The government in the Union Budget 2022 had introduced regulations to tax incomes from Virtual Digital Assets (VDAs), which have been defined in an exhaustive manner consisting of crypto assets, NFT, or any other token of a similar nature.
What are crypto assets for income tax purposes?
As per the Income-tax Act, 1961, crypto assets include any information, code, number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, that can be transferred, stored or traded electronically; providing a digital representation of value exchanged with or without consideration, with the promise or representation of 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 an investment scheme).
The definition covers all types of information, code or token generated through cryptographic means. In effect, it covers all types of cryptocurrency, irrespective of the underlying blockchain technology and name given to it.
NFTs are unique and non-interchangeable units of data, which is stored on a digital ledger termed as a blockchain and can be traded with interested buyers. In other words, an NFT is a proof, i.e., a token of ownership of the underlying digital/ physical asset, which is stored on a secured digital ledger, i.e., blockchain. It may be equated to dematerialised share certificate evidencing ownership of the underlying share.
Similar to cryptocurrency, NFT also uses cryptography and blockchain technology to secure transactions. However, the similarity ends there. The value of cryptocurrency depends on market forces of demand and supply whereas in NFT it depends on the value of an underlying asset. Further, cryptocurrency is “fungible” meaning it can be easily traded or exchanged for one another whereas an NFT is unique and not easily interchangeable. NFTs can be compared to digital passports because each token contains a unique, non-transferable identity to distinguish it from others.
Taxation of crypto assets and NFTs
To specifically tax crypto assets and NFTs, the government had amended section 2(47A) of the Income-tax Act. The amended law included the definition of crypto assets, a non-fungible token and any other token of similar nature.
It was also notified that any income from the sale or transfer of crypto assets or NFT is to be taxed at 30%. Further, no deduction is allowed except for the cost of acquisition.
Additionally, TDS at the rate of 1% is applicable whenever there is a sale or transfer of crypto assets or NFT.
While the taxation of VDA was introduced in the Union Budget 2022, the clarity on NFT being covered under the definition of VDA was provided by the government in a recent notification issued on June 30, 2022. The notification has further provided clarity that NFTs which represent ownership in underlying digital assets shall qualify as VDA.
An NFT would be covered under the Income-tax Act if it meets the prescribed conditions i.e.,
- It is any information, code, number or token (not being Indian currency or foreign currency) generated through cryptographic means or otherwise,
- can be transferred, stored or traded electronically;
- providing a digital representation of value exchanged with or without consideration, with the promise or representation of 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 an investment scheme).
Thus, a token which qualifies as VDA within the definition provided under the Income-tax Act would qualify as an NFT. However, if sale or transfer of any NFT results in the transfer of ownership of the underlying tangible asset and the transfer of ownership of such underlying tangible asset is legally enforceable, then it will not be treated as VDA. Sale or transfer of such NFT would be governed under the existing provisions of the Indian tax laws.
Here is an example where an NFT will not be considered as a VDA for the purpose of taxation. Suppose Mr A holds physical handwritten books of his father as an antique possession and sells those via NFT. This transaction is likely to be regarded as an excluded NFT if the transfer of NFT leads to a legally enforceable transfer of the ownership of the books. However, the transfer will be considered for taxation as per the existing provisions (i.e., taxable as capital gains or business profits, as the case may be) under the Indian tax laws, provided it doesn’t qualify as ‘personal effects’. If the capital asset qualifies as personal effects, there would not be any tax implications in the hands of Mr A.
Lifecycle of NFT
It is important to understand the lifecycle of an NFT because it is created from an underlying tangible asset. One needs to know how an NFT is created and when do income tax implications arise.
1. Creation of a digital asset, which converts the physical securities into a dematerialized form. Upload of the digital asset on a marketplace for selling the same.
2. There is a requirement to create ownership for the asset. In technical terms the process of creating ownership of the dematerialized asset is called ‘minting’. Since there is no transfer of asset at the time of minting, there are no tax implications.
3. Once the asset uploaded on the marketplace is sold, there will be tax implications in the hands of the seller and the cost of acquisition will be the cost for acquiring the underlying asset.
Here is an example of how lifecycle of an NFT works.
A company is engaged in the business of creating NFTs of cartoon characters (in GIF format) after obtaining the required copyrights. Once the digital image of a cartoon character is created, it is uploaded to the marketplace for interested buyers. The sale of such cartoon character NFT will be subject to tax as VDA if the NFT satisfies the conditions under the Income Tax Act. Also, such transfer or sale of the NFT does not lead to transfer of underlying tangible asset which is legally enforceable.
The income from the sale/transfer of such NFT would be taxable at 30% (slab-wise surcharge and cess would also be applicable) with a deduction for the cost of acquisition (i.e., the cost of buying the copyright of cartoon character GIFs). Currently, permissibility of deduction u/s 80C is a debatable issue and requires clarification from CBDT, although the intent of CBDT appears to not allow such deduction
With the fast-evolving nature of technology and the nascency of the blockchain mechanism, we can expect further clarity on the tax implications of the NFT and similar assets over time. Having said that, since there is no benefit available of indexation for VDA and no other expenses allowed as a deduction (except the cost of acquisition), the income from the transfer of VDA will be taxable at 30% and with the applicability of slab-wise surcharge and cess, the maximum tax rate can go as high as 42.744%.
(Amarpal S. Chadha, Tax Partner, EY India. Inputs from: Shanmuga Prasad (Director, EY India. (Views expressed are personal.)