From Blockchain to Balance Sheet: A Framework for Crypto Taxation

The authors are Ali Ahmed Chaudhary and Agastya Shukla, fourth Year Students from National Law University Delhi and University Institute of Legal Studies, Punjab University, respectively.

Abstract:

The rapid evolution of Virtual Digital Assets (VDAs) has introduced significant complexities in the realm of taxation and regulatory compliance. Industry estimates suggest there are 15 to 20 million crypto investors in India, with total crypto holdings of around 400 billion rupees. Cryptocurrencies, in contrast to fiat money, are decentralised and rely on a peer-to-peer network that functions independently of a central bank or other third party. Because of the volatility and discrete character of these digital assets, the current legal system is unable to handle the anonymity and decentralisation of cryptocurrencies, which leads to an inability to appropriately assign transactions to the appropriate tax bracket and monitor them. The purpose of this research paper is to identify the frequency of income obtained from trading VDAs and investigate the realm of taxable events and ambiguous regulatory regions in the crypto regime. Additionally, it seeks to identify the mathematical process for determining the revenue from cryptocurrency transfers, taking into account issues related to loss carryover and set-off, tax withholding requirements, fair market valuation techniques, cryptocurrency gifts, and the various tax ramifications for different kinds of VDAs, including those obtained through mining, airdrops, staking, and trading, with a focus on non-fungible tokens (NFTs). It lays the path for regulatory standard operating procedures (SOPs) for disclosure and compliance while attempting to provide a worldwide solution to the issue of residence-based crypto taxes and its regulation across numerous jurisdictions. These discussions provide a brief summary of the difficulties that both domestic and international parties in the current tax system confront, as well as how these difficulties affect the Indian economy. The study highlights the wider economic effects on India's investment and economic market by looking at the real-world effects of taxing cryptocurrencies. It also offers insights into finding a balance between raising tax revenue and encouraging investment in the market for digital assets.

Keywords:

Cryptocurrency Taxation, Virtual Digital Asset, Taxation, Blockchain, Crypto Tax.

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I. Introduction: Navigating The Digital Gold Rush

Cryptocurrencies are decentralized virtual currencies without a regulatory authority. Transactions are recorded in a ledger called Blockchain, which is a network accessible to everyone. The complex mathematical problems are solved to deal with the problem of currency falsification, wherein users are rewarded with cryptocurrency through a process called mining[1]. Verification of transactions is carried out by users called miners who lend their computational infrastructure. The appearance of Bitcoin in 2009 marked the emergence of the third hegemonic materiality of money[2] - that is, data. The rise of cryptocurrencies, often referred to as "data money," and the way they are treated on online platforms have challenged traditional categories. These new digital assets blur the lines between established concepts like commodities, property, inventory, and financial instruments like securities. At the same time, they complicate how we think about economic activities – how goods and services are exchanged and produced. Despite the robust taxation regime put in place, the present tax laws and regulations are predominantly based on the pre-digital economy, and they struggle to keep pace with the unique characteristics of cryptocurrencies[3].

The traditional taxation systems were caught off guard by the emergence of cryptocurrencies and the rapid uptake of Virtual Digital Assets (VDAs), sparking debates in the global tax landscape. A recent example underscores the impact of taxing cryptocurrencies: from February to October 2022, there was a transfer of approximately USD 3,852 million (around INR 32 thousand crores) in cumulative trade volume from domestic centralized VDA exchanges to foreign ones following the introduction of a new tax regime in India. Subsequently, they saw a further 14 % drop in trading volumes in the following three months (April to June 2022) after the implementation of the flat 30 % tax. Moreover, the introduction of the one percent TDS had the most significant impact, with Indian VDA exchanges witnessing an up to 81%  decrease in trading volumes in the subsequent four months (July to October 2022) following its levy[4].

This paper delves into the complex dynamics of cryptocurrencies and their implications for taxation. It is structured into five sections to provide a thorough examination of the topic. In Part I, the emergence of cryptocurrencies and the development of corresponding tax frameworks are introduced. Part II discusses the evolving international approaches to cryptocurrency taxation, showcasing how various countries are addressing this issue.  With an emphasis on standards such as IFRS and GAAP, Part III explores cryptocurrency accounting procedures and regulatory compliance. Part IV examines the income tax act's provisions in light of recent developments in the Indian tax system pertaining to cryptocurrencies. The findings and insights of the article are finally summarised in Part V, which also draws inferences from the analysis and identifies important areas for more taxation examination.

