A Ready Reckoner on NFTs – Ownership, Taxation & More

Dhir & Dhir Associates | View firm profile

Cryptocurrencies can be broadly divided into two categories, the first being coins, and the second one being tokens. Both are unequivocally dependent on the blockchain technology to exist, however, the implication differs. Coins require an independent blockchain altogether to function, whereas tokens can function 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. Subsequently,  if the same individual is paid back in bitcoin, and not Ethereum, it is the Bitcoin blockchain which will record it as a separate transaction. Tokens, however, can function on any blockchain as long as the coding supports the token on that particular blockchain, for instance, Tether, BAT and BNT are some of the tokens that function on the Ethereum blockchain.

Non Fungible Tokens (NFTs) are tokens that are based on one of the aforesaid blockchains. They  are utilized by linking the unique ID associated with the token to an asset, be it art, music, video clips, etc. NFTs can be coded in a manner so as to function on various blockchains, however, the one preferred the most is Ethereum due to its quality of being able to handle complex contracts, a notch above the Bitcoin blockchain. NFTs function on the smart contracts mechanism that is expounded upon below. The inherent value in an NFT is the fact that it is non-fungible, i.e., it cannot be replaced by another identical token due to the unique ID attached to each. This is, in a sense, a distinguishing factor when we consider 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 being dependent upon blockchains, tokens rely on the mechanism of ‘smart contracts’. Smart contracts are essentially just like contracts that parties may enter into, in a physical setting, however, the crucial difference being that smart contracts are not governed by provisions written down on a piece of 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. All 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. There are negative connotations to these as well, such as a 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 may be 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 shall also stand transferred from the owner to the purchaser. However, this is not the case for NFTs, unless so agreed explicitly in the smart contract. The sale of an NFT is closer to the analogy of an artist selling a physical copy of an artwork. In no way does that imply  sale of the underlying IPRs, only the physical version of the artwork is being sold, the artist continues to be the owner of the associated IPRs. The only possession an individual has over an NFT is that it can be subsequently sold to another individual. The sale of an NFT only implies that the purchaser henceforth owns the particular artwork associated with the NFT and nothing more. The transaction which shall be recorded in the blockchain can only be proof of ownership of the said artwork and not the IPRs attached. In technical terms, an NFT is 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 issues.

The royalty generation system for NFTs is dependent upon the smart contract. Each time an NFT is sold on the online market, a percentage of the sale stands transferred to the creator of the NFT. This royalty generation system can be adjusted as per the smart contract. The percentage of royalty attached to the NFT may be thus prescribed (on a standard basis, the percentage stands to be between 5-10%). As mentioned previously in this note, smart contracts automatically execute tenets of the contract, hence the royalty is automatically transferred to the creator as and when the sale happens. One particular aspect that must not be overlooked is that this royalty generation system is not inherent in every smart contract, just like transfer of IPRs have to be explicitly stated in a smart contract, the royalty ascribed and the accompanying percentage shall be etched explicitly into the terms of the smart contract. In essence, 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 resell 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. The circular above gave banks already dealing in virtual currency transactions 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 thus clarified its position on cryptocurrency and stated that banks cannot henceforth rely on the 2018 circular and allowed to trade in cryptocurrency after requisite due diligence through 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 was crucial.

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.

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