DeFi Tax in India: Challenges & Solutions

The recent Financial Stability Report (FSR) published by the Reserve Bank of India (RBI) identifies increasing trends towards digitization of financial systems across the world, including Decentralised Finance (DeFi). For instance, the RBI pointed towards the direction of renewed interest of quasi-judicial bodies like the Financial Action Task Force (FATF) and the International Organisation of Securities Commissions (IOSCO) on the DeFi innovations. These organizations worry that the fast expansion of DeFi may lead to unfavorable effects on the international monetary system. Acknowledging that DeFi technology is viewed as an enabler of new financial paradigms, the RBI identified several risks associated with it, particularly as regards the function of the asset market and financial systems. While regulators around the world keep an eye on DeFi, RBI’s cautious approach towards cryptocurrencies, including DeFi-related coins, demonstrates that it is always alert to innovation but also the risk that creates instability in the financial system.

Taxing Decentralized Finance (DeFi) Transactions in India: Challenges and the Need for a Tailored Regulatory Framework

Introduction

A new generation global financial system which has now empowered a peer-to-peer transaction without the intermediation of the financial industry is termed as DeFi or Decentralized Finance. The emergence of decentralized finance is now both a chance and a threat to global regulatory institutions. It on the one hand brings financial inclusion, decreases expenses, and creates new opportunities. On the other hand, decentralization and anonymity of the medium pose challenges in compliance, regulation, and levying of taxes. Since the Indian government is still grappling with the issues of regulating cryptocurrencies, it needs to confront these issues in order to develop a proper framework that promotes innovation without jeopardizing the potential revenues for the government through taxes. This article discusses the specifics of taxation in the Defi area and considers the questions that arise within this new type of economy and provides suggestions on how to solve them.

1. DeFi’s Operational Framework: Redefining Taxable Events

Decentralized Finance principal services include lending, borrowing, staking, and yield farming. Contrary to the established financial institutions that can be traced back as conventional and centralized systems that operate systematically to distribute rewards, DeFi utilizes smart contracts for providing ways on how such returns will be delivered to the participants. They explain that this fundamental change has rendered the determination of taxable events complex.

For example, staking rewards which is incentives given through freezing tokens into a protocol whether at contract creation or at every epoch, raises various concerns such as when should these rewards be taxed? Are such tokens to be treated as income when they accrue or should their taxation be deemed only when these tokens are exchanged for fiat money? Likewise, yield farming, where users obtain rewards for depositing their funds to certain protocols, generates questions about the taxation of rewards as regular income or gains.

Because cryptocurrencies are known to experience high levels of fluctuation with their values, the imposition of taxes on rewards as they accumulate may place participants in situations where they are taxed on unrealized gains that might later disappear or become actual losses. In this regard, India might follow the structure that considers taxation at the point when the DeFi rewards are transformed into fiat money to eliminate completely the valuation issue and synchronize the taxes paid with the actual gains. Clear definitions and guidelines around what constitutes a taxable event would help mitigate these uncertainties and ensure consistent treatment of DeFi transactions.

2. Active vs. Passive Engagement: Differentiating Taxation

One of the unique characteristics of DeFi is its ability to blur the lines between active and passive income. In traditional finance, business income and capital gains are clearly distinguished. However, in DeFi, activities such as yield farming, staking, or running a node may exhibit characteristics of both passive investments and active participation.

For instance, a participant who simply stakes tokens to earn rewards might view the income as a return on investment, akin to earning interest on a fixed deposit. Conversely, someone actively managing liquidity across multiple protocols or running a validator node may be engaging in what resembles a business operation. These distinctions have significant tax implications since income from business operations is typically subject to higher tax rates than capital gains.

To address this challenge, India could consider adopting thresholds or parameters to classify DeFi activities. For example, the frequency of transactions, the volume of funds involved, or the duration of activity could serve as criteria to determine whether income qualifies as business profits or capital gains. Jurisdictions like the UK have begun exploring such frameworks, and their experiences could offer valuable insights for India.

3. Cost Basis and Valuation Complexities

Frequent transactions are a hallmark of DeFi, with participants often swapping tokens or engaging in cross-chain activities. These transactions trigger capital gains tax events, but calculating the “cost basis” for each transaction can be highly complex.

For example, if a participant engages in a series of token swaps across different blockchains, the value of tokens may vary depending on the time and the platform. This creates difficulties in accurately determining the gains or losses for each transaction. Furthermore, DeFi lacks standardized reporting mechanisms, leaving participants to manually track and report their activities, which increases the risk of errors and non-compliance.

