Income Tax on Transactions in Virtual Digital Assets

Welcome to the Taxmann Podcast! 

We are proud to present our new special season featuring Dr Pushpender Puniha, former head of the Faceless Assessment Scheme. Dr Puniha is an alumnus of St. Stephen's College and the University of Southern California. 

His lifelong passion is the study of economics, finance, and income tax.

In this second episode, Dr Puniha will introduce the concepts, complexities and computations involved with Income Tax on Transactions of Virtual Digital Assets.

Connect with Dr. Puniha here: pushpinder.puniha@taxmann.com

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Transcript

Welcome to the second podcast of the Tax Concepts. In today’s podcast we shall cover specific issues of taxation of the Virtual Digital Assets. (VDAs for short) such as 

1.     Under which head of income the gains from VDAs will be taxed? Is it capital gains, profits and gains from business or income from other sources, and does the classification of head of income matters to you?

2.      When and how does the transfer of VDAs take place? What happens if you transfer VDAs without consideration; do you have to pay tax on notional gains from such transfer? How is notional value of VDAs is to be determined?

3.     What happens if I lend my VDA and earn interest in form of additional allocation of VDAs to me? Can I claim depreciation on such VDAs that I have lent to earn interest?  

4.      What are the elements of cost that are included in the cost of acquisition of the VDAs? Is indexation of cost of acquisition allowed? Can I add the cost of mining of the Bitcoin in the cost of acquisition? 

5.     What is the relevance of the phrase ‘if any” that the legislature has added to the cost of acquisition?

6.     Can I claim losses on my transactions in VDAs? Is there any scope of setting off the losses that I unfortunately made prior to 1st of April, 2022?

7.     And many more such intriguing issues of the taxation of the VDAs.

Before we deal with these specifics, I want to discuss two developments around VDAs in the last fortnight that are of interest to us. First is the apprehension expressed by the Finance Minister on transactions in VDAs in her meeting with the chief of the International Monetary Fund (IMF). Two elements of FM’s anxiety are particularly noteworthy; first is her mistrust of some of the actors dealing with VDAs and the purpose for which such transactions may be used. She expressed a fear that if VDAs are not closely monitored and supervised than disruptive elements like the terror organisations may use VDAs to fund their activities against the state and the nations.  Now, this is a clear indication that the transactions in VDAs are likely to be closely watched by the government agencies and the international organisations now, and in the future. So, my repeat advise to you is that please disclose all such VDA transactions in your tax returns; otherwise, you will run foul of the tax authorities; if not now, then in the immediate future by which time the government agencies’ would decipher any hidden or camouflaged software that any secretive VDA exchange may promise you. 

Second element of the FM’S interaction with IMF is the reiteration of the Indian government’s stand; taxation of VDAs do not make transactions in VDAs legal or above board. Taxation and legality are two separate issues, and their relationship is complex. In the famous case of CIT Vs. Piara Singh the supreme court as far back as 1980 allowed the expense of confiscation of currency notes of a smuggler by the customs authorities. The court held that if smuggling was a business to be taxed, then the confiscation of the currency notes was a loss occasioned in pursuing the business; it was a loss in much the same way as if the currency notes had been stolen or dropped on the way while carrying on the business; and it was a loss which sprung directly from the carrying on of the business and was incidental to it.

To overcome such controversies the legislature in its wisdom introduced Explanation to sub-section (1) of section 37 by the Finance (No. 2) Act, 1998, with retrospective effect from April 1, 1962, which reads thus :

"Explanation.-For the removal of doubts, it is hereby declared that any expenditure incurred by an assessee for any purpose which is an offence or which is prohibited by law shall not be deemed to have been incurred for the purpose of business or profession and no deduction or allowance shall be made in respect of such expenditure."

          My short point is that do not get taken in by taxation of gains from VDAs to presume that dealings in all VDAs is a legal activity. You may have been taxed on some VDA gains, and yet may face action under other laws for dealing with those exchanges of the VDAs that operate in grey area and in violation of laws of the land.  

