Virtual Digital Assets (VDAs) have grown significantly in popularity over the past few years. The allure of digital currencies, Non-Fungible Tokens (NFTs), and other virtual assets has captured the attention of investors, technologists, and governments worldwide. In India, the growth of VDAs has brought forth new regulatory challenges, primarily revolving around taxation. In this article, we explore the tax implications of VDAs in India, covering the current legal framework, recent developments, and challenges faced by individuals and businesses navigating this complex landscape.

1. Understanding Virtual Digital Assets (VDAs)

The term “Virtual Digital Asset” broadly encompasses cryptocurrencies like Bitcoin, Ethereum, and Ripple, as well as Non Fungible Tokens, tokenized assets, and other forms of digital value that utilize blockchain or distributed ledger technology. VDAs have distinct features, including their decentralized nature and use of cryptographic protocols, making them fundamentally different from traditional financial assets.

Recognizing the rising interest in VDAs, the Government of India introduced specific measures in the 2022 Budget to regulate the sector and ensure tax compliance. Since VDAs are a relatively new concept, the tax implications are evolving, with ongoing changes to both policy and compliance requirements.

2. Taxation of VDAs: An Overview

The taxation of VDAs in India was formally introduced in the Union Budget of 2022, which outlined a new regulatory framework. Under the Income Tax Act, VDAs were recognized as taxable assets, and specific guidelines were provided regarding how gains and losses from VDA transactions would be treated.

1. Income Tax on VDA Transactions

The 2022 Budget imposed a 30% tax on any income from the transfer of VDAs.. Key features of VDA taxation include:

• • Flat Rate of 30%: Regardless of the holding period, income earned from VDAs is taxed at a flat rate of 30%. This differs from the taxation of traditional capital assets, which are subject to different rates depending on the holding period (short-term or long-term). The flat rate of 30% effectively means that VDA transactions are treated as high-risk investments, subject to the highest tax rate comparable to the tax rates applicable to casual income streams such as lotteries, crossword puzzles etc..
  • No Deductions: No deductions are allowed against income from VDAs, except for the cost of acquisition. Expenses such as brokerage fees, transaction charges, or other transaction costs cannot be deducted when calculating taxable income. This rule significantly affects investors, as it increases the effective tax liability, making VDA trading less attractive compared to traditional asset classes.

  2. Tax Deducted at Source (TDS)

To increase transparency and ensure compliance, the government introduced Tax Deducted at Source (TDS) on VDA transactions. Effective from July 1, 2022, a TDS of 1% was mandated to all VDA transactions exceeding the prescribed threshold.

The TDS mechanism helps tax authorities track VDA transactions and encourages accurate reporting by individuals and businesses dealing in VDAs. Both resident and non-resident parties involved in the transaction are subject to this TDS provision. The reduction in TDS has significantly improved liquidity in the market, as the higher rate had previously led to reduced trading volumes and discouraged high-frequency trading.

 3. Gift Tax on VDAs

Gifts involving VDAs are also taxable. The scope of “property” under section 56 was enhanced by way of introduction of an explanation clarifying inclusion of VDA. If an individual receives a VDA as a gift, it will be taxable as “Income from Other Sources” at the applicable rate, unless the gift falls under exemption criteria outlined in the Income Tax Act (e.g., received from a close relative). This provision ensures that VDAs gifted as part of wealth transfer are not exempt from taxation, thereby bringing them under the tax net and ensuring compliance.

3. GST and VDAs

Apart from income tax, the Goods and Services Tax (GST) is another important area to consider. Goods under GST specifically excludes money and securities and VDA in its current form does not fall under the category of money or securities and would constitute “goods” and would be subject to GST under the miscellaneous category at the rate of 18%.

4. Challenges and Issues in VDA Taxation

1. Regulatory Uncertainty

One of the biggest challenges in VDA taxation is the ambiguity surrounding regulations. VDAs are still not recognized as legal tender in India, and the regulatory framework is evolving. This lack of formal recognition creates uncertainty about the legal and tax treatment of VDAs.

The Reserve Bank of India (RBI) has maintained a cautious stance toward cryptocurrencies, previously banning them in 2018 before the Supreme Court lifted the ban in 2020. Although the government has moved forward with taxation measures, there is still no overarching regulatory framework governing the use, transfer, or ownership of VDAs. This regulatory uncertainty makes it difficult for investors and businesses to make long-term decisions regarding their involvement in the VDA space.

2. Complexity in Compliance

The taxation of VDAs introduces significant compliance challenges. The flat 30% tax rate, combined with compliance requirements for TDS, adds complexity to the compliance process. Individuals who trade in VDAs need to maintain meticulous records of all transactions to determine their tax liability accurately. This can be particularly cumbersome for investors engaged in frequent trading, as they must account for each transaction’s gains or losses.

The introduction of TDS on VDA transactions adds another layer of complexity, particularly for those engaged in high-frequency trading. The responsibility for deducting and depositing TDS still lies with the buyer, which can be cumbersome. This is especially true for peer-to-peer (P2P) transactions, where individuals may not be familiar with TDS requirements, leading to unintentional non-compliance.

