“You can’t stop things like Bitcoin, it’s like trying to stop gunpowder. It will be everywhere, and the world will have to readjust. World governments will have to readjust.”
John McAfee, founder of McAfee Inc.
The recent bull run in world-wide crypto market made a big news all around. Those who were not even aware of ‘c’ of crypto currencies also in the hope to become off-shoot millionaire invested into crypto market. Doge, Ethereum, Litecoin, Cosmos, Ripple, Cardano, etc. are some of the coins which had their all-time highs. The market capitalization of crypto currencies at the time of writing this article is $1.70 Trillion. There are roughly 9900 plus crypto currencies in the world. Reserve Bank of India, though has imposed ban on banks dealing with crypto exchanges in 2018, Hon’ble Supreme Court in 2020 has overruled said decision and reinstated crypto trading in India. Presently, crypto currencies are not illegal but unregulated in India. As per latest data, India has 10 million plus crypto investors investing in Rs 15,000 crore plus into crypto assets.
The very avatar of crypto currencies to many is fanciful and imaginary and is beyond reality. That’s the reason it remains unregulated despite such huge market cap. Nonetheless, no one can overlook the fact that many investors are earning money from crypto assets. This leads to us to think whether it is taxable or not?
In this background, it is interesting to delve into what crypto currencies are, how they function, different purposes they serve and lastly, how they will be taxed from the Income Tax perspective.
2. WHAT IS CRYPTO CURRENCY?
The larger question is what is ‘cryptocurrency’?
As per Investopedia, a cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. A defining feature of cryptocurrencies is that they are generally not issued by any central governmental authority and thus immune to government interference or manipulation.
Granularly speaking, cryptocurrency is made up of two words ‘crypto + currency’. ‘Crypto’ denotes applying process of cryptography i.e. converting readable text into non-readable text by applying algorithms on the blockchain technology. Simply put, blockchain is a type of decentralised distributed ledger system having many blocks storing information which are chained to other blocks through hash functions. The information recorded on the blockchain is immutable i.e. it cannot be deleted at any one’s sweet will which gives security to the information stored. ‘Currency’ in cryptocurrency denotes the functions performed by these digital coins similar to fiat currency like dollar, rupee notes etc. such as store of value, medium of exchange and settling debts etc. However, the word ‘cryptocurrency’ is misnomer in as much as many cryptocurrencies are actually crypto-assets deriving their value from projects undertaken by issuer platforms.
3. TYPES OF CRYPTO CURRENCIES
There are mainly 4 types of crypto currencies based on the technology they adopt or purpose they serve.
A. Based on technology
3.1 Proof of work (PoW)
Bitcoin and Ethereum are two major cryptocurrencies based on PoW. This type of currencies relies on blockchain technology using proof of work to process transactions. Simply put, it means system of adding information/transaction unless the same is verified by others in the network. On a blockchain network, every participating computer (called ‘nodes’) maintains a complete copy of the system’s ledger. It is like sharing a copy of a check register with multiple people so that no individual node can add something to that register alone.
To add a transaction, nodes compete to solve a complex cryptographic problem that represents the data to be added. The one who solves the problem firs broadcasts answer to the rest of the network for verification. This process is commonly known as ‘mining’ because the node that gets the right answer first gets a reward from the network. It’s a secure and self-policing way of keeping airtight records.
Walmart is using it to manage its produce supply chain, Maersk is using it to track shipping containers as they travel the globe, and even the diamond industry has adapted it to track precious stones as they move through the value chain.
3.2 Proof of Stake (PoS)
Since PoW system requires large computing data thereby slowing down speed of system, PoS adopts different consensus model that allow smaller group of nodes to verify transaction. In a PoS system, not every node must validate every transaction. Instead, participating nodes have to use their own cryptocurrency holdings as a deposit to join a transaction validation group. Any node that tries to cheat or pass bad data into the ledger automatically forfeits their stake as a penalty. Those that play by the rules receive interest on their deposits as a reward for their work.
EOS, Tron etc. are some of currencies which operates on PoS system.
B. Based on purpose
Tokens are not general-purpose currency.
Shermin Voshmgir in is 2019 book ‘Token economy’ has categorized tokens into two types based on its purposes viz. token (a) representing underlying asset like fiat currency, commodities etc or (b) granting access rights like token of ownership, licence to software, streaming of songs etc.
While tokens represent cash or other assets of value, they may only be used only in the specific platform who has issued them unlike other currencies which can be accepted by most of the users.
Example is Musicoin which facilitates direct payment to musicians from users through Musicoin tokens. Similarly Basic Attention Token (BAT) used as a payment system within the recently-released Brave web browser.