Before closing this issue let me point out to the gender equality aficionados that both the FM of India and the IMF chief happen to be learned ladies: Madam Nirmala Seetharaman, the FM of India is a well known name; the IMF chief is Kristalina Georgieva, an outstanding economist from Bulgaria.  

                    The second development is that a very vocal supporter of digital currencies and VDAs, particularly ‘Dogecoin’, Elon Musk  has becomes the sole proprietor of ‘Twitter’, And as you all know, Twitter is perhaps the most influential opinion making platform in the world. So, expect VDAs to become more of an impassioned discussion point in near future.

                    Now let’s deal with our specific questions. How do we classify VDAs in the typology of heads of income. The income arising from the transfer of VDAs can be classified under any of the 3 heads of income:

(a)  It can be Profits and gains from business or profession.;

(b)  It may be Income under the head of capital gains; or

(c)  It sometimes would be Income from other sources.

When you hold VDAs for sale in the ordinary course of business (i.e., as a trading asset), then the profits arising therefrom would be taxed under the head Profits and gains from business or profession. This would clearly apply to traders of cryptocurrencies. Whereas, if the VDAs are held as a capital asset, the income shall be taxed under the head “capital gain”

When is an asset a capital asset as opposed to a trading asset? This is an intriguing issue that has led to lot of litigations especially in the case of shares and securities. The critical factor is the intent of the holder of the VDAs; do I hold them as investment or treat them as an everyday commodity that I often buy and sell? And this intent, motive or purpose of holding VDAs  is to be derived from the facts of transactions in the VDAs as well as the surrounding circumstances like how often I trade in VDAs, do I hold only one type of VDA, say dogecoin, or do I also deal in number of VDAs such as BitCoin or Etherum or other NFTs;  how long do I hold particular VDA would also be a factor. To reduce litigation and maintain consistency in approach, the CBDT had issued two important circulars prescribing the principles to classify shares or securities as capital asset or trading asset; Circular No. 4, dated 15-06-2017 and Circular No. 6, dated 29-02-2016. My favourite reading on this topic are two judgements in the case of H Holck Larsen, and I would recommend you to read these; the clarity of thought and articulation of language of Justice Chandrachud, while delivering the judgement for Bombay High Court in 1971, and of Justice Sabyascahi Mukherji in delivering the supreme court judgement in the same case in 1986 are worth admiring and learning. They bring clarity on the concepts and parameters you need to consider to decide when an asset is an investment, and how and when it becomes a stock in trade.  

Though the aforesaid circulars and judgements are applicable in the case of shares and securities, I strongly believe that the principles prescribed therein are ipso facto applicable to classify VDAs as a capital asset or trading asset. 

I cannot help but make a tangential point here. Notice the time gap in the two judgements; it is 15 years. Here is learning for both taxpayers and the tax administrators.  Let’s reduce litigation, particularly the frivolous disputes; it has huge financial, economic and psychological cost for the taxpayer as well as the nation.

The core issue is does it matter whether VDAs in my hand are classified as assets or stock in trade or taxed as income from other sources when gains from VDAs are taxed at a flat rate of 30 percent. The answer is, yes; it matters.

Though the tax rates are the same 30 percent, whether the income is taxed under the head of business or profession, capital gains or other sources. But the, classification of head of income is essential for computation of interest under Section 234C. If a shortfall in payment of advance tax happens on account of underestimating or failure to estimate the accrual of capital gains, then such shortfall shall be ignored while computing interest under Section 234C. If your gain from VDAs is to be taxed under the head profits and gains from trade or business, then you are liable for interest liability under section 234C. 

Classification of head of income matters in another way, also. What happens when a VDA is lost or stolen? It is possible that virtual digital assets may be lost or stolen. Cryptocurrencies can be lost when a private key is misplaced or forgotten, or on inheritance if the key is not shared or the inheritor did not otherwise have access to the wallet. Many such instances of loss and theft have been reported in reputed publications such as the Wall Street Journal.

