By Dr. Vikash Gautam and Tamanna Sharma
In 2022, the Union government introduced a 30 percent capital gains tax while disallowing set-off of losses and a one percent tax deducted at source (TDS) on virtual digital asset (VDA) transactions. This stringent tax policy, aimed at improving transaction traceability and discouraging speculative trading, has instead driven users towards offshore platforms. Our latest report highlights that offshoring has led to significant loss in tax revenue for the government and reduced participation on domestic platforms. Despite measures such as blocking the URLs of foreign exchanges, domestic platforms remain at a disadvantage. Our research indicates that reducing TDS to 0.01 percent would enhance tax revenues and liquidity, thereby promoting compliance and incentivize participation on domestic exchanges. Key recommendations include adjusting TDS to 0.01 percent, utilising Annual Information Returns (AIR) and the Prevention of Money Laundering Act (PMLA) to improve compliance, and engaging domestic exchanges for enforcement.
In 2022, the Union Government introduced a 30 percent capital gains tax on virtual digital asset (VDA) transactions while disallowing set-off of losses, effective from April 1 2022 and a one percent tax deduction at source (TDS) on transactions exceeding INR 10,000, effective from July 1, 2022.[1] The government’s rationale for this tax structure was to monitor VDA transactions, improve their traceability and discourage Indian users from speculative trading.
The Indian VDA tax architecture is one of the most stringent tax architectures in the world.[2] Not only that, it is also more punitive than the tax structure of similar asset classes such as securities and commodities.[3] For example, no other country has a one percent TDS provision for VDAs, while trading in securities and commodities in the country is usually subject to a TDS rate of 0.001 to 0.005 percent.
Our findings indicate that India's stringent VDA tax policy has had the opposite effect than intended. It discouraged trading on registered domestic exchanges and instead pushed Indian users to offshore platforms.[4] Our past research on this issue highlighted how Indian VDA exchanges lost up to 81 percent of their trading volumes in four months (i.e. Jul-Oct 2022) following the implementation of one percent TDS from July-October 2022.[5] This not only led to tax evasion due to a flawed tax design, but also thwarted the main objective behind these taxes, which was to improve traceability. Indian traders shifted to offshore VDA exchanges in large numbers and also engaged extensively in peer-to-peer (P2P) trading.[6] Over INR 3,50,000 crores worth of VDAs have been traded by Indians on offshore platforms between July 2022 and July 2023 through P2P transactions.[7]
The Financial Intelligence Unit (FIU-IND) issued compliance notices to nine foreign VDA exchanges in December 2023 and blocked access to the Uniform Resource Locator (URL) of these platforms on 12 January 2024 for not complying with the provisions of India's Prevention of Money Laundering Act (PMLA). [8] Implicitly, the measure was taken to limit exposure of Indian investors to offshore platforms.
Our latest report, “Taxes and Takedowns: An Assessment of India’s Key Policy Tools for Virtual Digital Asset Markets” examines whether URL blocking has been successful in curbing offshoring and assesses its effectiveness as a policy lever to ensure compliance with local laws in areas such as taxation and anti-money laundering.
Our analysis shows that domestic VDA exchanges continue to be at a disadvantage compared to foreign counterparts. Since 1 April 2022, domestic exchange volumes fell by almost two-thirds and increased only marginally following the blocking of foreign exchanges' URLs. Eighty-eight percent of the transaction volumes remain lost from domestic exchanges as of March 2024.
Deposits, withdrawals, profitability and assets under control (AUC) were also negatively impacted. Profitable users and AUC fell by 96 percent and 53 percent respectively. Deposits declined by almost 92 percent and withdrawals by 83 percent. Deposits fell more sharply than the number of depositors, and withdrawals also fell more than the number of withdrawals in the current tax regime. This indicates that most users of domestic VDA exchanges now conduct low-value transactions, while those that made higher investments left these exchanges.
Our research indicates that the problem with the current tax architecture is the one percent TDS. Under reasonable assumptions of assets under control, frequency of capital rotations, trading amount and trading spreads, more than 90 percent of liquidity is wiped out from the market within the first quarter of trading due to TDS. Of this, the excess tax (i.e. over 30 percent on capital gains) is not refunded until the sixth quarter (i.e. after the close of the financial year plus six months for the tax authorities to process tax returns). Locking liquidity for over a year is a fatal blow to the VDA market.
Using scenario-based modelling, our study estimates the impact of three different TDS rates on the Indian VDA market: one percent, 0.1 percent, and 0.01 percent. Our results show that TDS rates of 0.01 percent and 0.1 percent generate 32 times and 16 times higher tax revenues respectively, than the current TDS rate of one percent. A lower TDS leads to higher tax revenues because it unlocks liquidity for VDA exchanges and investors to trade frequently.
In addition, we show that the total VDA assets held by Indians in VDA exchanges globally amount to USD 13.38 billion, of which only 9.02 percent are held on compliant domestic platforms. We also modelled the tax revenue potential of VDAs over the next five years, which stands at Rs 10,966-14,837 crores. This is approximately 1-1.35 percent of the country's total corporate tax revenue.
Based on these results, we make three important recommendations:
The TDS on VDAs should be fixed at 0.01 percent. This will incentivise Indian investors to trade through compliant domestic VDA exchanges. It will also create a level playing field between domestic and offshore VDA exchanges.
The government should utilise the Annual Information Returns (AIR) in combination with the Prevention of Money Laundering Act (PMLA) to improve compliance. Utilising these policy tools can achieve the same level of transaction traceability that the TDS currently provides, without the distortionary effects of a tax.
Finally, the government should consider engaging domestically registered VDA exchanges as extended enforcement arms for compliance with the country's laws. User-centred compliance efforts have limited effectiveness due to the pseudonymity of VDA transactions and the availability of circumvention tools such as virtual public networks (VPNs).
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[1] Union Budget, Ministry of Finance (2022-23)
[2] Gautam, V. (Jan, 2023). Virtual Digital Asset Tax Architecture in India: A Critical Examination. Special Issue No. 208, Esya Centre.
[3] The Security Transaction Tax (STT) and Commodity Transaction Tax (CTT) in India ranges from 0.2 to 0.0001; MCX India (n.d.); Cleartax (n.d.)
[4] Ibid. Gautam (Jan, 2023).
[5] Ibid. Gautam (Jan, 2023).
[6] Ibid. Gautam (Jan, 2023).
[7] Gautam, V. (Nov, 2023). Impact Assessment of Tax Deducted at Source on the Indian Virtual Digital Asset Market. Special Issue No. 210, Esya Centre.
[8] Foreign exchanges whose URLs were blocked include Binance, Bitstamp, Kucoin, Huobi, Kraken, MEXC Global, Gate.io, Bitfinex, and Bittrex. See Indian Express (2023). “FIU issues notice to 9 offshore crypto platforms, writes to MeiTY for blocking of URLs.”