To tax or not to tax - The curious case of NFTs To tax or not to tax - The curious case of NFTs

'NFT' or Non-fungible token was declared Collins Dictionary's 'word' of the year in 2021.

You may not own it (yet), understand, or have experienced it, but you would have surely heard of - Cryptocurrencies, NFTs and Metaverse. With so much news surrounding these frontier technologies, the rush to invest and the related concerns about a possible ban in India, it was only a matter of time before the taxman would join the party to ensure that due taxes were paid.

In India, before February 2022, there was no provision under the Income-tax laws particularly dealing with the taxation of digital assets such as Cryptocurrencies or NFTs’. This mattered since the rules and the tax liability differ depending on how you classify the income - as a capital gain, business income, or income from other sources. With volatility being the hallmark of these emerging technologies, the impact of losses on the tax liability was also uncertain.

On February 1, 2022, the finance minister announced a slew of measures, which have come into effect from April 1, 2022, dealing with how digital assets would be taxed. To begin with, like any fiscal statute, definitions matter. The Finance Act 2022 introduced a new class of assets termed, Virtual Digital Assets (VDA). To deal with possible emerging technologies, the definition has been kept wide to mean:

1. Any information or code or number or token (not being an Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration with the promise or representation having inherent value, or functions as a store of value or a unit of account including its use in any financial transaction or investment but not limited to investment scheme; and can be transferred, stored or traded electronically;
2. A non-fungible token or any other token of similar nature, by whatever name called
3. Any other digital asset as the Central Government may notify.

The definition under 1 appears to be influenced by the draft Banning of Crypto Currency and Regulation of Official Digital Currency Bill 2019. This suggests that VDA would include cryptocurrency, whereas NFTs have been specifically called out as VDA.

The tax implications can be severe with NFTs being painted with the same brush as cryptocurrency. In a nutshell, gains arising from the sale of NFTs shall be taxed at 30 per cent, with only the acquisition cost being an eligible deduction. Where a person has sold other NFTs’ and made losses, such losses are not allowed to be set off. Exchanges or platforms which enable transactions of NFTs’ would be required to withhold taxes at 1 per cent on payment to resident sellers subject to specific monetary thresholds.

India’s nascent NFT industry has voiced its concerns, seeking to distance itself from cryptocurrency, widely believed to be the intended target of the new tax regime. On a fundamental level, while NFTs and cryptocurrency are based on blockchain technology and are digital tokens, unlike cryptocurrency, NFTs are unique, i.e. non-fungible. Further, while cryptocurrency (even though not recognized as a currency in India) has only economic value, NFTs are blockchain based tokens that can represent a unique asset like a piece of art, content, media or even a physical item. Recognizing these concerns, the Government, recently, vide a notification dated June 30, 2022, has decided to make amends by excluding the following from the rigours of VDA taxation:

a non-fungible token whose transfer results in the transfer of ownership of the underlying tangible asset, and the transfer of ownership of such underlying asset is legally enforceable.

Would this exclusion suffice to address the concerns of NFT players? Let us look at few examples. Assume a meme is sold as an NFT. For the gain made on such sale to be excluded from the VDA tax regime, there must be transfer of an underlying tangible asset. Can a meme be considered a tangible asset? No. Not under income-tax laws.

In comparison, if a celebrity musician auctions their NFT video of signing original posters/ album cover which also results in transfer of ownership of such physical posters to the buyer of the NFT, such a transaction can potentially get excluded from the rigors of VDA taxation.

While the transfer of ownership of the underlying tangible asset is a sine qua non to be exempt from the VDA taxation regime, so is the legal enforceability of the contract. The majority of the transactions under NFTs are conducted via smart contracts - self-performing, blockchain-based technology for the performance and execution of contracts virtually. One would need to evaluate whether a smart contract executed would be legally enforceable in view of the provisions of the Indian Contract Act, 1972 and allied regulations.

While the current use case has been dominated by celebrities auctioning digital representations, with increased adoption of these technologies, the use case would become more utility based. As the market for NFT evolves, more novel tax issues are going to come to light. In this ever-evolving technology space, it is imperative that policy measures going forward foster an environment of entrepreneurship to benefit from these frontier technologies.

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