As the name suggests, these crypto currencies are created for the main purpose of providing reliable value of storage. They emerged because of huge fluctuations in popular coins like bitcoin or Ethereum in shot span. Stablecoins achieve their purpose by pegging their value to one or more fiat currencies, and keeping reserves of those currencies as a guarantee of the token’s value.
For example, Tether is a token whose sole purpose is to remain at a value that’s on par with the US dollar at all times.
4. WHY CLASSIFICATION OF CRYPTOCURRENCY IS NECESSARY
At its birth in 2008, cryptocurrency was conceived of only as an alternative to money, however cryptocurrencies assumed different shapes, different shades and different utility over the past decade.
Often times the cryptocurrencies crosses thin line of classification may classify themselves in all or more than one category. This is because this technology is at nascent stage and is far away from achieving maturity in near future. Thus, the underlying principle is to find out what purpose a cryptocurrency serves and based on that the cryptocurrency may be classified instead of going by the nomenclature of currency.
It is however important from income tax point of view that we classify these cryptos appropriately otherwise taxation may affect severely which we will see in forgoing discussion.
5. NATURE & IDENTITY OF CRYPTOCURRENCY
5.1. Economic Theory
Meaning of Money
Traditionally, ‘money’ has always been defined in terms of following functions or services that it provides namely –
(1) a medium of exchange
(2) a unit of account and
(3) a store of value.
(4) a final discharge of debt or standard of deferred payment.
Cryptocurrencies based on their use can sometimes act as medium of exchange (for eg. When say goods are purchased in exchange of bitcoin) or store of value (for eg. When 1 Bitcoin bought in 2008 for say Rs 100 becomes of Rs 10 lakhs in 2020) or unit of account (for eg. When price of product/service is denominated as say 5 Bitcoin) or as standard of deferred payment (for eg. Decentralised Finance ‘Defi’ whereby one can loan bitcoins or other virtual currencies).
Thus, going by the traditional meaning of money, cryptocurrencies fulfils one or more of the functions performed by the money.
5.2. Indian Statutes
Let us find in various statues in India what cryptocurrencies would be considered.
“Section 2(7) “goods” means every kind of moveable property other than actionable claims and money; and includes stock and shares, growing crops, grass, and things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale”[emphasis supplied]
It does not define ‘money’ or ‘currency’ but excludes money from the definition of the word ‘goods’.
“Section 2(75) defines ‘money’ to mean “the Indian legal tender or any foreign currency, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, traveler cheque, money order, postal or electronic remittance or any other instrument recognised by RBI, when used as a consideration to settle an obligation or exchange with Indian legal tender of another denomination but shall not include any currency that is held for its numismatic value.”
Since cryptocurrencies are not legal tender in India, they does not fall within the above definition of money as CGST Act.
“Section 2 (h) “securities” include—
(i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;
(iii) rights or interest in securities;”
Since, cryptocurrencies are not shares or any other marketable securities of like nature of shares and more so when coins like Bitcoin are not issued by any incorporated company or body corporate, prima facie, it cannot be termed as ‘securities’ under the Indian law.
Section 2(14) defines “capital asset” to mean property of any kind held by an assessee, whether or not connected with his business or profession, but does not include Stock in trade , personal effects, agricultural lands and certain specified bonds.
Hon’ble Supreme Court in the case of J.K Trust vs. CIT – 32 ITR 535 had held that “’property’ is a term of the widest import, and subject to any limitation or qualification which the context might require, it signifies every possible interest which a person can acquire, hold and enjoy.”
As regards meaning of word ‘held by an assessee’ Hon’ble Calcutta High Court in the case of CIT vs. All India Tea & Trading Co. Ltd – 117 ITR 525 observed that ‘The words “held by an assessee” in section 2(4A) of 1922 Act include physical, actual, constructive and also symbolic possession of a property of any kind.’
Now, coming to cryptocurrencies, they are held either in personal hard wallet or on an wallet provided by an exchange (which may be akin to symbolic or constructive possession of property).
Further, from the Income Tax perspective, it is irrelevant that cryptocurrency is not a security under present Securities Contract Act, 1956, it is not money under IGST Act, 2017 and goods under present Sale of Goods Act, 1930.
Thus, prima facie, based on definition of capital asset and its interpretation by the judiciary in wide manner, the cryptocurrency may be classified as capital asset u/s 2(14) and may attract capital gains tax. However, there is counter view which believes that cryptocurrency is neither capital asset nor goods nor service nor property nor money and hence is out of present income tax net. This seems to be super aggressive approach.
