[Kartik and Sharmishtha are students at Symbiosis Law School, Noida.]
Cryptocurrencies are digital tokens used as a medium of exchange, secured and verified by cryptography. They are designed to be quicker, cheaper and more reliable than the regular government-issued money given the virtual nature of the token, and they allow the users to store, send and receive the currency without the aid of the government or any other intermediary in an affordable manner. In this article, the attempt of the authors is to navigate through the global developments as regards cryptocurrency and thereafter examine the regulatory issues that are critical to the evolution and growth of cryptocurrency in India.
The global market for cryptocurrency
Cryptocurrencies gained popularity especially in cross border trade because of free flow of money, facilitated in turn by the lack of domestic restrictions. Countries in Asia such as Japan and South Korea have become leaders in the cryptocurrency market, and they are predicted to exercise more influence in the future.
In Japan, cryptocurrency is regulated as a crypto-asset and not a security under the Financial Instruments and Exchange Act (FIEA). Crypto-asset is defined under FIEA as a proprietary value which may be exchanged reciprocally or for payment to an unspecified person not denominated in fiat currency. On the other hand, South Korea regulated cryptocurrency as virtual currency securities until 2017, when the sale of cryptocurrency at exchanges and initial coin offerings was banned, and thereafter revived by way of amendment to the Act on Reporting and Use of Specific Financial Information in March 2020. The UK took a different approach and put out taxonomies to guide regulation in the future with bitcoin and its equivalents being referred to as ‘exchange tokens’, clarifying that cryptocurrency is not considered as money and that capital gains tax would be collected on cryptocurrency transactions.
Cryptocurrency gained popularity in India with pioneers like BtcxIndia, Unocoin, and Coinsecure offering cryptocurrency exchange along with trading services in India, followed by other digital currencies such as Zebpay, Koinex, and Bitcoin-India. With the onset of crypto trading and exchange platforms, the crypto market has grown significantly with an increase in over-the-counter (OTC) crypto shops established apart from the online platforms for exchange.
Domestic regulatory framework
The power to legislate on matters of 'currency, coinage, legal tender, foreign exchange and bill of exchange, cheques, promissory notes and other like instruments respectively' is vested on the central government under Entries 36 and 46 of List I of the Seventh Schedule of the Constitution of India. Therefore, it is important to understand how cryptocurrency is defined within the scope of the central legislations in order to regulate legal tender and banknotes. Until now, there has been no specialized law which defines 'cryptocurrency' or 'virtual currency' (VC) or gives any recognition to the same. Section 22 of the Reserve Bank of India Act 1934 (RBI Act) confers upon RBI the sole right to issue banknotes and currency notes of the Government of India and makes it the sole repository responsible for the management of currency notes and bank notes. However, cryptocurrencies or VCs do not come under the ambit of currency or banknotes, as they have neither been issued by the RBI nor recognized as legal tender. Further, Section 2(i) of Foreign Exchange Management Act 1999 (FEMA) defines 'currency notes' as cash only in the form of coins and banknotes, which term does not include cryptocurrency or any VC issued either under the Coinage Act 2011 or the RBI Act. Therefore, cryptocurrency cannot be considered as currency notes.
The boycott imposed by RBI
The RBI vide notification dated 6 April 2018 (VC Notification) prohibited all RBI regulated entities from dealing in VCs or providing services in relation thereto and provided a three-month period to shut down their dealings in the same, putting an end to all financial dealings in cryptocurrency and affecting individuals and businesses who are left with no channels to continue dealing in VCs through regulated electronic payments or convert their VCs to Indian rupees through the banking system.
RBI discouraged the parties in dealing in VCs due to lack of accountability and its subsequent inability in regulating VCs, leaving no recourse for cases of technical glitches in transfer of funds. Before the VC Notification, the RBI and the Ministry of Finance on 24 December 2013 had highlighted the risks associated with VCs being susceptible to high volatility as they are not backed by any underlying asset and are exposed to legal and financial risk due to their unclear status in the international market.
