Legalising trade in Cryptocurrency

Taxation

Legalising trade in Cryptocurrency

By Faranaaz G Karbhari on 04 Mar 2020

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Author by Faranaaz G Karbhari

While disposing of the Civil Writ Petition in the case of IAMAI v RBI, Supreme Court on March 4, 2020 set aside the ban which the Reserve Bank of India’s (RBI) had put on financial institutions providing banking services to cryptocurrency businesses. Although the said judgment, according to which the RBI’s measure violated Article 19 (1) (g) for virtual currency exchanges, has nonetheless cheered the industry but contains a multiple red flag.

Bitcoin is the preeminent cryptocurrency and first to be used widely. However, hundreds of cryptocurrencies exist, and more spring into being every month. Cryptocurrencies use cryptographic protocols, or extremely complex code systems that encrypt sensitive data transfers, to secure their units of exchange. Cryptocurrency developers build these protocols on advanced mathematics and computer engineering principles that render them virtually impossible to break, and thus to duplicate or counterfeit the protected currencies. These protocols also mask the identities of cryptocurrency users, making transactions and fund flows difficult to attribute to specific individuals or groups.

One can generate bitcoins or other cryptocurrencies by solving problems available in the blockchain network. Once the problem is solved a new block is added and bitcoins are generated accordingly. Generally CGMiner and GUIMiner software/s are used for mining. The person or group of persons that solves the problem are called miners who can sell the bitcoins to end users either directly or through exchanges such as Zebpay and Unocoin. The end user can use bitcoins as a medium of exchange just like a currency by sending a transaction request to another user who agrees and proceeds with the transaction. The blockchain verifies the transaction via the global network, transferring the value from one user to the next and inserting cryptographic checks and verification at many levels (nodes). Since Bitcoin is not recognised as a legal tender in India, this process cannot be realised. However, Bitcoin trading which is not yet illegal has gained momentum and exponential growth of its price. The Current value of one Bitcoin is INR 5,76,848.18.

Here the primary issue is regarding the legal sanction of the virtual currency by stringent regulations and combating the crimes that would be triggered out of it. Many countries have regulated bitcoin operations like some parts of USA, Australia and Canada among others. Recently, Supreme Court in Dwaipayan Bhoumik v Union of India has directed the Central Government to clarify the legality of bitcoin in India.

Legal Issues

Bitcoins regulation would create several encumbrances in the following forms. Firstly, determining the nature of the bitcoins could be a problem for RBI would contend that it should come under it by virtue of it being a currency whereas SEBI would contend that it is a security. Secondly, the functional definition of Bitcoin or the wallet would not come under the ambit of IT Act 2000. Thirdly, even if a separate statue is enacted, provisions to combat crimes of distinct nature would cause problem. Bitcoins could be a lucrative tool to commit cyber offences like money laundering, drug trafficking, terror funding, tax evasion, kidnapping and ransomware attacks and theft of bitcoins from wallets of end users. In Slovenia hackers stole bitcoins worth 64 million dollars from a mining company. Similarly, in India, bitcoins fraud in relation to miners have tremendously increased. However, the greatest challenge would arise with respect to imputation of criminal liability when a crime illustrated below would commence.

Moreover, due to the irreversible nature of the transaction the bitcoins could not be retrieved. Thus there would be a problem of jurisdictional determination firstly, due to the anonymous nature of the transaction where it would be very difficult to trace the flow of bitcoins from one jurisdiction to another. Secondly, the cumbersome process of the Code of Criminal Procedure section 166A and 166B would further delay the process of investigation. Fourthly, it would affect the computation of tax structure. There could be two possibilities, one taxation of miners who have generated bitcoins which might not fall under Section 55 of the Income Tax Act. 1961(generating bitcoins might not come under the ambit of cost of acquisition) and secondly of those who hold it as an investment instrument (whether long term capital Gain tax or short term). Finally, given the lack of technologically skilled investigating officers in the police department and lack of infrastructure in relation to cyber offences, imputation of criminal liability would further become problematic in the following manner.

