CRYPTOCURRENCY TAXATION UNDER THE INCOME TAX ACT, 1961

Introduction

Cryptocurrency (‘crypto’) is an ideal example of the intersection between finance and

technology. The reason being, This is because technology makes crypto decentralized and
unregulated, which gives rise to concerns related to finance. One such concern is taxation, and
this is precisely the backdrop against which this paper is set. Structurally, the paper is divided
into three parts. First, I will critique the scheme of taxation of crypto prescribed under the
Income Tax Act (‘ITA’). Furthermore, I will flag some definitional issues in the present scheme
of taxation. Second, I will employ the law and economics framework of analysis to argue that the
true purpose behind the present scheme of taxation is deterrence through negative externality.
Third, I will provide a policy design based on economic principles through which crypto should
be taxed in India.

Through these parts, the thesis of the paper is, ‘The present scheme of taxation is not sound
either from a revenue maximization perspective or from addressing a negative externality’.

I. The scheme of taxing crypto under the Income Tax Act has multiple issues.

The Finance Act 2022 inserted four components in ITA:1

 The definition of Virtual Digital Assets (‘VDAs’) – section 2(47A)

 An explanation clarifying that VDA will come under the definition of property –
section 56(2) (x).
 Imposition of 30% tax rate on transfer of VDAs – section 115BBH.
 Tax will be deducted at source for payment of consideration for the transfer of VDAs
– section 194S.

All these sections pose challenges. However, I will only mention those that raise compliance
costs. The reason for this will become apparent in Section II. Compliance costs cover all costs
that a taxpayer, as well as a third party, has to bear to comply with the tax law and other
requirements of the tax authorities.

1
The Finance Act 2022, ss. 3(c), 16(b) (iii) (b), 28, 194S.
Section 115BBH imposes a flat rate of 30 percent on the transfer of VDAs. There are two ways
in which this increases compliance costs. First, a flat tax rate obliterates the distinction between
income from capital gains and business income. Under the ITA, the former is charged at a lower
rate.2 However, in the new taxation regime, a person will not be able to seek the benefit of a
lesser lower tax rate. Second, Ssection 115BBH does not allow setting off the loss from the
transfer of VDAs against any other income.

Section 194S mandates every person paying consideration in exchange for crypto to withhold tax
at 1%. Although someFirst, ‘Specified persons’ have been given certain exemptions from the
section; however, information is needed to assess who is a specified user. This will increase the
compliance cost and will also result in a decline in trading volume since users will stop dealing
in crypto due to anonymity concerns. Further,Second, the compliance costs will be significant in
crypto-to-crypto transactions. This is because, firstly, both the parties will have to deduct tax at
the source, and secondly, the fair market value of the crypto will have to be ascertained to deduct
the tax at the source.3 Now, I will base peg this analysis of compliance costs on the policy goals
behind taxation.

[II.] The real purpose behind the taxation of crypto is that to of establishingestablish
control over virtual digital assets

i. Tax as Revenue Maximization

The first view is the traditional theory of taxation, which advocates that the purpose of taxation is
revenue maximization so that public funding activities can be financed. 4 Hence, due to the large
trading volume of crypto, it can serve as a good source of revenue. However, if revenue
maximization is the purpose, then the existing scheme of taxation of crypto is not optimal. Net
revenue equals administrative costs and compliance costs subtracted from gross tax revenue. 5
This can be derived from Adam Smith’s four canons of taxation. The second and third canons,

2
Ketan Dalal, ‘Capital gains versus business income’ (LiveMint, 24 June 2007) <
https://www.livemint.com/Money/jku4udatfPQg6HNEcoa6uK/Capital-gains-versus-business-income.html>
accessed 6 August 2022.
3
Vipul Kharbanda, ‘Addressing the Crypto Question in India: An Analysis of the Union Budget’s Crypto Tax
Regime’ (Jurist, 21 February 2022) <https://www.jurist.org/commentary/2022/02/vipul-kharbanda-crypto-
regulation-india-budget/#> accessed 7 August 2022.
4
Beverly I. Moran, ‘Taxation’ in Mark Tushnet, and Peter Cane (eds), The Oxford Handbook of Legal Studies (OUP
2012) 377.
5
ibid.

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the canons of certainty and simplicity, state that the levying of taxes should be certain, non-
arbitrary, and convenient for the taxpayer.6 Furthermore, the fourth canon states that the
difference between the amount in the public treasury and the amount recovered as tax should be
minimal.7 In other words, costs such as the salary of tax officers, the costs of legislation, etc.
must be minimal.

