DeFi, short for decentralised finance, has gained significant popularity in the world of blockchain and cryptocurrency. By leveraging the power of blockchain technology, DeFi aims to revolutionise traditional financial systems by enabling individuals to have direct control over their assets without relying on intermediaries. However, the lack of a unified regulatory approach to DeFi has created challenges and uncertainties. In this blog post, we will explore the complexities surrounding DeFi and crypto taxation, focusing on India's position in regulating this emerging industry.

DeFi Income

When it comes to taxing DeFi transactions, specific guidance from tax authorities is often lacking. Therefore, we need to refer to existing provisions of the Income Tax Act for guidance. The following types of DeFi transactions may be subject to taxation at your tax rate:

• Earning new liquidity mining tokens, governance tokens, or reward tokens.
• Receiving referral rewards.
• Generating income through play-to-earn mechanisms.
• Participating in browse-to-earn platforms like Permission.io or Brave.

India'S DeFi Journey

Regulating decentralised finance in India presents a unique challenge. The Reserve Bank of India (RBI) has expressed concerns about cryptocurrencies, citing risks to financial stability and emphasising their high volatility. Under its G20 presidency, India aims to develop a global regulatory framework that could potentially include measures to prohibit unbacked crypto assets, stablecoins, and DeFi. However, regulating DeFi, with its decentralised nature, poses significant challenges for Indian regulators.

To effectively regulate DeFi, India must prioritise the implementation of anti-money laundering (AML) and countering financing of terrorism (CFT) regulations. These regulations are designed to prevent financial crimes such as money laundering and terrorist financing by requiring financial institutions to verify customer identities and report suspicious transactions. Indian regulators need to create a framework that mandates DeFi platforms to incorporate robust KYC (know your customer) procedures, closely monitor and report suspicious transactions, and ensure compliance with relevant regulations.

India's success in regulating DeFi will serve as a global template, given its track record in rolling out digital public goods like Aadhar and UPI. Striking a balance between innovation and compliance will be crucial, as maintaining integrity and ethical conduct is paramount.

Crypto Taxation

Cryptocurrencies and non-fungible tokens (NFTs) have been a worldwide topic of interest and debate. In India, however, they are presently unregulated, existing in a state of regulatory limbo. In 2018, the Reserve Bank of India (RBI) attempted to prohibit cryptocurrencies; however, the Supreme Court intervened and overturned the ban, making cryptocurrencies neither illegal nor strictly legal. The Supreme Court justified this decision by applying common law reasoning, stating that anything not expressly prohibited should be considered legal. NFTs, on the other hand, have not attracted the same level of regulatory attention but share the uncertain legal existence of cryptocurrencies.

Amidst this regulatory ambiguity, the Indian government has implemented a new tax regime to tax gains and income from virtual digital assets (VDAs), which include cryptocurrencies, NFTs, and other specified assets. The tax rate imposed is 30% plus surcharge and cess under the Income Tax Act, 1961. However, the legal position of cryptocurrencies and NFTs remains unclear.

Let's understand how the new tax on income from VDAs works and the challenges it presents.

Assets Subject to the New Tax: The Income Tax Act was amended on April 1, 2022, to include the taxation of gains and income derived from VDAs. VDAs, as defined by the Act, include cryptocurrencies, NFTs, and other digital assets specified by the Central Government. 

Tax Liability and Determining Fair Market Value: Tax liability arises in various scenarios under the Income Tax Act. If a person receives a VDA without consideration, and its fair market value exceeds INR 50,000, the entire fair market value is considered taxable income. Similarly, if a person receives a VDA for considerably lower than the fair market value, and the difference exceeds INR 50,000, the difference becomes taxable income.

Determining fair market value can be challenging due to the volatility of cryptocurrencies and NFTs. While the purchase price on a crypto-exchange or marketplace may serve as an initial reference, the income tax authorities may require fair market value determination per the Income Tax Rules, 1962. This creates a lacuna since the Rules do not specifically address VDA valuations.

Additionally, problems arise when a person incurs losses from the transfer of a VDA. The Act prohibits the set-off of losses from VDAs against gains from other VDAs, treating VDAs differently from other assets.

Tax Deducted at Source (TDS) and Withholding: The Income Tax Act mandates that 1% of the consideration be deducted as income tax at the source when a resident transfers a VDA for consideration. This applies regardless of the form of consideration or if it involves another VDA.

However, the tax deduction is not required when the consideration is paid by a "specified person" and the aggregate value remains below specific thresholds. A specified person refers to an individual or Hindu Undivided Family (HUF) who didn't earn any income from business or profession in the previous financial year; however, If the person did earn income from business and profession in the last year they are still be considered as a specified person if their total gross receipts from the business don't exceed is 1 crore or 50 Lakhs from the profession.

Conclusion

Decentralised finance (DeFi) is a new and innovative financial system that uses blockchain technology to allow people to access financial services without the need for a central authority. While DeFi has the potential to revolutionise the financial industry, it also raises several regulatory challenges. In India, the Reserve Bank of India (RBI) has expressed concerns about cryptocurrencies and has even attempted to ban them in the past. However, the Supreme Court of India quashed the ban, leaving the legal status of cryptocurrencies in a state of limbo.

To address the regulatory challenges posed by DeFi and cryptocurrencies, the Indian government has implemented a new tax regime that taxes gains and income from virtual digital assets (VDAs), which include cryptocurrencies and NFTs. The tax rate imposed is 30% plus surcharge and cess. While the new tax regime clarifies the taxation of DeFi and cryptocurrencies, there are still several unanswered questions. For example, it is unclear how the tax regime will apply to DeFi protocols that are not based in India.

Overall, the regulatory landscape for DeFi and cryptocurrencies in India is still evolving. As the industry continues to grow, the government will likely issue additional regulations and guidance. In the meantime, it is important for individuals and businesses who are involved in DeFi and cryptocurrencies to be aware of the current tax laws and regulations. By doing so, they can avoid potential penalties and ensure they comply with the law.

byAstik Dubey

Astik is a law student diving deep into indirect Tax and business law. With a flair for business writing and a special interest in crypto taxation, he turns complexity into captivating articles. Join his enlightening blog, where law and business intersect.

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