MAY 01, 2017

By Neeraj Prasad, IRS (C&CE)

BROADLY speaking, digital currency is a representation of value that can be digitally traded and is not denominated in legal tender.

Created in 2009, Bitcoin was the first of these digital currencies. The recent past has seen an enormous growth in Bitcoin as a form of payment. As per reports, global Bitcoin trade is skyrocketing touching 35 billion USD per month in December 2015. One of the pivotal reasons behind this spike in digital currency usage is that the fee charged in case of making payments with the use of digital/virtual currency is much lower than the general 2-3% interest imposed by credit card processors. There are now over 600 digital currencies of a similar nature to Bitcoin, each with their own design, characteristics and distribution model, with more being constantly developed.

Bitcoin trade in India is growing exponentially and is at an estimated Rs 500 crores per year. There are around 50,000 Bitcoin wallets in India and around 700-800 Bitcoins are traded every day. Quite a few Bitcoin exchanges are in operation. India is poised to see an explosion in the transactions of virtual/digital currency in days to come.

But what exactly is a digital/virtual currency and how does it work?

The Oxford Dictionary of English defines Bitcoin as:

a type of digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank.

The driving technical innovation of Bitcoin was the creation of the 'block chain' (or 'distributed ledger'), a cryptography - based method of transaction validation undertaken by a network of users who are incentivised to maintain the system, and with no need for a central authority to perform this function.

A 'distributed ledger' is essentially an asset database that can be shared across a network of multiple sites, geographies or institutions. All participants within a network can have their own identical copy of the ledger. Any changes to the ledger are reflected in all copies. The assets can be financial, legal, physical or electronic. The security and accuracy of the assets stored in the ledger are maintained cryptographically through the use of 'keys' and signatures, to control who can do what within the shared ledger. Entries can also be updated by one, some, or all of the participants, according to rules agreed by the network.

One of the most striking features of crypto - currency is that it eliminates the need for a trusted third party such as a governmental agency, bank etc. The crypto - currency system collectively creates the units. The rate at which such units are created is defined beforehand and is publicly known unlike the traditional currencies where the government or the authorized banks control the supply. The production of most crypto - currencies is designed to gradually decrease, eventually placing a cap on the number of units that will ever be in circulation. This can lead the currency to mimic the scarcity that is usually seen in the supply of precious metal, thus avoiding hyperinflation.

When the Bitcoin algorithm was created, a finite limit of 21 million on the number of Bitcoins that would ever exist was set. Currently, over 12 million are in circulation. The system was intended to be set up in a way where the difficulty of mining every next Bitcoin is greater than the previous one. The final Bitcoin will be mined in the year 2140, at the current rate.

REGULATORY RESPONSE:

Virtual/digital currencies have not been recognized by the Reserve Bank of India (RBI), as a 'currency' in India. Currently, creation, trading or usage of virtual/digital currencies as a medium of payment is not authorized by RBI or any other monetary authority in India. RBI has through its press release dated 24/12/2013 cautioned users, holders and traders of virtual currencies, including Bitcoins, about the potential financial, operational, legal, customer protection and security related risks that they are exposing themselves to.

In its December 2013 press release RBI also referred to several media reports of the usage of virtual/digital currencies, including Bitcoins, for illicit and illegal activities in several jurisdictions, and that absence of information of counterparties in such peer-to-peer anonymous/pseudonymous systems could subject the users to unintentional breaches of anti-money laundering and combating the financing of terrorism laws.

RBI in its latest Press Release Dated February 1, 2017 has stated that it has not given any licence/company to operate such schemes or deal with any virtual/digital currencies. RBI also added, that the user, holder, investor, trader, etc. dealing with virtual/digital currencies will be doing so at their own risk.

RBI also regulates 'payment systems' and 'prepaid instruments', which require prior authorization of RBI and compliance with the regulations/directions issued by RBI relation thereto. However, virtual/digital currencies are not recognized payment systems that enables settlement of payments between the payer and beneficiary.

TAXATION RESPONSE:

For the purposes of the CGST Act 2017, the term 'money' is defined in section 2(75) as:

"money" means the Indian legal tender or any foreign currency, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, traveller cheque, money order, postal or electronic remittance or any other instrument recognised by the Reserve Bank of India when used as a consideration to settle an obligation or exchange with Indian legal tender of another denomination but shall not include any currency that is held for its numismatic value.

Evidently virtual/ digital currencies does not qualify to the coverage of "money" under GST.

Some experts are of the view that virtual/digital currencies would fall under the definition of 'computer programme', which has been defined under the Indian Copyright Act, 1957, as 'a set of instructions expressed in words, codes, schemes or in any other from, including a machine readable medium, capable of causing a computer to perform a particular task or achieve a particular result.' Further, virtual/digital currencies can possibly be classified as 'goods' of intangible nature (akin to a computer programme or software) under GST.

Digital currencies are treated in a variety of different ways under different tax jurisdictions.

In October, 2015, the European Court of Justice ruled that Bitcoin traders exchanging "fiat" currencies (such as euros or Swedish krona) into Bitcoin are exempt from having to charge and remit VAT. According to the CJEU, transactions involving non traditional currencies should be considered VAT-exempt financial transactions to the extent such currencies have been accepted by the parties to a transaction as an alternative to legal tender and have no purpose other than to serve as a means of payment. To interpret article 135(1)(e) of the VAT directive as covering only transactions involving traditional currencies would deprive it of part of its effect. On this basis, the CJEU concluded that the VAT exemption under the directive covers the supply of services consisting of the exchange of traditional currencies for units of Bitcoin virtual currency, and vice versa.

