With digitization sweeping the world and almost every aspect of our life becoming largely attached with, and in some cases dependent on, technology, it is no surprise that currency has also transmuted into what we know today as cryptocurrency. While the genesis of cryptocurrency can be traced back to a little more than a decade ago, it is now that cryptocurrencies have finally manifested their potential and taken the world by storm.

Cryptocurrencies can be broadly divided into two categories, the first being coins, and the second one being tokens. Even though both are unequivocally dependent on the blockchain technology to exist, their methods of operation differ. While coins require an independent blockchain to function, tokens have no such specific requirement and can exist on another blockchain's technology. For instance, Ethereum is a coin which functions only on the Ethereum blockchain. If an individual is paid in Ethereum, this transaction will be recorded within the Ethereum blockchain. Similarly, if an individual is paid in bitcoin, and not Ethereum, it is the Bitcoin blockchain that will record it as a separate transaction. Tokens, however, can function on any blockchain as long as its coding supports the token. Tether, BAT and BNT are some of the tokens that function on the Ethereum blockchain.

This article focuses on Non Fungible Tokens (token/ NFT) and touches upon the aspects of intellectual property rights and taxation related to NFTs. NFTs have a unique digital footprint, which makes them irreplaceable. This uniqueness can be attributed to a distinctive asset associated with each token, such as art, gif, music, video clips, etc. NFTs can be coded in a manner so as to function on various blockchains, however, the most preferred one remains Ethereum, for its ability to handle complex contracts, thus putting it ahead of Bitcoin. The inherent value in an NFT is, as the name suggests, the fact that it is non-fungible. This is, in a sense, a distinguishing factor when compared with other cryptocurrencies or fiat currency since these are fungible in nature and can be used interchangeably with another unit of the respective currency.

Drawing an analogy with coins, which depend on blockchains, tokens rely on the mechanism of 'smart contracts'. Smart contracts are, in essence, just like contracts that parties may enter into in a physical setting, however, the crucial difference lies in the fact that smart contracts are not governed by provisions written down on paper. Smart contracts envelop within them all the clauses, sanctions and provisions that are present in a physical contract, but in the form of codes. The provisions are coded into a format that can be executed on a said blockchain. A smart contract is potentially a more reliable and efficient mechanism since it administers enforcement, management, performance and payment. Thus, two parties, after executing a smart contract have to simply fulfill their obligations and in case they don't, the contract is automatically rescinded. While the pros of smart contracts, such as transparency, efficiency, and exclusion of intermediaries, are well known, there are cons as well, such as the blatant disregard for the 'spirit of law' whereby the contract cannot take into account any extraneous factors which may have led to the non-fulfillment of the contract's terms.

IPR & Ownership

Coming to the Intellectual Property Rights (hereinafter referred to as "IPR") that are associated with Non-Fungible tokens, one may be under the impression that the sale of an NFT associated with an artwork or a piece of audio would imply that the underlying IPRs associated with the same would also stand transferred from the owner to the purchaser. Regardless of how obvious it may sound, this is not the case with NFTs, unless it is explicitly agreed in the smart contract. The sale of an NFT is analogous to an artist selling a physical copy of an artwork. The sale of physical artwork does not imply the sale of the underlying IPRs, and the artist continues to be the owner of the associated IPRs. Similarly, in case of an NFT, it is only possession that an individual acquires, and has the right to subsequently sell it to another individual. The transaction which would be recorded in the blockchain will prove the ownership of the said artwork, and not the IPRs attached to it. In technical terms, an NFT can be described as metadata that gives information about the underlying asset. To elaborate further, if an individual buys an NFT associated with an artwork, the said individual cannot print that artwork on a shirt or a cap since the ownership rights still exist with the owner and would thus lead to copyright infringement.