The Supreme Court has held in the case of Vania Silk Mills (P.) Ltd. v. CIT [1991] 59 Taxman 3 (SC)  that there is no transfer when the asset is destroyed as the asset must exist in the process of transfer. Thus, the definition of transfer does not apply in case VDA is stolen or misplaced and, accordingly, the taxability in such cases may be governed by the general provisions of the Act, and not the Section 115BBH of the Act. If VDAs have been treated as a capital asset, no capital loss shall be allowed to the owner.  If such VDAs have been treated as stock-in-trade, any loss due to such an event ought be allowed under Section 29. Business losses, though fall outside the purview of Sections 30 to 43D, may be allowed under Section 29 on the basis of ordinary commercial principles. The trading loss of a business is deductible for computing the profit earned by the business. But every loss is not so deductible, unless it is incurred in carrying out the operation of the business and is incidental to the operation. A business loss shall be allowed provided the following conditions are satisfied:

(a)  Losses are revenue in nature. Losses of a capital nature are not allowed as deduction;

(b)  Losses are incurred in the relevant previous year;

(c)  Losses are incidental to the business or profession carried on by the assessee;

(d)  Losses are real and not fictional or expected in future;

(e)  There is no provision, direct or indirect, in the Income-tax Act restricting such deduction.`

Now let’s discuss the issue of transfer of the VDAs. The income from VDA is taxable, only if it arises on the transfer of VDA. The word ‘transfer’ is defined under section 2(47) of the Act in relation to capital assets. Now, a VDA can be held as a stock in trade or a capital asset. Can we argue that tax on gains would apply only in case of transfer of VDA held as a capital asset? To avoid any dispute, sub-section (3) of section 115BBH provides that the definition of transfer shall apply to any VDA, whether it is a capital asset or not.

When we analyse the definition of ‘Transfer’ under Section 2(47), we find it has been defined in an inclusive manner.  Inclusive definition in law implies that the term shall be deemed to include all transactions prescribed in the section as well as what constitutes a transfer in the common parlance. So, the definition of transfer is broad, and it includes all those transactions that may be construed as a transfer by a common man. It can be 

(a)  Transfer by way of sale;

(b)  Or, Transfer by way of exchange;

(c)  also it may be, Transfer by way of relinquishment;

(d)  The answer is yes to Transfer by way of extinguishment of rights;

(e)   compulsory acquisition is a transfer, too; 

(f)    and so is Transfer by way of conversion into stock in trade.

It is important to remember that  3 typologies of transactions are statutorily excluded from definition of transfer.

(a)   Lending of VDAs; 

(b)  Any distribution of VDAs in kind by a company to its shareholders at the time of liquidation is not to be treated as a transfer of an asset by the company.  But, the shareholders are liable to pay tax, if any capital gain arises therefrom under section 46 of the Act. 

(c)     Transfer of VDAs through a gift, will, partition of HUF, or business restructuring as per section 47 of the Act.

An interesting implication of definition of transfer arise when the VDAs are exchanged. All crypto exchanges allow buyers to buy a cryptocurrency in exchange for another cryptocurrency. For example, Mr. Singh buys 20 Bitcoin from Mr. Kumar in exchange for 100 Ethereums. In this case, there is transfer of VDA from both sides– transfer of Bitcoin by Mr. Singh and transfer of Ethereum by Mr. Kumar. Accordingly, tax liability would arise in the hands of both Mr. Singh as well as Mr. Kumar.

Another interesting instance is where a cryptocurrency is acquired by Mr. Kumar for investment, but he subsequently converts it into stock-in-trade of a business carried on by him. It shall be deemed that the capital asset is transferred during the previous year in which such conversation takes place, and capital gain is to be computed in the same year. It is worth noting that the capital gain so computed in the year of conversion shall be charged to tax in the year in which the stock-in trade is ultimately sold or otherwise transferred by Sh. Kumar. Thus, the two types of income shall be charged to tax in the year in which stock-in-trade is sold. First, the capital gain so computed on the date of conversion under the head capital gains and second, the business income arising on the sale of stock, under the head profits and gains of business or profession. 