Judiciary's approach to cryptocurrency
A three-judge bench of the Supreme Court quashed the VC Notification in Internet & Mobile Association of India v. RBI and held that despite cryptocurrencies not being legal tender, they function as a medium of exchange, units of account and stores of value, which make cryptocurrency viable for use as consideration for goods or services and subject to RBI’s purview. The VC Notification was held as a colourable, disproportionate and unreasonable exercise of power. The court further observed that the RBI failed to demonstrate the extent of damage caused to regulated entities like banks and financial institutions while pointing out the risks and the illegal purposes associated with cryptocurrency. While analyzing existing regulatory frameworks for cryptocurrency, the court noted that a similar structure can be implemented in India.
Other regulatory issues
For regulating VCs as legal tenders, RBI has to accommodate the lack of recognition of VCs as deposits in any other form. For instance, the Companies (Acceptance of Deposits) Rules 2014 regulates companies accepting receipts of money by way of deposit or loan or in any other form by demarcating the transactions falling under a ‘deposit’ and provides categories exempted from its application. It, however, does not provide for receipt of VC by a company as a deposit.
VCs cannot qualify as securities because there are no underlying assets or identifiable issuers. However, VCs may fall under ‘collective investment scheme’ as an instrument and hence under the purview of SEBI, which has jurisdiction over registration and regulation of collective investment schemes under Section 11(c) of the SEBI Act 1992. The Allahabad High Court in Paramount Bio-Tech Industries v. UOI ruled that to determine whether an instrument falls under ‘collective investment scheme’, the Howey Test (SEC v. Howey) must be satisfied, which provides for three features for the instrument to qualify as an investment contract viz money investment, an expectation of profit, and the profit so generated being the efforts of the issuer of the instrument.
Taxation of cryptocurrency
In India, tax is either levied on income (direct tax) or expenditure (indirect tax), and VCs can be taxed on both income and expenditure generated from them.
Direct tax in India is governed by the Income Tax Act 1961 (ITA). Under the ITA, the income from VC may be treated as capital gains, as in the UK, or as profits and gains of business or profession (and hence taxed under ‘income from other sources’).
Indirect taxes are primarily governed by the Central Goods and Services Tax Act 2017, the Integrated Goods and Services Tax Act 2017 and the respective state legislation as applicable. The Tariff Schedule for Goods does not contain any specific section for VCs but contains a residuary category for goods, which may include VC as goods also include intangibles, and goods and software are treated alike as they are both movable property.
The future of cryptocurrency in India
The Indian government needs to choose between standardizing regulatory framework for cryptocurrencies by introducing it as a separate asset class or security, like Japan and South Korea, and imposing an outright ban on cryptocurrencies, like China, Pakistan, and Indonesia. In the case of the latter, it will have to demonstrate using research and data whether a ban is required and justified. So far, no country has demonstrated through data or research any negative ramifications of cryptocurrencies on the macroeconomy. The lack of accountability on the part of the issuer makes cryptocurrencies a potential means to launder dirty money or fund criminal or terrorist activities.
VCs, if not recognized as a medium of exchange or as a security, can be treated and regulated as a commodity by SEBI, if notified as specific goods under the Securities Contracts (Regulation) Act 1956 by the Central Government. However, the SCRA notification only applies to commodity derivatives and not ready derivatives contracts, therefore it is unlikely that VC would be regulated as a commodity.
Therefore, in the authors’ view, it is recommended that a regulatory framework for the effective functioning of cryptocurrencies is required to be established, which provides for the protection of rights of the investors by ensuring transparency, disclosure and accountability in transactions. The approach that has to be taken by the regulators is to first understand the functioning of VCs and how it could be regulated. Regulation of cryptocurrency would not only facilitate international trade but also allow for curbing the negative impact of the use of VCs including illegal activities such as money laundering.