A. Drawing Parallels: Analogy To Demystify Crypto Taxation

Let us consider Company Z, which operates in two main sectors: offering high-end digital services and investing in digital assets. In 2021, Company Z spent ₹1 billion to purchase a collection of Non-Fungible Tokens (NFTs).  It also purchased Bitcoin in 2020, and by the end of 2021, its holdings were worth about ₹1 billion. Instead of trading these digital assets often, Company Z stated in its financial records that it planned to hold them for a long time. According to accounting standards, NFTs and Bitcoin were both listed as indefinite-lived intangible assets. This indicates that their initial cost was documented and that they were then periodically assessed for any deterioration, or decrease in value.

 A decrease in the value of certain NFTs resulted in ₹1.5 crore in impairment losses for Company Z in the first quarter of 2021. Similarly, it reported impairment losses of ₹4 crore on its Bitcoin assets in 2020. The business must record an impairment charge to reflect the decreased worth of these assets if their value declines. Accounting regulations, however, do not allow the business to raise the value if the market value of these assets rises in the future. Any profit from the eventual sale of these assets by Company Z is subject to capital gain taxes. On the other hand, this loss might be able to offset other profits for tax purposes if the value had decreased and an impairment was noted. Because NFTs and Bitcoin are classified as indefinite-lived intangible assets, their accounting treatment has a considerable impact on profitability assessments. Company Z must record impairment losses when the market value of these assets declines, which lowers net income. Accounting regulations, however, prevent the business from recording these gains in its financial statements if the market value subsequently rises. Because of this, reported profitability declines as a result of impairment losses, and future rises in market value have no positive impact on reported results. The overall evaluation of Company Z's financial performance is impacted by this biassed acknowledgement. As a result, this illustration illustrates the erratic character of cryptocurrencies as well as the difficulties in their accounting and taxation.

II. Global Perspectives: A Tour Of Crypto Taxation Around The World

Around the world, governments have taken diverse stances towards cryptocurrencies, including accommodating, banning, classifying, or taking no action. Many governments issue warnings about the risks of cryptocurrency, emphasizing their volatility and the lack of regulation, with no legal recourse for losses. These warnings often highlight the differences between fiat currencies, which are government-backed, and privately owned cryptocurrencies. Concerns include the potential for illegal activities such as money laundering and terrorism. Some countries, including Algeria, Morocco, Nepal, Pakistan, and Vietnam, have banned all cryptocurrency activities, while China and Thailand have imposed indirect restrictions by preventing financial institutions from facilitating cryptocurrency transactions[5]. Conversely, some countries see potential in blockchain technology and are creating cryptocurrency-friendly laws to attract investment in this sector. Venezuela and Eastern Caribbean Central Bank member states are developing their own cryptocurrencies[6]. The UK and South Africa, recognizing the small market size, have issued warnings but neither banned nor heavily regulated cryptocurrencies[7]. India's taxation framework for Virtual Digital Assets (VDAs) is perceived as regressive compared to other countries with high VDA adoption rates like the USA, UK, South Africa, Vietnam, Philippines, and Brazil. Austria and Belgium are awaiting common European regulation, while Bulgaria has accepted digital currency and issued tax guidelines treating income from the sale of digital currencies as income from financial assets taxed at a 10% rate. Croatia's National Bank concluded that Bitcoin is not illegal, but there is no specific regulation on virtual currencies.

Germany treats cryptocurrencies as commercial activities subject to capital gains taxes unless held for over a year, with Bitcoin considered private money subject to sales and VAT taxes. Finland subjects Bitcoin to VAT and capital gains taxes, but capital gains losses are not deductible. Italy exempts purchases and sales of Bitcoin from VAT but applies income tax to speculative uses.  In Japan, capital gains from cryptocurrency transactions are subject to income and capital gains tax, with Bitcoin sales exempt from VAT. Turkey recognizes cryptocurrency as a commodity, with gains from transactions potentially subject to capital gains or self-employment tax[8]. Slovakia has comprehensive regulations for virtual currencies within its Accounting and Income Tax Acts, while the Czech Republic relies on recommendations from the Ministry of Finance. The UK Bank of England suggests subjecting cryptocurrencies to Capital Gains Tax, while Sweden's regulatory agency considers Bitcoin a legal currency[9].