In March, 2014, HM Revenue and Customs(UK) outlined that when Bitcoin and other similar 'crypto currencies' are exchanged for sterling or foreign currencies, no VAT is due on the value of the cryptocurrencies themselves as they are recognised as 'other negotiable instruments'.

For the GST treatment of Bitcoin, the Australian Tax(ATO) Office ruling of 2014 outline that Bitcoin is considered a form of 'intangible property'. ATO Ruling explains the goods and services tax (GST) consequences of transactions involving the use of Bitcoin. In particular, this Ruling considers whether Bitcoin may involve 'money' coming to a negative conclusion. As a result, domestic supply of Bitcoin, in exchange for money is subject to GST. In addition, domestic transactions where Bitcoin is exchanged for other taxable goods and services are akin to a barter arrangement (exchanging property for property) and are also subject to GST.

Guidance issued by the Japanese Government in March, 2014 outlined its views that digital currencies are a tradable asset for taxation purposes, subject to full consumption taxes. In March 2016, updated guidelines were adopted, recognising digital currencies as having the same functions as legal tender for regulatory purposes, but not changing their tax treatment.

The supply of the virtual currency is treated as a supply of services with Singaporean GST payable in the supply, as well as payable on any subsequent trade of 'virtual currency' for other goods or services.

In 2013, the Canadian Revenue Agency issued guidance relating to digital currencies, outlining their view that digital currencies are intangible goods for tax purposes. As a result where digital currencies are used to pay for goods or services, the rules for barter transactions apply in Canada.

CONSEQUENCEs OF THE TAXATION TREATMENT:

Excluding virtual/digital currencies such as Bitcoin from the definition of money by treating it akin to intangible goods results in transactions where consumers use Bitcoin to pay for other goods and services in effect bearing GST twice - once with the embedded GST borne on the acquisition of the Bitcoin and once again on its use in exchange for other goods and services to the GST. Besides disadvantaging consumers, this 'double taxation' treatment creates a competitive disadvantage for the use of digital currencies as a mean of exchange, when compared to 'fiat currencies'.

FUTURE ROAD MAP AND CHALLENGES:

For government applications, 'permissioned' ledgers such as central bank digital currency are likely to be more appealing than Bitcoin's un - permissioned model, because they allow the owner, or owners, of the data to enforce rules on who is and is not allowed to use the system. Some governments around the world are exploring the possibility of central bank issued digital currencies using disturbed ledger technology (DLT) which could compete with private digital currency systems such as Bitcoin.

A research paper of Bank of England issued in 2013 studied t he macroeconomic consequences of issuing central bank digital currency (CBDC) - a universally accessible and interest-bearing central bank liability, implemented via distributed ledgers, that competes with bank deposits as medium of exchange. In a DSGE (Dynamic stochastic General Equilibrium) model calibrated to match the pre-crisis United States, it arrived to the findings that CBDC issuance of 30% of GDP, against government bonds, could permanently raise GDP by as much as 3%, due to reductions in real interest rates, distortionary taxes, and monetary transaction costs. Countercyclical CBDC price or quantity rules, as a second monetary policy instrument, could substantially improve the central bank's ability to stabilise the business cycle.

Subsequent to the ATO's rulings, the Australian Senate Economics References Committee considered the issue and recommended that the 'double taxation' of digital currencies under the GST be removed, in a report entitled Digital currency - game changer or bit player. The Australian Productivity Commission's Inquiry into Business Set Up, Transfer and Closure also subsequently recommended similar changes. Going by these recommendations the Australian Government has come up with a policy intent statement support as detailed in the Treasurer's Backing Australian FinTech statement, released on 21 March 2016. The policy outcome that the Government is seeking to achieve is to address the 'double taxation' of digital currencies under the GST by ensuring the supply of digital currency is no longer a taxable supply. More broadly, the Australian government's stated objective is to encourage innovation in the Australian economy, particularly in the FinTech sector, by removing impediments to the development and use of digital currencies and related technology in Australia.

India is the world's biggest remittance market at more than billion. The majority of the remittance is small amounts of around 0. For small amounts especially, users end up paying up to 15% in fees to companies like PayPal, Western Union or to banks through transfer and exchange rate fees. Virtual/digital currency can potentially make it extremely easy to send a small remittance back home. This could save India billions in fees paid to third party and add to country's wealth. In addition, distributed ledger technologies have the potential to help governments to collect taxes, deliver benefits, issue passports, record land registries, assure the supply chain of goods and generally ensure the integrity of government records and services.

The Government of India has set up a time-bound inter-disciplinary committee to recommend an action plan for dealing with digital currencies. We need to remember that - one, we are not competing with our self and an inward apprehension driven approach won't be desirable and two, the changes in this field are happening at a scorching pace, our regulatory response should also be equally nimble.

The Governments objective should be to encourage Indian Economy, particularly, in the Fin-Tech Sector, by removing impediments to the development and use of digital currencies and related technology in India. This will assist the entire Indian Fin-Tech ecosystem to be internationally competitive.

Lest we would be left humming the lyrics of "Beautiful Boy" of the Beatles "Life is what happens to you while you are busy making other plans."

(The views expressed are strictly personal.)