5.3. Supreme Court decision in Internet & Mobile Association
RBI, in 2018 has directed all banks under its control to stop providing banking services to crypto exchanges in India. Against this, association and some of the crypto exchanges approached Supreme Court challenging the constitutionality of the direction of RBI. The central plank of argument of challenge was RBI has no power to issue direction as cryptocurrencies are not money/currency but it is goods. The larger bench of Hon’ble Supreme Court in the case of Internet and Mobile Association of India vs. RBI – in Writ Petition (Civil) No. 528 of 2018 order dated 04-03-2020, before deciding constitutionality, has posed unto themselves a discission ‘Fixing the Identity of Victual Currencies’. In para 6.52 to para 6.91, Hon’ble Apex Court studied the positions taken by regulatory authorities all over the world, discussed about meaning of currency, its functions etc.
The important observations of Hon’ble Supreme Court are as under –
“6.62. It is clear from the above that the governments and money market regulators throughout the world have come to terms with the reality that virtual currencies are capable of being used as real money, but all of them have gone into the denial mode ….. But what an article of merchandise is capable of functioning as, is different from how it is recognized in law to be. It is as much true that VCs are not recognized as legal tender, as it is true that they are capable of performing some or most of the functions of real currency.”
6.85. Thus (i) depending upon the text of the statute involved in the case and (ii) depending upon the context, various courts in different jurisdictions have identified virtual currencies to belong to different categories ranging from property to commodity to non-traditional currency to payment instrument to money to funds……
6.87.….. If an intangible property can act under certain circumstances as money (even without faking a currency) then RBI can definitely take note of it and deal with it.”
Thus, Supreme Court has held that the some of the attributes of virtual currencies are amenable to the jurisdiction of RBI by treating it as intangible money.
5.4. International jurisprudence –European Court of Justice in Skatteverket v. David Hedqvist
The ruling of the European Court of Justice in Skatteverket v. David Hedqvist – Case C-264/14 dated 22-10-2015 was with direct reference to the identity of virtual currencies. ECJ was in this case asked to decide a reference from Supreme Administrative Court, Sweden on whether transactions to exchange a traditional currency for the ‘Bitcoin’ virtual currency or vice versa were subject to value added tax. The opinion of the court was to the effect that:
(i) Bitcoin with bidirectional flow which will be exchanged for traditional currencies in the context of exchange transactions cannot be categorized as tangible property since virtual currency has no purpose other than to be a means of payment.
(ii) Virtual Currency transactions do not fall within the concept of the supply of goods as they consist of exchange of different means of payment and hence, they constitute supply of services.
(iii) Bitcoin virtual currency being a contractual means of payment could not be regarded as a current account or a deposit account, a payment or a transfer, and unlike debt, cheques and other negotiable instruments (referred to in Article 135(1)(d) of the EU VAT Directive), Bitcoin is a direct means of payment between the operators that accept.
(iv) Bitcoin virtual currency is neither a security conferring a property right nor a security of a comparable nature.
(v) The transactions in issue were entitled to exemption from payment of VAT as they fell under the category of transactions involving ‘currency [and] bank notes and coins used as legal tender’.
(vi) Article 135(1)(e) EU Council VAT Directive 2006/112/EC is applicable to non-traditional currencies i.e., to currencies other than those that are legal tender in one or more countries in so far as those currencies have been accepted by the parties to a transaction as an alternative to legal tender and have no purpose other than to be a means of payment.
The court accordingly concluded that virtual currencies would fall under this definition of non-traditional currencies.
5.5. Key principles regarding identity of Crypto Asset
From the above discussion, following key principles emerges –
6. TAXATION OF VARIOUS TRANSACTIONS OF CRYPTOCURRENCY
6.1. Medium of exchange
It may be noted that if cryptocurrency is used as medium of exchange i.e. to buy or sell goods/services etc., then it may be treated like foreign currency/money and only resultant gain or loss on account of fluctuation in the market rates should be added to the cost of goods/services. The FMV can be gathered from the crypto exchanges and accordingly, cost of goods or service may be computed.
6.2. Unit of value
If cryptocurrency is used as a unit of value (i.e. to represent value of goods/service), it should be treated like money and treatment in para 6.1 should follow.
6.3. Store of value
If cryptocurrency is used as a store of value i.e. as an investment, then the resultant gain may be taxed under the head ‘capital gains’. It may be a long term if said cryptocurrency is held for more than 24 months, otherwise it will be considered as a short-term capital gain. In case of a long term, benefit of indexation would be available.