In the United States, despite the absence of specific requirements within generally accepted accounting principles (GAAP) for cryptocurrencies, regulatory bodies have issued rules from various perspectives, including taxation and commodity trading. The American Institute of CPAs (AICPA) has taken steps to address this gap by forming a Digital Assets Working Group and releasing nonauthoritative guidance on accounting for digital assets under GAAP. However, the accounting profession still relies on concept statements, existing standards, and discretionary judgment, highlighting the ongoing need for clearer and more comprehensive accounting standards for cryptocurrencies under both GAAP and IFRS.

In a globalized economy, accountants and auditors encounter growing complexities when dealing with virtual currencies in financial statements. In the European Union (EU)[10], VAT treatment aligns with the CJE's ruling in the Hedqvist case, exempting exchanges of virtual currency for fiat currency or other virtual currencies from VAT. However, VAT exemptions apply only if cryptocurrencies are used as means of payment for goods or services, with the sale of goods and services subject to taxation. The taxation of mining activities involving cryptocurrencies remains uncertain under the VAT Act, leading to conflicting interpretations. Income from mining is classified as taxed income for individuals engaged in self-employed activities, while trading in cryptocurrencies requires a trade license and incurs corresponding tax obligations. Additionally, exchanging cryptocurrencies for other cryptocurrencies or services/goods triggers income tax liabilities, while cryptocurrency ownership itself is tax-neutral, exempt from income tax.

Opinions on classifying cryptocurrencies vary widely, with suggestions ranging from financial assets to intangible assets, inventory, and even cash. However, the lack of consensus arises from the complexities of cryptocurrencies, including valuation and measurement issues. While some classify them as intangible assets or financial instruments, others opt for inventory status, particularly for companies involved in mining and issuing.

In practice, dealing with cryptocurrency accounting and tax implications presents significant challenges for both natural and legal persons. Cryptocurrency transactions are taxed according to specific slab rates, and a variety of activities, including trading, selling, and using them as payment, are taxable. The lack of precise standards makes accounting for bitcoin transactions difficult, causing financial reporting to be inconsistent and relying on pre-existing frameworks. Extreme price volatility and unclear regulations can make matters more difficult. To guarantee compliance and transparency in their cryptocurrency activities, both natural and legal people must follow tax laws, accurately report transactions, consult experts, and make use of tools like software and bitcoin tax consultants.[11]. Among the many difficulties faced by accountants are the intricacies of valuation, the unpredictability of rules, and the requirement for ongoing education to stay abreast of the ever-changing cryptocurrency markets and laws[12].

III. Bridging The Compliance Chasm: Aligning Accounting And Tax Treatment

The current practices in cryptocurrency accounting not only lead to inconsistencies between Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)[13] but also create distortions in portraying a firm's true operating performance. This inconsistency is evident in asset recognition and valuation methods among firms adhering to different accounting standards[14]. While US firms recognize cryptocurrencies as intangible assets at cost with subsequent impairment adjustments, most IFRS-following firms recognize them as intangibles and inventories at fair value[15]. Even if the market value of these assets increases post-impairment recognition, the firm's asset value and profitability may remain depressed. Clarity and convergence in cryptocurrency accounting standards are imperative to address these discrepancies and ensure accurate financial reporting for stakeholders and investors[16].

The G20 leaders have agreed to provide tax authorities with greater insights into crypto transactions, signalling global cooperation[17]. The New Delhi Leaders’ Declaration and the IMF-FSB Synthesis Paper highlight steps for global taxation of crypto assets. In order to improve tax transparency and prevent tax evasion, the Declaration urges the quick adoption of the Crypto-Asset Reporting Framework (CARF) and changes to the Common Reporting Standard (CRS) [18]. By 2027, CARF will guarantee uniform reporting of cryptocurrency transactions, enabling automatic information sharing between governments.[19]. The International Monetary Fund- Financial Stability Board paper[20] underscores the need for comprehensive policies to mitigate macroeconomic and financial stability risks posed by crypto assets. To increase tax compliance and collection, it promotes transparent tax treatment, regulatory supervision, and cross-border cooperation. This entails using data from external parties, making data infrastructure investments, and giving taxpayers explicit instructions. In order to properly manage the fiscal ramifications of cryptocurrency assets, both documents stress the significance of an open, predictable tax law framework and international collaboration.