To simplify this process, Indian tax authorities could mandate the use of standardized cost basis calculation methods, such as average-cost or first-in, first-out (FIFO). These approaches are already used in traditional capital gains tax calculations and could be adapted to DeFi transactions. Additionally, requiring Indian DeFi platforms to issue periodic transaction statements to users would help streamline compliance and reduce administrative burdens.

4. Categorizing DeFi Returns: Addressing Ambiguities

DeFi activities generate diverse forms of returns, including staking rewards, yield farming profits, and interest from lending protocols. Each of these returns may fall under different tax categories depending on their nature, creating confusion for participants and tax authorities alike.

For instance, staking rewards might be considered ordinary income, while profits from liquidity provisioning could align more closely with capital gains. However, existing tax laws in India do not account for the unique characteristics of DeFi returns, leading to inconsistent treatment.

To address these ambiguities, India could establish specific tax categories tailored to DeFi. For example:

• Staking rewards could be taxed as income at the time of accrual.
• Yield farming profits could be classified as capital gains if they result from the appreciation of assets.
• Lending interest could follow traditional interest income tax rules.

By introducing clear guidelines, tax authorities can ensure consistent treatment across DeFi activities, reducing uncertainty and fostering compliance.

5. Expense Deductions in DeFi Operations

DeFi participants incur significant expenses, such as gas fees for executing transactions on the blockchain or impermanent losses incurred while providing liquidity to pools. However, Indian tax laws currently lack provisions that explicitly address whether these expenses are deductible.

Gas fees, for instance, could be categorized as transaction costs and deducted from taxable income. Similarly, impermanent losses—a common phenomenon in liquidity pools where token prices fluctuate—should be recognized as legitimate costs that can offset taxable gains. Without these deductions, participants could face unfair tax burdens, paying taxes on gross income rather than net earnings.

Introducing clear rules for deducting legitimate expenses would not only promote fairness but also encourage broader participation in the DeFi ecosystem.

6. Addressing Administrative Challenges

One of the most significant challenges in DeFi taxation is enforcement. DeFi operates on public blockchains where participants are identified only by wallet addresses, making it difficult for tax authorities to track transactions or identify taxpayers.

To overcome this, India could leverage blockchain analytics tools to monitor activity on public ledgers. Companies like Chainalysis and Elliptic specialize in analyzing blockchain data and could assist tax authorities in tracing transactions and ensuring compliance.

Additionally, international cooperation is critical, as DeFi transactions often cross borders. Double taxation risks arise when multiple jurisdictions attempt to tax the same income. India could adopt global frameworks like the OECD’s Crypto-Asset Reporting Framework (CARF) to ensure standardized reporting and minimize jurisdictional conflicts.

7. Lessons from Global Practices

Countries like the United States, the United Kingdom, and Australia have made strides in addressing DeFi taxation, offering valuable lessons for India. The United States’ IRS has issued guidance treating most DeFi returns as taxable income but continues to face ambiguities regarding specific activities like staking. Similarly, the UK’s HMRC distinguishes between income and capital gains for DeFi returns, providing clarity for participants. Australia’s ATO emphasizes detailed transaction reporting, setting a benchmark for transparency and compliance.

India could study these international models to craft a taxation framework that aligns with global best practices while addressing the unique challenges posed by its regulatory environment and economy.

8. Recommendations for a DeFi-Specific Framework

To address the complexities of DeFi taxation, India needs a comprehensive framework. This framework should include:

i. Clear Definitions: Establish clear guidelines for taxable events, income categorization, and valuation methods.

ii. Reporting Infrastructure: Mandate Indian platforms to issue transaction reports and leverage blockchain analytics for compliance.

iii. Expense Deductions: Allow deductions for legitimate DeFi expenses, such as gas fees and impermanent losses.

iv. International Collaboration: Participate in global initiatives like CARF to harmonize tax practices and address cross-border issues.

v. Innovation-Friendly Policies: Strike a balance between regulation and innovation to ensure the DeFi ecosystem thrives without undue burdens.

Conclusion

Taxing DeFi in India is a complex but necessary endeavor. By adopting a tailored approach that addresses ambiguities, simplifies compliance, and fosters innovation, India can position itself as a global leader in DeFi regulation. A progressive taxation framework will not only ensure fair revenue generation but also encourage growth in this transformative sector, paving the way for a decentralized and inclusive financial future.