However, there is an alternate view which suggest that cryptocurrency is not a capital asset within the meaning of section 2(14) of the Income Tax Act, 1961 and hence, any gain arising on dealing with cryptocurrency should be taxed under the head ‘income from other sources’ under section 56. In such case, deduction u/s 57 of the Act will be restricted to only such expenses which are incurred to earn such income.
6.4. Personal Use Assets
As per Australian Tax Office (ATO), Cryptocurrency is a personal use asset if it is kept or used mainly to purchase items for personal use or consumption. Section 2(14) of the Indian Income Tax Act, 1961 also excludes personal effect from the definition of a capital asset and hence, if one can establish that cryptocurrencies are held for personal effects, the gain arsing thereon should be non-taxable. Whether the cryptocurrencies are held for personal use or investment purpose, the relevant time for working out that is at the time of its disposal.
6.5. Yield farming
Cryptocurrency can also be used for yield farming i.e. in lending cryptocurrencies to crypto exchanges and in turn, recipient receives interest from those exchanges. In such case, such interest may be treated like interest earned on FD and will be taxed as income from other sources. The guidance may be found from cases dealing with stock lending which are decided under the Income Tax Act like Phulchand Sons – Mumbai ITAT – ITA 293/Mum/2009 or Mukesh Ambani – Mumbai ITAT – 7604/Mum/2007.
6.6. Initial Coin Offerings
Cryptocurrencies can also be used for fundraising through Initial Coin Offering(‘ICO’). Like there is an IPO for shares, start-ups can raise funds by issuing their tokens in exchange of fiat currency. In this case, if investors are investing in start-ups as an investment with an intention to have appreciation in the token value in future, it can be treated as a capital asset and resultant gain should be treated as capital gain. ICOs are also subscribed with a view to avail services or products of the start-up company. In such case, it should be treated as a medium of exchange and only resultant gain be taxed like exchange gain as mentioned in para 6.1. As regards receipts of ICO in the hands of start-ups, its treatment would depend whether the purpose is to raise fund which is akin to share capital and hence capital receipt. However, if it is like an advance towards future services/products to be offered to subscribers, then its proceeds may be treated as revenue receipt similar to business income.
When participants solve the complex problem and mint a coin which is of high value, a question arises is it taxable? The miners need to have computer set-up with high computational powers so that probability of solving complex problem increases. When find solution and others approve it, miners are awarded with coin as a reward. Question arises is it a capital receipt or a revenue receipt? If the infrastructure is set-up with the purpose of mining thereby making it regular activity, the resultant value of coins awarded may be taxed as a business income. However, in case of a person casually uses his personal computer for mining which is also possible in some cases, it can be contended that the cost of earning coin is not determinable and hence applying ratio of BC Shrinivasa Shetty -Supreme Court, no capital gains would get attracted. However, there is an alternate view under which such receipt can be taxed as income from other source. However, in the absence of any clear guidance, it would be highly debatable.
6.8. Air drops, Hard and soft Forks
An airdrop is a distribution of a cryptocurrency token or coin, usually for free, to numerous existing cryptocurrency holder’s wallet addresses. Airdrops are primarily implemented as a way of gaining attention, spreading awareness about new token and new followers, resulting in a larger user-base and a wider disbursement of coins. In some cases, a recipient may be required to hold particular tokens or maintain a minimum balance in order to be eligible for an airdrop. For instance, TRX holders will continue to receive BTT airdrops consistently until February 2025. The air-drops are considered as pre-Initial Coin Offering strategy to gain attention.
Tokens can be distributed through hard forks or soft forks. In blockchain technology, ‘fork’ means change in set of governing protocol rules. A fork/chain split can also be referred as a situation where there are two or more competing versions of a blockchain. These competing versions share the same history up to the point where their core rules diverged.
Hard fork is a material change in blockchain system protocol that creates new blockchain protocol. Usually, at the point of the hard-fork a second branch (and therefore a new crypto token or coin) is created. After hard-fork there are two blockchains: pre-split blockchains using old rules and post-split blockchains using updated protocol rules. A holder of pre-split currency receives additional cryptocurrency that is generated by the newly created blockchain. Recent hard-fork example is of Bitcoin in 2017, which resulted in a split creating Bitcoin Cash. The network split was mainly due a disagreement in how to increase the transactions per second to accommodate for demand. All pre-split bitcoin holders received bitcoin cash.
A soft fork updates the protocol and is intended to be adopted by all nodes. No new tokens, or coins, are expected to be created.