A taxable event will also happen when the reverse happens. If the VDAs held as inventory of a business are converted into capital assets, its fair market value as on the date of its conversion shall be taxable as business income under Section 28(via) of the Act. The problem is that Section 115BBH neither provides the method of computation of fair market value nor gives power to the CBDT to prescribe it, unlike Section 50CA or Section 50B. There are practical difficulties in determining the market value of cryptocurrencies due to the high fluctuation in value, and exchange platforms may have different prices for the same cryptocurrency at any point of time. For example, it has been reported that the price of a Bitcoin on 09th February 2022 at 4:55 PM was:

(a)  Wazirx was Rs. 34,10,245;

(b)  Coinbase was Rs. 32,56,082;

(c)  Binance was Rs. 32,53,331.

I suggest that the CBDT ought to be empowered to provide the rules for computation of fair market value in case of transfer of VDAs. However, in the absence of any guidance, the fair market value can be determined based on the price at which it is listed on an exchange platform on the date of exchange/transfer. In the case of an over-the-counter deal or barter transaction, the taxpayer may take the lowest value amongst all exchange platforms. This is  prescribed method in context of valuation of shares or securities under Rule 11UA, but the principle can be applied for valuation of VDA in absence of specific guidance.

Most exchanges allow the investors to lend their holding of cryptocurrencies to earn interest. Such lending of cryptocurrencies cannot be termed as transfer as the title of the asset is not transferred to the borrower. The amount of interest earned by the investor from such lending is credited in the same cryptocurrency he has lent. Such interest income ought to be taxed under the head of income from other sources or business, as the case may be, at the applicable tax rate and not at the rate specified under Section 115BBH.

A related query is that can a person engaged in lending of VDAs claim depreciation on it as intangible asset? Section 32 allows depreciation in respect of intangible assets such as know-how, patents, copyrights, trademarks, licences, franchises or any other business or commercial rights of similar nature. Here, the meaning of the expression “any other business or commercial rights of similar nature” has been explained by the various courts to mean those business or commercial rights which are either akin to know-how, patents, copyrights, trademarks, license, franchises or falls within the same genesis or genre. As the VDA is neither akin to know-how, patents, copyrights, trademarks, license, franchises nor falls within the same genre of assets, it cannot be treated as intangible asset for the purpose of depreciation under section 32.

Cost of acquisition of VDA

Section 115BBH(2)(a) provides that no deduction in respect of any expenditure (other than the cost of acquisition, if any) or allowance or set off of any loss shall be allowed to the assessee under any provision of this Act in computing the income referred to in Section 115BBH(1)(a). In other words, while computing the capital gains or business income, except the cost of acquisition, no other deduction or exemption shall be allowed. Thus, the following items shall be ignored while computing the income from the transfer of virtual digital assets:

(a)  Expenditure incurred in connection with the transfer of a virtual digital asset;

(b)  Cost of improvement relating to a virtual digital asset;

(c)  Indexation of cost of acquisition of a virtual digital asset;

(d)  No Exemption is available under Section 54F;

(e)  Depreciation;

(f)    Other expenses.

Is indexation of cost of acquisition allowed?

Section 115BBH(2)   starts with a non-obstante clause,  “Notwithstanding anything contained in any other provision of this Act” This Clause will override all other provisions of the Act including the second proviso to Section 48. Inspite of the fact that there is no specific prohibition on indexation of the cost of acquisition of VDA under Section 115BBH or Section 48, my opinion is that the indexed cost of acquisition would not be not be allowed while computing the long-term capital gains from the transfer of VDA.

Relevance of the words ‘if any’ after cost of acquisition

While computing the income from the transfer of VDA, an assessee is allowed to claim the deduction of the only cost of acquisition thereof. However, there could be situations where the cost of acquisition of VDA is ‘nil’ or cannot be determined or ascertained (like VDA acquired under a slump sale agreement, airdrop of VDA, etc.). For example, new VDAs are launched and airdropped to an influencer. On the said date, as the VDAs are not listed on any exchange, the valuer thereof would be nil.