Now, as abovementioned, the prohibition of setting off losses from crypto (section 115BBH) and
the onerous TDS requirements (section 194S) increase the compliance cost. Furthermore,
vagueness in the definition of virtual digitals and a lack of a coherent mechanism for the
valuation of fair market value will increase the administrative costs of litigation, appeals, and
explainers.

ii. Tax as Negative Externality

The central argument of Modern Monetary Theory is that “sovereign governments face resource
constraints, not financial constraints”8.Hence, Tthe theory further advocates that the traditional
mechanism of first imposing taxation and then spending on public financing is outdated and
worked only in times of commodity-based money. With the introduction of fiat money, there
now exists a mechanism in which the government spends first and imposes taxation later. 9 This
is because unlike non-state actors, which use the currency, the state issues it. Hence, revenue
maximization is not the sole purpose of taxation. Rather, oOne such other purpose is Pigouvian
taxation. For instance, pollution imposes external costs on society that are not borne by the
private actor, the polluter. SHence, Aa tax is imposed on the polluter to ensure that, while
deciding how much to pollute, the polluter internalizes the external costs (examples are the
carbon tax and the plastic tax)10. Due to the private cost being less than the external cost, the
society faces a deadweight loss, and hence, the tool of Pigouvian taxation is used to minimize the
deadweight loss.

6
Edwin Canan, Adam Smith: An Inquiry into the Nature and Causes of the Wealth of Nations (University of Chicago
Press 1977) 639,640.
7
ibid 640.
8
Warren Mosler, Soft Currency Economics II: The Origin of Modern Monetary Theory (CreateSpace Independent
Publishing Platform 2013) 33;YevaNersisyan and L. Randall Wray, ‘Are We all MMters Now? Not so Fast’ (Levy
Economics Institute of Bard College, 10 April 2020) < https://www.levyinstitute.org/pubs/op_63.pdf> accessed 9
August 2022.
9
L. Randall Wray, Modern Money Theory: A Primer on Macroeconomics for Sovereign Monetary Systems (2nd
edn, Palgrave Macmillan 2015).
10
‘Environmental Taxation’ in James Mirrlees (ed), Tax By Design (OUP 2010)231.

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Now, I will argue that the present system of crypto taxation is an example of Pigouvian taxation.

The current approach to cryptocurrency taxation can be viewed as an instance of Pigouvian

taxation. As, The Indian regulatory landscape has been hostile towards crypto. For instance,
Section 8 of the Banning of Cryptocurrency and Regulation of Official Digital Currency Bill,
2019 states that direct/indirect mining, generating, holding, selling, dealing in, disposing, and
issuing are declared offenses and can have penal consequences. Furthermore, all these offenses
are non-bailable and cognizable”11However, this staunch opposition does not extend to Central
Bank Digital Currency (‘CBDC’), which is a digital token recognized as legal tender.12The
exclusion of ‘Indian currency’ from the ambit of sSection 2(47A) of the ITA saves CBDC from
falling within the definition; otherwise, it would have also been treated as a virtual digital asset
under the ITA. This is becauseBut even private digital currencies fulfill the three roles of
money13 (store of value, medium of exchange, and unit of value). 14Hence, Which demonstrates
that the elephant in the room is not the ‘digital’ nature of private crypto but the lack of control of
the government over private crypto. Based on this we can say thatThis is because; first, unlike
CBDCs, private crypto is not easily traceable, and hence monitoring, reporting, and surveillance
is difficult,15 and second, unlike CBDCs, crypto operates independently of financial
intermediaries such as banks because crypto is only dependent on the demand-supply in the
market.16 Hence, the central bank loses control in addressing concerns such as inflation because
crypto is independent of the monetary measure of interest rates.

The government will justify control through taxation because decentralization and (pseudo)
anonymity present in the crypto transactions makes crypto a tax haven.17Furthermore, there have
been numerous instances of crypto being used to finance terrorist activities and in money
laundering.18To sum up, those people who illegally deal in crypto impose external costs on
11
Banning of Cryptocurrency and Regulation of Official Digital Currency Bill 2019, ss. 8(1), 12(1).
12
Ministry of Finance, Budget 2022-23: Speech of Nirmala Sirharaman (IndiaBudget, 1 February 2022) para 111.
13
Micheal McLeay and others, ‘Money in the modern economy; and introduction’ (Bank of England, Quarterly
Bulletin 2014) 5, <https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-in-the-modern-economy-an-
introduction> accessed 8 August 2022.
14
Hatim Hussain, ‘Reinventing Regulation: The Curious Case of Taxation of Cryptocurrencies in India’ (2017) 10
(4) NUJS Law Review 729.
15
Anubhav Khamroi, ‘Central Bank Digital Currency – The Future of Money?’ (The Wire, 20 July 2022) <
https://thewire.in/economy/central-bank-digital-currency-the-future-of-money> accessed 8 August 2022.
16
Omri Marian, ‘Are Cryptocurrencies Super Tax Havens’ (2013) 112 University of Florida Levin College of Law
38, 42.
17
ibid.
18
Hussain (n 14) 812.

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society (iIf there is an increase in criminal activities and the focus of the sState is towards
preventing that activity, then there might occur be a resource crunch due to which welfare
activities are compromised). Hence, a high taxation rate will act as deterrence, and the external
costs due to crime will be internalized.