Soft forks don’t need all miners on the network to agree to run the new code, it can be implemented with the majority of the miners agreeing on it. A soft fork refers to the changes applied to a blockchain for modifying or adding any functionality without causing any fundamental structural change. It vanishes ability of post-split blockchain nodes following new rules to validate of older transactions or blocks. However, it still allows the nodes following the old protocol rules to consider newer transactions or blocks as valid.
Thus, arises a question what will be its taxation in case of receipt of airdrops, hard-forks or soft-forks? There will be issues such as whether hard or soft forks is taxable event, timing of taxation, whether FMV is the value of sale consideration, what is the cost of acquisition of new coins, characterization of income etc. It is worthwhile to review comparatively the positions taken by Australian Taxation Office (ATO), Her Majesty Revenue & Customs, UK (HMRC) and Internal Revenue Service, USA (IRS) as under-
|Whether air-drops, hard/soft forks considered as taxable event ?||No||No||No
Yes – for airdrop
|Computation of cost of new currencies||Original blockchain will be assigned all cost. New currency’s cost will be treated as zero||Costs must be split on a just and reasonable basis||No specific guidance|
|Value||Traded value as on the date of sale/exchange etc.||No specific guidance||FMV as on the date on which dominion of investors is established.|
|Characterization of Income||If received by investor and held as investment – capital gain
If received in business – stock in trade and hence business income
|Mostly Capital gains||Ordinary income akin to income from other sources|
From the above, it is seen that every country has its own set of rules while taxing these transactions. As regards Indian scenario, one needs to tread with caution as government will surely try to tax at the earliest point of time.
6.9. Trading in cryptocurrency
If one holds cryptocurrency for sale or exchange in the ordinary course of his/her business, then provisions dealing with stock-in-trade may apply. It may be akin to shares trading. As regards its valuation, in all probabilities, provision of ICDS-2 may also be applicable but its application is highly complicated.
6.10. Exchange of one crypto with another
Exchanging one crypto currency for another for eg. Bitcoin for say Litecoin is common. Question arises whether such exchange gives rise to taxable event and thus income? As we have seen, the definition of a capital asset under section 2(14) is of vide amplitude and may include cryptocurrencies which are held for investment. Further, as per section 2(47) exchange is a transfer. Thus, on the date of exchange, taxable event gets triggered. As regards valuation, in the absence of any guidance, Fair Market Value on recognised exchange can be used.
6.11. Receiving cryptocurrency in business transactions
If one receives cryptocurrency for goods or services in the course of regular business, the converted value of the cryptocurrency in Indian rupees is nothing but a business income. As observed by ATO, this is the same process as receiving any other non-cash consideration under a barter transaction.
6.12. Receipt of cryptocurrency by service providers
Projects may reward third party service providers like network testing, application development or provision of specialist advice (accounting, legal, marketing, etc) who provide services to the crypto based projects with their native tokens. The money value of these tokens should be business income of the recipients at the time the tokens are derived. It may be noted that these tokens may not be converted but still on the date of receipt of tokens, same should be taxable in the hands of recipient. However, one may contend that it becomes income only when such tokens are encashed and hence income will arise only when such tokens are sold on exchange. However, this view seems to be too aggressive.
7. Points to ponder
After above discussion and going through jurisprudence across the globe, still many questions remain unanswered from income tax point of view. They are as under –
7.2. If characterized as capital gains
7.3. If characterized as Business Income
The crypto world is constantly changing and new inventions are happening every day. With the advent of number of practical uses of the blockchain technology like smart contracts, Decentralised Finance (Defi), Non-Fungible Tokens (NFTs) etc. and the incessant desire of the crypto-baby to become an adult, crypto currencies cannot be overlooked by the regulators, industry or investors. The World Economic Forum (WEF) anticipates that 10% of global GDP will be supported by blockchain by 2025 as one of the most critical technologies. Unlike USA who has started regulating crypto market slowly, India is still in dilemma as to which path it should chose and it is still deliberating how to regulate this market. Irrespective of it become legal or not, considering significant volume of crypto assets in India, CBDT should issue guidance on various aspects of taxation of crypto assets like ATO, which will be helpful and would facilitate taxpayers in taking informed decision and avoid uncalled for disputes.
a. Title is inspired from the quote of Chamath Palihapitiya, venture capitalist which is ‘It’s money 2.0, a huge, huge, huge deal.’
b. Decrypting Crypto World – Whitepaper on market opportunities in India – May 2021 by Indiatech.org
c. Blockchain and Cryptocurrency: Federal Income Tax Issues – Tax Notes- by Mary Voce and Pallav Raghuvanshi
g. Rev. Rul. 2019-24 by IRS
1. https://coinmarketcap.com accessed on 19-05-2021
11. Niti Aayog- Blockchain India Strategy