In a seminal judgement in the case of CIT v. B.C. Srinivasa Setty [1981] 5 Taxman 1 (SC) Supreme Court has held that if there is no cost of acquisition of any capital asset then computation provision will fail and, therefore, no capital gains can be computed. To avoid any controversy in case of VDA, the words “if any” have been inserted after the cost of acquisition. It implies that income from transfer of VDA shall be computed as per Section 115BBH even if the cost of acquisition thereof is ‘nil’ or ‘not available’.

Method for computation of cost of acquisition

For the computation of capital gain, a capital asset is bifurcated into short-term and long-term capital assets. However, this distinction is not important to compute the capital gains or business income from the transfer of VDAs as the incidence of tax is the same in every situation.

Nevertheless, if a person is regularly selling and buying VDAs, it is essential for him to identify the cost of acquisition of a VDA being sold. Section 115BBH does not provide any guidance on how such correlation should be made. Either he can follow the FIFO method or the weighted average method to compute the cost of acquisition of a VDA sold.

The circular Number 768 of 1998 issued by the CBDT provides that the First-In-First-Out (FIFO) method should be used to determine the period of holding of securities held in Demat form. In the absence of guidance in Section 115BBH or similar clarification from the CBDT for the VDAs, the investor might take the position to use either the FIFO method or the weighted average method, whichever is more beneficial.

In the FIFO method, the VDAs acquired last will be taken to be remaining with the assessee, while VDAs acquired first will be treated as sold. In the weighted average method, the cost of acquisition of the VDAs sold is the weighted average price of all his holdings at the time of sale.

Can cost of mining be included in the Cost of acquisition?

To mine a cryptocurrency, a person invests in computers & mining machinery and incurs huge electricity charges. Whether such capital expenditure and electricity charges be considered the cost of acquisition of a mined cryptocurrency. In other words, can the cost of creating a capital asset be considered its cost of acquisition?

The word ‘acquisition’ is of wider amplitude than the word ‘purchase’. A purchase is one of the modes of acquisition, and a property can be acquired even otherwise than purchase. The decision of the Gujarat High Court in CIT v. Mohanbhai Pamabhai, (1973) 91 ITR 393 (Guj) affirmed by the Supreme Court in [1987] 165 ITR 166 can offer useful guidance to the meaning of the words ‘acquisition of the capital asset’? The court held as under:

The word "acquire", according to its plain natural meaning, is a word of very wide import. It is not confined to obtaining of a thing from a third party. When an assessee gains a thing by his own exertions or comes to own it or have it by any recognised mode which would doubtless include the mode of creation, he can be said to have acquired the thing. There are various modes of acquisition by which a thing may be acquired, by an assessee and creation is one of them.

Relying upon the aforesaid judgement, it may be claimed that when a cryptocurrency is created, it is deemed to be acquired. Therefore, all expenditure incurred during the creation process should be considered the cost of acquisition unless Section 55 explicitly disallows such cost of creation.

The Income-tax Act is silent on the method of the computation of cost of acquisition of a VDA generated during the mining process. In absence of any such guidance on the aspect, the revenue expenditure specific to the mining operation could be added in full to the cost of acquisition and capital expenditure specific to the mining operation (i.e., mining machine) may be added to the cost of acquisition in a proportion of the asset mined during the year to the total mining capacity. All other capital and revenue expenditures not specific to the mining operation but attributable to the general operation should be disallowed.

This issue is not free from doubts and it is likely to generate huge litigation. I would suggest that CBDT may bring out a clarificatory circular on this issue.

Treatment of loss

Sub-section (2) of Section 115BBH starts with a non-obstante clause and contains the following two clauses:

(1)  Clause (a) provides that no set-off of any loss shall be allowed to the assessee in computing the income referred to in Section 115BBH(1)(a); and

(2)  Clause (b) provides that no set-off of loss from the transfer of the VDA computed under Section 115BBH(1)(a) shall be allowed against income computed under any provision of this Act, and such loss shall not be allowed to be carried forward to succeeding assessment years.

