• Prakriti Patnaik

NFTs and Mapping its Regulation in India

[Prakriti is an Advocate practicing at the High Court of Odisha and a Legal Research Associate at the Department of Public Policy in KIIT Deemed to be University, Odisha.]


Traditionally, owning anything was primarily physical in nature, but the introduction of non-fungible tokens (NFT(s)) changed it. An NFT is a digital token or asset that cannot be changed throughout time. Fungible tokens are divisible and non-unique like the dollars or fiat currencies, whereas NFTs, are unique and non-divisible. They are a form of deed or title of ownership for a one-of-a-kind, non-replicable item, like an artwork.


NFTs represent the ownership of things on a digital platform that is fully secure and registered in the individual’s name. It is a token or a code that is owned by an individual who is on the block formed under the technology of the blockchain. A blockchain is a distributed ledger technology by which transactions may constitute various information, a number, a code, or a token, which are secured through the process of verifying or substantiating them on the network through the process of cryptocurrency. Therefore, the process of purchasing and selling NFTs is very secure and transparent as the history of NFT ownership is verifiable by blockchain users. The market price of an NFT is contingent on the digital file it substantiates and the demand for purchasing NFTs decides the market value. While NFT trading began circa 2017, it gained popularity in early 2021.


What Does an NFT Purchase Constitute?


An NFT purchase constitutes the purchase of data or a code that indicates to a server that hosts the picture or a video which we all see as an NFT. It is not the image that we purchase but the specific code or data which represents that image that one owns on the blockchain by issuing a unique cryptographic key to represent the item. It is essentially metadata that is minted on a blockchain and stored in the form of a link. Furthermore, it functions as a digitized token that symbolizes real-life objects, like a certificate of ownership for virtual or physical assets. Generally, NFTs are part of the blockchain called “Eth”. Ethereum (Eth) - a cryptocurrency, just like “BTC” or “Doge”.


NFTs could be anything at all - an image, a video, music, sports collections, even tweets, and a signature that can be bought or sold as NFT. However, why should one purchase an NFT, when it is possible to find the exact copy over the internet to download for free? One approach is that NFTs are designed to provide the purchaser with a unique asset incapable of reproduction, in addition to the fact that the artist may still hold original copyright and reproduction rights of the (physical or digital) artwork, moreover, the prints or artworks which are available for ‘free’ online are mostly pirated versions, therefore, free downloads are available but not necessarily legal. As an example, the reader may consider that anyone can purchase a copy print of the famous painting of the Mona Lisa but only one France owns the original. Therefore, NFTs are emerging as a new avenue for artists to earn from their artwork.


Indian Regulatory Framework


The Government of India has included NFT in the virtual digital assets in the Finance Bill 2022 (Finance Bill) and thus, taxes have been imposed at a 30% rate. Apart from imposing taxes, there are no other regulations that have been made for regulating them in India. As cryptocurrencies are taxable under the Income Tax Act 1962 as ‘virtual digital assets’, hence NFTs are also included as ‘virtual digital assets’ in the Finance Bill, due to the similar concept of trading and storing data in blockchain technology. They can be considered a subset of cryptocurrency. The primary barrier in NFT trading appears to be the uncertainties surrounding the legal legitimacy of cryptocurrencies in India. The Reserve Bank of India (RBI) on 6 April 2018, through the issuance of a circular, cautioned users by prohibiting them from dealing in virtual currencies (RBI Circular). Soon thereafter, the Supreme Court of India set aside the RBI Circular on 24 March 2020, in the matter of writ petition (civil), Internet and Mobile Association of India v. Reserve Bank of India, which violated the fundamental right of Article 19(1)(g) of the Indian Constitution. Thus, the RBI came up with another circular that did not prohibit the users to deal with virtual assets but instructed banks and other entities to carry out necessary due diligence processes for transactions in virtual currencies, in line with the governing standards for the know-your-customer guidelines and anti-money-laundering regulations, to ensure compliance with relevant provisions under the (Indian) Foreign Exchange and Management Act 1999 and International Convention for the Suppression of the Financing of Terrorism 1999. The exchanges of the marketplace are identical to cryptocurrency exchanges. An NFT is auctioned on the platform and the highest bidder gets it. The medium of exchange being cryptocurrencies, a few NFTs can also be bought in dollars or fiat currencies.