3. Treatment of Different Types of VDAs

Different VDAs, such as cryptocurrencies, NFTs, and other digital tokens, have varying economic characteristics, which makes their taxation challenging. NFTs, for example, may be considered digital collectibles or artistic creations, raising questions about their treatment under the income tax and GST regimes. The lack of differentiation between types of VDAs under the current tax framework leads to confusion for both taxpayers and tax authorities. For instance, should an NFT be taxed the same way as a cryptocurrency, or should it be considered a form of intellectual property? These questions remain unanswered, leading to uncertainty and potential disputes.

5. Impact on Investors and Businesses

1. Impact on Retail Investors

The current taxation regime has had a significant impact on retail investors in India. The flat tax rate of 30%, coupled with restrictions on loss set-off, made investing in VDAs a high-risk proposition.

Retail investors face challenges in navigating the complex tax landscape. The inability to deduct transaction-related expenses, combined with the need to comply with TDS provisions, increases the effective cost of trading VDAs. Many retail investors have found it difficult to keep up with the compliance requirements, particularly those who are new to the world of digital assets. Additionally, the lack of clarity around GST applicability has created further confusion, deterring some investors from participating in the VDA market altogether.

2. Impact on Cryptocurrency Exchanges

Cryptocurrency exchanges in India have faced significant challenges since the introduction of the tax regime. Exchanges face challenges in ensuring compliance with the TDS provisions, as they are responsible for deducting and remitting TDS on transactions. This increased administrative burden, coupled with reduced trading activity, has forced some exchanges to explore alternative markets or relocate their operations outside India. Moreover, exchanges have had to invest heavily in compliance infrastructure to ensure adherence to AML and KYC (Know Your Customer) regulations, which has further increased operational costs.

3. Impact on NFT Creators and Artists

For NFT creators and artists, VDA taxation presents unique challenges. The inability to deduct expenses, such as gas fees for minting NFTs, reduces the profitability of creating and selling digital art.

NFT creators often rely on blockchain platforms to mint and sell their digital art, and these platforms charge fees (often in the form of gas fees) for each transaction. Since these fees are not deductible, the effective tax liability on NFT sales becomes higher, reducing the profitability for creators. Additionally, the lack of clarity on whether NFTs should be treated as digital goods or intellectual property for tax purposes creates confusion, making it difficult for artists to plan their finances effectively.

6. Looking Ahead: Potential Reforms and Recommendations

The government has taken a proactive approach by introducing a taxation regime for VDAs, but there is room for improvement to foster the growth of the digital asset ecosystem in India. Here are some potential reforms and recommendations:

1. Differentiated Tax Treatment: The government could consider differentiated tax treatment for various types of VDAs, taking into account their unique characteristics. For instance, NFTs could be taxed differently from cryptocurrencies, given the inherent difference in their properties. This would ensure that the tax regime is more equitable and reflective of the underlying value and nature of different VDAs.
2. Further Reducing Compliance Burdens: Reducing the administrative burden for TDS compliance, particularly for smaller investors, could help create a more balanced and investor-friendly tax regime. Streamlining TDS processes and increasing automation could also enhance compliance. For example, integrating TDS calculations directly into VDA trading platforms could simplify the process for users, reducing the likelihood of non-compliance.
3. Clarification on GST: Providing additional guidelines on GST applicability to various VDA transactions would help further reduce uncertainty for businesses and investors. This includes defining whether GST should be levied on different types of VDAs and the transaction value on which such GST should be levied for varied cases of VDAs. Clear guidelines on the classification of NFTs, utility tokens, and security tokens would help address the unique nature of these assets and ensure consistent tax treatment.
4. Comprehensive Regulatory Framework: Establishing a comprehensive regulatory framework for VDAs would bring much-needed clarity and legitimacy to the industry. A well-defined regulatory environment would encourage greater participation from both institutional and retail investors, leading to increased innovation and growth. The framework could include licensing requirements for VDA service providers, clear definitions of various types of VDAs, and guidelines for AML and CFT compliance.
5. Education and Awareness: The government and industry bodies could work together to educate investors about the tax implications of VDAs and the compliance requirements. Given the complexity of the tax regime, many investors are unaware of their obligations, leading to inadvertent non-compliance. Awareness campaigns, workshops, and educational content could help bridge this knowledge gap and promote voluntary compliance.

7. Conclusion

The taxation of Virtual Digital Assets in India is a work in progress, and the current regime represents a significant first step toward bringing digital assets under the tax net.

To unlock the potential of VDAs and foster a vibrant digital economy, it is essential for the government to adopt a balanced approach that encourages innovation while ensuring tax compliance. Clearer regulations, differentiated tax treatment, reduced compliance burdens, and increased investor education could pave the way for India to become a global hub for digital assets and blockchain technology. As the world moves toward greater adoption of digital assets, India has an opportunity to be at the forefront of this revolution, provided the right regulatory and tax environment is in place.