tried to provide some clarifications on the taxability of crypto currencies and NFTs as a new class of assets to be brought under taxation regime. The government has introduced a rigid taxation regime of flat 30% tax rate. This clearly shows the government’s approach towards curbing this practice of trading in crypto currencies, as specified by RBI vide its press release dated December 24, 2013 stating the risk associated with such trading. The RBI also issued notice dated April 6, 2018 prohibiting some regulated entities from dealing with such instruments.

The new amendments brought forward by the Finance Bill 2022, gave some clarifications e regarding taxability of crypto currencies. Just to put a taxation bar on such kinds of trading (also known as mining), the government has come up with a solution for making a particular class of assets called Virtual Digital Assets, that will be taxable as per the provisions inculcated in the Income Tax Act, 1961.

However, this new tax regime has still left behind many loopholes for the taxability of such kind of assets that needs to be clarified.

WHAT ARE VIRTUAL DIGITAL ASSETS

Virtual Digital Assets, also known as virtual assets or digital tokens, are digital representations of values that exist and can be traded on blockchain networks or in virtual worlds. These assets can take various forms, including crypto currencies, non-fungible tokens (NFTs), and many more.

Crypto currencies are digital currencies that use cryptographic techniques to secure transactions and control the creation of new units. On the other hand, NFTs are unique digital assets that can represent ownership or proof of authenticity for a particular item or piece of content.

VDAs are often based on blockchain technology, which provides a decentralized and transparent infrastructure for recording ownership and facilitating secure peer-to-peer transactions. The value and demand for these assets can vary widely, driven by factors such as scarcity, utility, perceived value, and market demand.

TAXABILITY OF VIRTUAL DIGITAL ASSET

The very first step taken towards putting the taxation cap on virtual currency transactions and transfer of VDAs in India has been initiated by the Finance Bill of 2022, with the following rationale explained in its memorandum :-

"Virtual digital assets have gained tremendous popularity in recent times and the volumes of trading in such digital assets has increased substantially. Further, a market is emerging where payment for the transfer of a virtual digital asset can be made through another such asset. Accordingly, a new scheme to provide for taxation of such virtual digital assets has been proposed in the Bill."

Therefore, the Bill purports to bring VDAs especially crypto currencies, under the taxation regime of the Income Tax Act, 1961. The Bill also seeks to insert Section 115BBH to the Act in order to calculate the aggregate income earned from the transfer of any VDA and add it to income tax payable by taxing it at the flat rate of 30%.

However, no deduction for expenditures incurred or set off for losses incurred, during the transfer of such VDA, has been allowed to the assessee under these new provisions.

LOOPHOLES

· No Situs for Locating the Asset- An Issue

The taxation of any asset or event places substantial importance on the situs i.e., the location of the taxable event for determining the overall tax liability of the event. Many a times, the amount of tax for any transaction is decided after considering the location of the taxable event. This situs is usually determined using several factors, such as the location of the parties involved, the location of the assets in the transaction, etc. However, in case of VDAs, the task of locating the situs would be somewhat complex due to lack of their physical appearance as well as the anonymity of the buyer and the seller. Due to this anonymity, it would be difficult to classify these transactions as intrastate or interstate, which is a major determining factor for calculating the taxability.

· Ambiguity in Determining Cost of Acquisition

The gains on transfer of VDAs have been brought under taxation from the amendments proposed by the Finance Act 2022, which provides for taxation of capital gains based on the difference between sale consideration and cost of acquisition. However, no method for computation of cost of acquisition has been specified. If we take a brief view, VDAs are almost like dematerialized securities being fungible assets without any serial number or identity. Therefore, where partial holding of VDAs is transferred, it would be difficult to compute the cost of acquisition for calculating capital gains.

One approach could be that since these assets are similar to dematerialized securities i.e. the securities are not held by the investor in their physical form with him, for which a First-In-First-Out (FIFO) mechanism has been provided for computing the cost of acquisition in case of sale of such securities from multiple tranches. Under this mechanism, for computing capital gains chargeable to tax, the cost of acquisition and period of holding of any security shall be determined on the basis of FIFO. This means the investor does not has the discretion to select the specific lot of the scrip to be sold -- the one dematerialized first would be deemed to have been sold first. hence similar FIFO method could be used for computing cost of acquisition of such VDAs too i.e. VDAs bought first would have to be sold first. However, clarification for the same is required from the side of the government to remove the ambiguities.

· Ambiguities in Taxation of VDAs Transferred as Gifts

With the amendments brought forward by the Finance act, in order to provide for the taxability of VDAs as gifts, the explanation to Section 56(2)(x) was amended to include VDAs in the term ‘property’ for the purposes of including VDAs given as gifts under the taxation for exchanging gifts as per this section.

The taxation of such gifts is usually based on the fair market valuation of such assets. However, crypto assets being such volatile assets, have several ambiguities in their fair market valuation. They may include a variety of variables for the overall valuation which could lead to diverse opinions. Also due to the ambiguous nature of these assets, the categorization of securities, whether quoted or unquoted, as described by Rule 11A of the income tax rules, which is generally used for the fair market valuations of such type of assets, cannot be a reliable guide for these assets. Henceforth, more clarity and proper guidelines are required to reduce the ambiguities in the fair market valuation of such types of assets.

· The Unfavorable Tax Regime

As per these amendments brought forward by the Finance act 2022, everyone is required to pay a flat rate of 30% on the gains from the transfer of these VDAs, irrespective of the amount of profit that has been gained. This flat rate is somewhat discriminatory as it would not be reasonable to tax the same proportion from a person who has earned a small amount as compared to a person earning large amounts. It would put a kind of barrier on these small investors for tradingin such assets, while the large investors will still play the same role in the market. This approach will not even fulfill the government’s desire to cut down the trading in these virtual digital assts and will just impact the small investors.

· Further, there has been no deduction or set off for losses provided for the taxation of these assets, which is too unfavorable for the investors in VDAs as compared to those who invest in other physical or tangible assets. The government is following the restrictive approach for curbing the harmful effects of increasing digital economy while it should rather follow a preventive approach by banning several suspected currencies and allowing the trading of only reliable and stable currencies.

CONCLUSION

The new approach taken by the government for bringing the VDAs within the ambit of Income Tax Act, 1961 can clearly be seen as a method for increasing the revenue of the government, due to the overgrowing nature of these transactions. Moreover, the need to regulate the crypto market is also a possible cause for introducing this regime.

But while following this, the drafters have neglected some important aspects of taxation law that form the core of this tax law, such as location, avoiding double taxation, non-discrimination etc. Hence, there is a strong need to reform these laws in accordance with these principles of taxation law. Several issues such as dispute over situs, double taxation of gifts, ambiguities in determining gains, the no deduction policy etc., remain unresolved. However, the approach of the drafters must be to provide a favorable perspective to this law rather than providing an ambiguous and unfavorable legal structure. Therefore, the taxation aspect of VDAs still needs various considerations and only after that its proper implementation in the country will be possible.

*Aryan Patwari is a fourth year student at Himachal Pradesh National Law University, Shimla at the time of publication of this blog.