Regulation Of Ownership


NFTs represent various types of things, but the digital art form is the most popular form of NFT in India. Consequently, it is a digital copy or a token of an underlying original work, however owing an NFT does not confer the ownership. A smart contract is made available prior to any transaction of the NFT which mentions the terms and conditions of the sale establishing the ownership of the NFT by the buyer, such as if the buyer has the copyright rights or is authorized to use it for personal non-commercial purposes; they are a predefined contract which is drafted by the platform in the form of computer code and processed by the blockchain, however, contracts for NFTs may be in digital form as well due to the grey areas in the regulation. Once the rights are determined in compliance with the Copyright Act 1957 (Copyright Act), the buyer would be treated as the owner of the specific version of the original copyrighted work. The contract comes into effect once the payment has been made and both the parties would be regulated under the laws of the Indian Contract Act 1872. The parties to this smart contract are the seller and the purchaser with the platform companies (Binance, WazirX, etc.) being mere intermediaries. Moreover, irrespective of the contractual terms between the parties concerning among others, the copyright, and the moral rights of the artist (here, seller) are protected under Section 57 of the Copyright Act. Particularly, these rights exist independently and comprise the right to (a) claim authorship of the work; and (b) the right to claim damages for distortion to the work, or any adverse reputation effects. Therefore, the key distinction between the difference between purchasing an NFT and the original work, is that the copyright in the original does not automatically vest in the buyer on the purchase.


Securities Law Regulation


Renaming cryptocurrency into a crypto asset is brought under the governing ambit of the Securities and Exchange Board of India (SEBI), under the proposed Cryptocurrency and Regulation of Official Digital Currency Bill 2021 (Crypto Bill), to avoid the overlapping between ‘crypto-assets’ and the ‘digital currency’. ‘Cryptocurrency’ is being considered as a ‘digital token’ i.e., a digital representation of the securities that are evidenced on and can be electronically received and stored using distributed ledger technology and therefore brought under the security regulations. However, categorizing NFTs as commodities can create many complications. It would be difficult to regulate them as these digital assets do not have a pre-set value as they are subjected to the free market. Presently, due to a lack of definition, there is ambiguity on whether they are currency or a commodity.


NFTs as Derivatives under Securities Law


As discussed above, NFTs are yet to be categorized as securities under, among others, the SEBI framework. Some argue that NFTs are merely contracts, while others argue that NFTs are derivatives because of their properties. If the latter is true, it would provide legal backing to a ban on trading. Section 2(ac) of the SCRA states that derivatives include: (a) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security; or (b) a contract which derives its value from the prices, or index of prices, of underlying securities. Additionally, derivatives of a contract are only valid if they are traded and settled on a recognized stock exchange in accordance with the laws of that exchange, as per Section 18A of the SCRA. Therefore, until NFTs are categorized or recognized as ‘securities’, NFT trading platforms will remain largely unregulated.


As previously noted, being non-fungible, and the inability to be replaced sets them apart from other securities. As a result, designating a particular NFT as security (derivative) would be inappropriate if it simply pertains to an existing asset and is given as a guarantee of the asset's validity. Rather, contract rules should be used as a guide. If classification and authorization will go hand in hand, it may be unlikely for the regulator to classify NFTs as a derivative and permit trading. Be that as it may, there is no requirement of authorization as they are constructed more like platforms for exchanges where a purchase takes place with a payment of a nominal gas fee (it is an amount paid towards the computing energy to validate NFT transaction on the blockchain). A lot of the leeway has to do with marketing gimmicks, and the Advertising Standards Council of India released guidelines for crypto advertising.


Conclusion


Certainly, there are a lot of concerns, particularly when the nation is still struggling with the cryptocurrency conundrum of regulation. The easy trading of NFTs in India requires the legalization of cryptocurrencies. Trading is risky unless and until a definitive decision on the legality of cryptocurrencies is reached. In India, there is currently no specific legal framework for regulating NFTs, hence they are controlled by general contract principles. Nevertheless, if the Crypto Bill would build out exemptions for NFTs apprehending its extensive demand and new regulations would be capable of providing long-term solutions to this new facet of technology. Although the future of NFTs remains uncertain, it is dicey that they are here to stay and be regularized.

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