Both the clauses attempt to ring-fence the losses arising from VDA. It neither allows any loss to set-off against income from VDA nor allows loss from VDA to set-off against income computed under any provision of this Act. 

The expression used in clause (b) is “any provision of this Act”. Thus, it shall include even income computed under Section 115BBH, i.e., income from transfer of VDA. In simple words, any loss arising from the transfer of VDA would be a dead loss, and it will not be allowed to be adjusted even against income arising from the transfer of another VDA (whether of the same category or not). 

Losses incurred on or before assessment year 2022-23

Section 115BBH(2) prohibits carrying forward and setting-off of losses from VDAs with effect from the assessment year 2023-24. Would such provision impact the losses incurred on or before the assessment year 2022-23? In other words, can such losses be carried forward and set-off with income taxable under the relevant head (except income from transfer of VDA) in the assessment year 2023-24 and onwards.

A similar issue was dealt with by the Supreme Court in the case of CIT v. Shah Sadiq & Sons [1987] 31 Taxman 498 (SC). The apex court held that under the 1922 Act, the assessee was entitled to carry forward the losses of the speculation business and set off such losses against profits made from that business in future years. The right of carrying forward and set off accrued to the assessee under the 1922 Act. A right that had accrued and had become vested continued to be capable of being enforced notwithstanding the repeal of the statute under which that right accrued unless the repealing statute took away such right expressly. 

My opinion is that taxpayer has a right to carry forward and set-off the losses incurred on or before the assessment year 2022-23. However, such losses shall not be allowed to set-off against income taxable under Section 115BBH. Such rights can be exercised within the four corners of the provisions specified in Section 72, Section 73, and Section 74 read with Section 80.

Is VDA a property and does it attract tax for receipt without adequate consideration?

The Finance Act, 2022 inserted ‘virtual digital assets’ in the meaning of property  [Explanation (d) to section 56(2)(vii)]. Thus, after the amendment, property shall mean:

(a)  Shares and securities;

(b)  Jewellery;

(c)  Archaeological collections;

(d)  Drawings;

(e)  Paintings;

(f)    Sculptures;

(g)  Any work of art;

(h)  Bullion; and

(i)    Virtual Digital Asset.

Thus, if a person receives a virtual digital asset without consideration (gift) or for inadequate consideration and the value of such benefit exceeds Rs. 50,000 it shall be taxable in the hands of the recipient under Section 56(2)(x) as income from other sources. It is be noted that the property defined under Explanation (d) to section 56(2)(vii) should be the 'capital asset of the assessee'. Thus, properties in question must constitute capital assets in the hands of the recipient. 

No deemed income shall arise under this provision, if the VDAs are received in the circumstances or occasion specified in Proviso to Section 56(2)(x),  including the following:

(a)  on the occasion of the marriage of the individual;

(b)  under a will or by way of inheritance;

(c)  in contemplation of death of the payer or donor;

(d)  from any specified relative.

The value of the benefit arising under Section 56(2)(x) will be taxed at the rate applicable to the taxpayer. Such income shall not be taxed at 30% under Section 115BBH because it does not arise due to the transfer of a virtual digital asset. However, when the recipient further transfers such assets, the resultant gains shall be taxable under Section 115BBH.

Conclusion

Number of other issues arise in taxation of the VDAs. I have selected those which in my opinion are significant and are also open to some discussion. The foundation of the VDAs is transactional trust and a belief in the fairness and equality of all the participants in the financial transactions.  The core principle is very well articulated in the definition of the Distributed Ledger Technology by the World Bank Group. I end by quoting that definition and in the hope the transactions in VDAs shall be carried out in this spirit of collective maintenance and control of the VDAs will remain in a distributed network;  “a novel and fast-evolving approach to recording and sharing data across multiple data stores (ledgers), which each have the exact same data records and are collectively maintained and controlled by a distributed network of computer servers, which are called nodes” (emphasis added).

In the end,  I also recommend a wonderful book written by a professor at the Cornell University. It is a scholarly research on future of money and digital currencies and written in simple language. “The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance” (2021). Harvard University Press.