RBI Ban Cryptocurrency

As part of the proceedings, the RBI accepted the fact that it never implemented a ban on Bitcoin but rather “instructed” banks to simply refrain from dealing with cryptocurrency exchanges

The RBI has maintained that owing to ‘significant spurt in the valuation of many virtual currencies and rapid growth in initial coin offerings’, virtual currencies were not safe for use. It had, in 2013, cautioned ‘users, holders, and traders of virtual currencies, including bitcoins, about the potential financial, operational, legal, customer protection, and security-related risks that they were exposing themselves to’. The RBI had on April 6, 2018, said it had repeatedly ‘cautioned users, holders, and traders of virtual currencies, including bitcoins, regarding various risks associated in dealing with such virtual currencies. As a follow-up to those warnings, it had barred all entities which are regulated by the RBI from either dealing in virtual currencies or providing services to those dealing in such currencies.

Reasons for the curb by RBI

  • Losses caused due to hacking, malware attacks, compromise of access credentials, loss of passwords etc. Since there is no authorized central agency to govern it, there could be the loss of e-wallet which could cause the permanent loss of virtual currencies stored in such e-wallets.
  • Price volatility of virtual currencies could lead to potential loss to the customers for the reason value of virtual currency is the result of speculation. For instance in the past cryptocurrencies turned into rage in 2014 when the price of Bitcoin (the most well known currency) escalated USD 1,000. While the rally ended soon after, the frenzy continued when the prices of the Bitcoin went past USD 10,000 in the month of December 2017. Retail investors, uninformed of the dangers, started converging on virtual currencies exchanges in the nation, making volumes to rise in December 2017 and January 2018.
  • Use of such virtual currencies could lead to money laundering, tax evasion and fraud due to the untraceable nature and difficulty in evaluating the taxability of the transaction. RBI also cited media reports which claim that dealing in such virtual currencies could lead to illicit activities. One can use it to buy and sell drugs or weapons.
  • There are also legal and financial risks associated with dealing in virtual currencies to the investors as the legal status of the exchange platforms established in several jurisdictions is not clear. Apart from the price volatility, numerous unregulated cryptocurrency exchanges started mushrooming in the nation, putting investors to great dangers.

Supreme Court’s Decision on Cryptocurrency

The Supreme Court lifted the ban imposed by the Reserve Bank of India (RBI) on virtual currency trading, including cryptocurrencies. on the “ground of proportionality”.

When the consistent stand of RBI is that they have not banned virtual currencies and when the government of India is unable to take a call despite several committees coming up with several proposals, including two draft bills, both of which advocated exactly opposite positions, it is not possible for us to hold that the impugned measure is proportionate,”

The RBI’s core defence included arguments claiming that cryptocurrencies pose a huge threat to the nation’s monetary system and overall stability. Additionally, the RBI also stated that digital currencies were being used mainly by bad actors for money laundering, tax evasion, financing of terrorism-related activities, and so on. Lastly, the RBI’s legal counsel argued that crypto should be banned simply because a number of high-profile finance experts and economists such as Warren Buffet are against it.

The Court held that the RBI’s circular, which prevented regulated entities from providing banking services to those engaged in the trading or facilitating the trading in VCs, was liable to be set aside on the “ground of proportionality”.

When the consistent stand of RBI is that they have not banned VCs and when the Government of India is unable to take a call despite several committees coming up with several proposals including two draft bills, both of which advocated exactly opposite positions, it is not possible for us to hold that the impugned measure is proportionate”, the Court observed.

The Court took note of three factors while setting aside the circular:

  1. RBI has not so far found, in the past 5 years or more, the activities of Virtual Currency exchanges to have actually impacted adversely, the way the entities regulated by RBI function.
  2. The consistent stand taken by RBI up to and including in their reply dated September 4, 2019 is that RBI has not prohibited Virtual Currencies in the country and
  3. Even the Inter-Ministerial Committee constituted on November 2, 2017, which initially recommended a specific legal framework including the introduction of a new law namely, Crypto-token Regulation Bill 2018, was of the opinion that a ban might be an extreme tool and that the same objectives can be achieved through regulatory measures.
  4. The court also referred to cryptocurrencies as a “by-product” of blockchain technology and said the government could separate the two.

Conclusion

Clarity is, however, it is much awaited to be seen how vulnerable is the future of crypto currency in India, given the judgment of Supreme Court with red flags together with a draft bill, released on Feb 28, 2020 banning the use of cryptocurrency as legal tender in India. The said draft bill prohibits mining, buying, holding, selling, dealing in, issuance, disposal or use of cryptocurrency.