The tax ramifications of cryptocurrency mining activities vary based on the country and type of operation. The fair market value (FMV) of mining awards at the time of receipt is subject to income tax. The FMV at the time of receipt is used as the cost basis for capital gains tax, which is applied to the gains on the sale or exchange of these awards. Gains from cryptocurrency trading are taxed at a rate of 30% plus cess in India; the only deductions permitted are for acquisition costs. This ultimately implies that any profits from cryptocurrency trading are subject to significant taxation, with limited opportunities to offset other expenses. Moreover, the environmental impact of cryptocurrency mining is a growing concern due to its high energy consumption. The substantial electricity required for mining operations contributes to environmental degradation, adding another layer of complexity to the regulatory and social considerations surrounding cryptocurrency mining.

Taxation of cryptocurrency transactions, including sales tax, introduces significant complexities due to varying state regulations and the meticulous record-keeping required. States differ in their calculation methods, using either fair market value or listing price for cryptocurrency transactions, adding to the burden for merchants. Additionally, income tax applies without a "de minimis" exception[21], necessitating complex cost basis tracking methods like first in first out (FIFO) or last in first out (LIFO)[22].

Novel economic concepts like “Data Money” and “Stack Economization” offer innovative solutions to address cryptocurrency taxation challenges. Stack Economization enhances visibility into exchange platform activities, aiding regulation and taxation. Taxing data money similarly to traditional currencies simplifies compliance and increases revenue, fostering a more comprehensive taxation approach.

Approaches to taxing data money, such as legitimizing cryptocurrencies as fiat currencies or benchmarking with central bank digital currencies, offer simplified solutions for accurate taxation and income location without tracing currency sources. To effectively navigate this landscape, several software tools provide valuable assistance in tracking cryptocurrency transactions. Elliptic, DataWalk, CoinStats, Etherscan, and Dune Analytics offer comprehensive monitoring, forensic capabilities, and detailed analytics, enabling efficient compliance with regulatory standards and mitigating financial crime risks. As blockchain technology continues to evolve, these tools play a crucial role in ensuring transparency and security in the crypto ecosystem[23].

IV. The Indian Context: Crypto Taxation In A Developing Digital Economy

India's tax regime for Virtual Digital Assets (VDAs) has introduced significant challenges, particularly with its flat tax rate of 30% on VDA transactions, alongside additional surcharges and education cess.[24] Notably, losses from VDA transactions cannot offset other income, emphasizing the severity of the tax regime. The determination of Fair Market Valuation (FMV) for VDAs poses significant challenges due to the absence of a prescribed valuation method, leading to potential discrepancies and complications in tax assessments[25]. India's tax code includes a rule (Section 194S)[26] that requires a 1% tax to be withheld on certain cryptocurrency transactions. This aims to improve government oversight by requiring quarterly reports. However, this rule only applies when buying crypto from someone residing in India. Since many crypto exchanges are located outside the country, there is an argument to be made that these transactions don't involve Indian income and therefore wouldn't be subject to the 1% tax withholding.[27]

There is another wrinkle: the tax withholding rule only applies if you buy more than a certain amount (₹50,000 or ₹10,000 depending on your filing status) from a single seller in a year.  Therefore, tax withholding would not be applicable for smaller transactions either. Proposed legislative amendments, such as the inclusion of VDAs under "property" for section 56(2)(x)[28]  of the Act, further complicate the tax environment for VDAs in India. The absence of a clear valuation technique akin to sections 50C or 50CA in this modification to the taxation system for VDA gifts complicates tax calculations. Moreover, this issue is exacerbated by variations in VDA trading prices among exchanges, highlighting the need for thorough regulatory policies and consistent valuation methods to manage price swings.

In India, Fair Market Valuation (FMV) is used to tax cryptocurrency transactions, including mining, airdrops, staking, and employee compensation. Determining the source of VDA revenue for tax purposes is made more difficult by the ambiguity surrounding the application of taxes to non-residents caused by the unclear residency criteria under Section 115BBH.[29] Furthermore, regulatory clarification is required to ensure proper tax treatment due to the contradiction between paragraphs (a) and (b) of section 115BBH regarding the set-off of VDA losses. Clause (a) implies no set-off between different VDAs or transactions, while clause (b) suggests possible set-off within VDAs but not against other income sources. This inconsistency necessitates regulatory clarification to ensure proper tax treatment

The Ministry of Corporate Affairs (MCA) in India has mandated businesses to disclose their cryptocurrency holdings and any profits or losses from cryptocurrency transactions in their balance sheets[30]. However, India lacks a formal definition for cryptocurrencies, and the Reserve Bank of India (RBI) has not defined them in its circulars, contributing to regulatory ambiguity. Nonetheless, legal perspectives, such as the UK LawTech Panel's 2019 declaration, reinforce the view of classifying crypto assets as property, aligning with the IASB Conceptual Framework's support for classifying cryptocurrencies as assets[31].