The generation of royalty on NFTs depends on smart contracts. Each time an NFT is sold in the online market, a percentage of the sale stands transferred to the creator of the NFT. This royalty generation system can be adjusted through a smart contract where the percentage of royalty attached to the NFT can be prescribed (on a standard basis, the percentage stands anywhere between 5-10%). Smart contracts automatically execute tenets of the contract, hence the royalty is automatically transferred to the creator as and when the sale takes place. One particular aspect that must not be overlooked is that this royalty generation system is not inherent in every smart contract, and just like the requirement of explicitly stating terms regarding the transfer of IPRs, the royalty ascribed and the accompanying percentage needs to be expressed specifically. The concept of NFTs and smart contracts caters well to content creators, artists, etc. since there is a way through which transactions can be tracked as opposed to physical sales. In the physical world, once a book or a painting is sold, no royalty is accrued to the creator on a resale of the said item.

The Tax Traumas

Given that the buying and selling of NFTs have so many features of a physical transaction, there are bound to be tax implications. The increasing scale and volume of these transactions, have further made it necessary to establish a distinct tax structure.

The Union Budget 2022 proposes that future income from the sale of virtual digital assets, including NFTs would be taxed at a fixed rate of 30%. Section 115BBH, which provides for the said tax, has been inserted by the amended Finance Bill, 2022 and shall be brought into effect from 1.04.2023.  Additionally, on all payments made for the transfer of digital assets, a TDS of 1% will be applicable. The Finance Minister has further clarified that except the cost of acquisition, no deduction for any expenditure or allowance shall be permitted for computing income from the sale of virtual digital assets. Also, a loss incurred from the sale of a digital asset cannot be set off from any other source of revenue.

While the government's decision towards eliminating uncertainties around the tax treatment of cryptocurrencies is laudable, given the high frequency and value of transactions, the imposition of 1% TDS has not been received very well by the players.

As per the Finance Act, 2020, 2 % equalization levy shall be levied on NFT transactions by a non-resident 'e-commerce operator' on the amount received/receivable by them. However, the idea of a 2 % equalization levy for cryptocurrencies within India was shot down by the Finance Minister since it is to be levied upon 'e-commerce operators' and not investors.

RBI's Stance post 2018 Circular

The stand of the RBI has changed from absolute prohibition to allowing banks to deal in virtual currency after a process of due diligence conducted by banks to ascertain where the money to invest in virtual currency is derived. In the RBI master circular dated 6th April, 2018, the RBI prohibited entities regulated by it from providing any service in relation to virtual currency with immediate effect including those of transfer/receiving of any money to buy and sell virtual currencies. It gave banks already dealing with virtual currency transactions a mere 3 months to exit such transactions. The reasons cited by RBI included consumer protection, money laundering, national security and market manipulation.

The Supreme Court on 3rd July 2018, refused to stay the order and thus, no one could effectively buy or sell virtual currencies in the Indian market. Banks such as SBI and HDFC, relying on the 2018 RBI circular, advised their customers not to deal in virtual currencies, the penalty for which would be cancellation or suspension of their cards. Eventually, the Supreme Court in the Internet and Mobile Association of India v RBI writ petition of 2018 set aside the 2018 RBI circular and allowed all financial institutions to deal in virtual currency. RBI thereafter clarified its position on cryptocurrencies and stated that banks cannot henceforth rely on the 2018 circular and are allowed to trade in cryptocurrency after requisite due diligence and abiding by standard norms relating to KYC (Know Your Customer), AML (Anti Money Laundering), CFT (Combating of Financing of Terrorism) and obligations of regulated entities under Prevention of Money Laundering Act, 2002.

While the status remains so, the Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (Draft Bill), has been on the government's agenda and was to be introduced during the last parliamentary session. The objective of this Bill, as stated in the bulletin of the Lok Sabha dated November 23, 2021, is "to create a facilitative framework for the creation of the official digital currency to be issued by the Reserve Bank of India." The Bill seeks to ban all private cryptocurrencies in India, and to promote the official digital currency to be issued by the Central Government. Even though the proposed Bill was not debated in the winter session, the mere proposal has sparked a lot of concern about the legality of cryptocurrencies in India.

While the government is deliberating upon the text of the Bill, it will be interesting to watch what course digital currencies in India finally tread on.

This article is for information purpose only. It is not intended to constitute, and should not be taken as legal advice, or a communication intended to solicit or establish commercial motives with any. The firm shall not have any obligations or liabilities towards any acts or omission of any reader(s) consequent to any information contained herein. The readers are advised to consult competent professionals in their own judgment before acting on the basis of any information provided hereby.