However, my counter-argument is that characterizing crypto taxation as a Pigouvian tax by itself

is insufficient. This is because a cardinal principle of taxation is neutrality. It Which means that
taxation should not be used to distort consumer choices, and consumers should be allowed to
make a decision based on welfare and/or economic reasons. 19However Nonetheless, one might
argue that Pigouvian acts as an exception to neutrality since it establishes equilibrium between
private costs and social costs.20 Even Tthough this is true, however, the exception is not attracted
in the present case. This is because The reason being that the issue of tax evasion, illicit
activities, and the solution of levying a Pigouvian tax is like apples and oranges. Under the ITA,
the main mode of filing returns is based on self-assessment. 21 That is taxpayers must self-assess
their tax liability based on factors such as (i)income, (ii) taxable income, (iii) under which head,
(iv) concessions, (v) exemptions, and (vi)TDS. Furthermore, techniques of summary
assessment,22 regular assessment23 and re-assessment24 are not adequate to receive taxation
because crypto acts independently of banks and financial institutions and a cloud of anonymity is
present. Moreover, it can be said that the probability of self-assessment and third-party reporting
is indirectly proportional to the compliance costs and directly proportional to the probability of
detection of tax evasion.25 As stated before, compliance costs are high and the probability of
detection is low in a crypto transaction, and thusso, negative externality by itself is not the
optimal solution. To find out about one such optimal solution through taxation, let us go to the
last section.

II.[III.] A policy design of taxation of crypto using principles of economics

19
Jason Furman, ‘The Concept of Neutrality in Tax Policy’ (Brookings, 15 April 2008) 2,
<https://www.brookings.edu/wp-content/uploads/2016/06/0415_tax-_neutrality_furman-1.pdf> accessed 8 August
2022.
20
ibid 7.
21
The Income Tax Act 1961 (‘ITA’) ss, 139, 140A.
22
ibid s. 143(1).
23
ibid s. 143(2).
24
ibid s. 144.
25
Hussain (n 17).

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The economic deterrence model proceeds on the assumption that taxpayers make the decision to
comply of complying with tax reporting based on utility. That is to say, that compliance will be
preferred if economic gains arising from finance outweigh the economic costs. The functional
expression of the model is
Declared income = f (level of income, probability of detection, penalty, tax rate). 26
HenceIt can be said that, penalty and tax rates are crucial factors. Hence, using these, I will use
through gGame tTheory which argues that the ideal solution (Nash Equilibrium) is the situation
of 'low tax rates and high penalty'.27

To arrive at a solution, I have made assumptions based on the fact that a taxpayer is a rational
person, who makes decisions based on economic gains. Where, Y denotes taxable income, r
denotes tax rate, G denotes the profit of the government, and C denotes the loss of the crypto
taxpayer. Now, Llet’s assume that the sample taxable income is 20,000 rupees, and there are two
potential tax rates (15% and 30% {the current tax rate}). Furthermore, Y denotes taxable income,
r denotes tax rate, G denotes the profit of the government and C denotes the loss of the crypto
taxpayer. Moreover, let us assumeProvided the assumption that if the penalty is high, there will
be full disclosure of income and if it is low, then half of the income, will be disclosed.
(In such a scenario, if the government applies ‘the lesser tax rate and higher tax penalty’ (Case
A), then there will be more tax payments as opposed to ‘lesser tax rate and lesser tax penalty’
26
Michael G. Allingham and AgnarSandmo, ‘Income tax evasion: A theoretical analysis’ (1972) 1(3-4) Journal of
Public Economics 323; Gary Becker, ‘The Economics of Crime and Punishment’ (1968) The Journal of Political
Economy 169.
27
Gamse Oz Yalaman and Hakan Yildirim, ‘Cryptocurrency and Tax Regulation: Global Challenges for Tax
Administration’ in UmitHacioglu (ed), Blockchain Economics and Financial Market Innovation (Springer 2019)
413.

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(Case B) due to the deterrence effects. Though the investor loses less in Case B, a high penalty
will be deterrent enough for him to comply with Case A.
Examining further, Furthermore, if the tax rate is high with a high penalty (Case C), the
deterrence effect is very high. However, the investor will accrue maximum losses in Case C.
ThusConsequently, he might think that his profits in crypto will not be able to outweigh these
huge costs in taxation. On the other hand, if the tax rate is high with fewer penalties (Case D),
there is less deterrence and more costs for the investor. Hence, he will prioritize Case A). 28
Thus, Case A is a meeting point between the government and investors, and hence it minimizes
instances of tax evasion.

28
ibid 413, 414.

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 Conclusion

First, I have explained the compliance costs issues in Sections 115BBH and 194S. Second, I
have argued that the present scheme of taxation is not optimal. Third, I have argued that low tax
rates combined with high penalties are a sound policy design.

Hence, the present taxation of crypto under the ITA does not solve the fintech issue of tax
evasion due to the de-anonymity inherent in the technology used in crypto.

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