While "cryptocurrency mining" might conjure images of pickaxes and tunnels, it is a digital process of verifying transactions on a blockchain network and earning new coins as a reward. These coins are like hidden treasure waiting to be discovered within the system's code. Miners play a crucial role in bringing these "unmined" cryptocurrencies to light, essentially creating new capital assets for themselves. Selling these mined coins then results in capital gains.[32] 

The Indian Income Tax Act (Section 55)[33] defines how to calculate the acquisition cost of self-generated assets. However, a Supreme Court case (B.C. Srinivasa Shetty) offers an interesting interpretation[34]. It suggests that capital gains tax might not apply if the asset has no acquisition cost because it was not bought, but rather "discovered." This creates a potential loophole for cryptocurrency mining. Interestingly, there were discussions about including crypto mining under India's Goods and Services Tax (GST). This could have been the first step towards taxing activities related to cryptocurrency. However, it appears this proposal has not been implemented yet[35].

V. Addressing The Gaps: Future Course For Crypto Taxation

Cryptocurrency taxation presents multifaceted challenges, with existing regulations often struggling to keep pace with the rapidly evolving digital asset landscape. The absence of specific IFRS standards for cryptocurrencies necessitates the application of current accounting rules, potentially referencing frameworks like the Conceptual Framework for Financial Reporting. Despite the government's willingness to engage stakeholders, recent actions by Indian banks, prompted by the RBI's informal request, have hindered cryptocurrency transactions, impacting millions of investors.

To address this, several design changes are recommended. Firstly, lowering the rate of Tax Deducted at Source (TDS) to align it with the securities transaction tax (STT) is proposed to reduce its distortionary impact on the industry while enhancing transaction tracking. Secondly, conducting a Laffer-Curve analysis to determine the optimal taxation point(s) for revenue maximization is suggested to reconcile tax rates accordingly. Additionally, adopting a progressive tax structure with differentiated rates for short-term and long-term gains is recommended to align with international best practices. Furthermore, enhancing international coordination and institutional oversight on VDA exchanges through measures like a licensing scheme is deemed necessary, given the high volumes of peer-to-peer (P2P) trade. Despite these proposed changes, challenges remain in categorizing cryptocurrencies and their transactions for taxation purposes, which impacts the applicable tax bracket. In crafting tax laws, states should adopt approaches that value cryptocurrency transactions based on the list price of goods rather than the value of the cryptocurrency used for payment. The Streamlined Sales Tax Governing Board should establish favourable guidelines for sales tax, streamlining the recording and reporting process[36]. Similarly, for income taxes, a de minimis rule exempting gains from small-scale cryptocurrency purchases from taxable income should be implemented at both federal and state levels[37]. Congressional approval of a Cryptocurrency De Minimis Exemption Bill would simplify tax filing processes and encourage cryptocurrency adoption for everyday transactions, benefiting consumers and merchants alike.

In India, the present tax regime for VDA transactions poses significant challenges, including a high flat tax rate and a lack of loss-offsetting provisions. These issues could be resolved while promoting a competitive VDA ecosystem by lowering the TDS rate, implementing a progressive tax structure, and carrying out research to identify the best tax rates. In order to properly manage VDA exchanges, better licensing schemes and cooperation are required, along with international coordination and institutional control. By putting these policies into place, India might become more competitive in the VDA ecosystem and guarantee effective tax revenue collection.

Finally, the evolving landscape of VDAs and Virtual Asset Service Providers (VASPs)[38] demands a comprehensive regulatory framework to ensure transparency, security, and fairness. Regulatory measures should include mandatory approvals and rigorous cybersecurity protocols for VASPs, alongside robust fraud and Anti-Money Laundering (AML) standards[39]. Effectively combating misconduct and promoting a reliable and long-lasting VDA ecosystem require interagency cooperation. These steps are intended to strengthen investor protections, encourage the creation of economic value, and preserve the integrity of the market for digital assets.

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