What are digital assets?

Digital assets, a term now common in our digital age, refer to any asset stored digitally that holds value. These assets range from familiar ones like digital photos, videos, and music to more complex forms like digital currencies, tokens, and virtual assets. Their significance is immense as they represent a shift in how we perceive and interact with value, ownership, and exchange in the digital world.

Why are they important?

The importance of digital assets lies in their versatility and transaction efficiency. They can be transferred globally in seconds, often without traditional financial intermediaries, reducing costs and increasing speed. Moreover, digital assets are not confined by physical boundaries, making them accessible to anyone with internet access.

In this blog post, we will dive into virtual digital assets (VDAs), such as cryptocurrencies and tokens, and explore their impact on accounting and taxation. VDAs have introduced new complexities in these fields, requiring novel approaches to valuation, risk assessment, and reporting. As these assets integrate into mainstream finance, robust accounting and taxation frameworks are crucial for market transparency, trust, and stability.

We will examine the challenges VDAs pose to traditional accounting practices, we will also discuss the implications for taxation, where verifying transactions and balances in a decentralized and often anonymous environment presents unique hurdles.

Our discussion will also cover the regulatory landscape, which is rapidly evolving to keep pace with digital asset innovation. We will consider the role of regulatory bodies in establishing standards and guidelines for VDAs, and how these regulations affect accountants and auditors.

As we explore digital assets, it is clear they are not just a fleeting trend but a transformative force reshaping the financial world. Their impact extends beyond individual ownership to influence corporate finance, investment strategies, and monetary policy. This journey into VDAs promises to be enlightening, offering a glimpse into the future of finance in the digital age. So, let us begin.

Accounting for digital assets

Classification of transactions in virtual digital assets (VDAs)

In the evolving landscape of digital finance, individuals and entities engage in transactions involving Virtual Digital Assets (VDAs) for various purposes. These transactions can be broadly categorized as follows:

1. For investment purposes

Short-term and long-term investments: The most common reason for purchasing VDAs is investment. Investments can be classified as short-term (less than 12 months) and long-term (12 months or more). Investors might also speculate or trade without holding real exposure to VDAs through activities such as short sales, futures, options, or intraday trading, aiming to profit from short-term price volatility.

Investment treatment: VDAs held as assets for investment purposes are treated as investments. For those engaged in VDA trading as a full-time profession, VDAs can be classified as inventory.

2. As an alternative currency

Cryptocurrencies as a store of value: Cryptocurrencies can serve as a store of value, with any asset being priced and traded in crypto. For instance, Tesla (a popular electric car manufacturer) once allowed customers to purchase cars using Bitcoin. If widely adopted, cryptocurrencies could become a viable alternative to regular currencies. Applications built on blockchain, and smart contracts often price their services and commissions in cryptocurrencies.

Currency treatment: VDAs used as an alternative currency can be treated as cash equivalents or foreign currency.

3. Businesses built around VDAs

Creation and trade: New-age businesses include entities involved in the creation of VDAs, such as miners or NFT content creators. Exchanges and marketplaces facilitate VDA trading, like stock exchanges. Some digital banks and financial institutions accept deposits and lend in cryptocurrencies or utilize blockchain technology for payments and clearing systems.

Business Treatment: VDAs held by these businesses can be treated as inventory or intangible assets.

Accounting issues and challenges

The accounting for VDAs is still in its initial stages, presenting unique challenges and requiring flexible approaches. Here are some key considerations:

1. Matching principal challenges:

Mining operations: Entities involved in cryptocurrency mining incur capital and operating expenditures to earn revenues from selling cryptocurrencies. The timing and amount of these revenues are often unpredictable, complicating the application of the matching principle.

Expert guidance: Mining setups can be recognized as assets due to potential future economic benefits. However, annual impairment analyses are necessary, especially in the event of market crashes. Miners in pooled systems generate regular revenues, allowing operating costs to be matched against them.

2. Shared costs in multiple revenue streams:

Gaming and music industries: Businesses with both NFT and non-NFT revenue streams face challenges in attributing shared costs, such as technology or content costs, which may not be directly attributable to NFT sales.

Cost allocation: Shared costs should be allocated based on the value of revenues from both streams. If consistent NFT revenue recognition is difficult due to subjectivity, costs can alternatively be allocated on a physical basis, using non-financial metrics to determine the benefit generated by NFT content.

3. Regulatory grey zone and need for clarity

The procedural emphasis over fundamental aspects of VDAs has resulted in a significant regulatory grey zone. On one hand, anyone can transact in VDAs on Indian or international exchanges and be liable for taxes. On the other hand, there is no clear guidance on how to account for these transactions, necessitating reliance on interpretations of individual accounting standards.

Taxation & regulation of digital assets in India

Direct taxes

Income from transfer of VDAs

The Finance Act 2022 introduced significant changes in the taxation of Virtual Digital Assets (VDAs) with the introduction of Section 115BBH. Effective from April 1, 2022 (Assessment Year 2023-24 onwards), this section mandates a flat 30% tax (excluding surcharge and cess) on profits arising from the sale of VDAs. Importantly, only the cost of acquisition can be deducted from the sale proceeds when calculating the profit. Additionally, losses from the sale of one VDA cannot be set off against profits from the sale of another VDA, emphasizing the need for meticulous tax planning and record-keeping for investors.

Gift of VDAs

Under Section 56(2)(x) of the Income Tax Act (IT Act), receiving property for less than its fair market value results in the difference being taxable in the recipient's hands. The Finance Act 2022 expands this definition to include VDAs. Consequently, if VDAs are transferred without consideration or for less than their fair market value, the recipient is liable to pay tax on the difference, provided it exceeds Rs. 50,000.

Tax deduction at source (TDS) under section 194S

To regulate VDA transactions, Section 194S was introduced, effective from July 1, 2022. This section mandates a 1% TDS on any consideration paid for the transfer of VDAs to a resident. TDS must be deducted at the time of credit or payment, whichever is earlier. However, no TDS is required if the total consideration does not exceed Rs. 50,000 (for specified persons) or Rs. 10,000 (for others) in a financial year. Specified persons include individuals or Hindu Undivided Families (HUFs) with total sales or turnover not exceeding Rs. 1 crore in business or Rs. 50 lakhs in the profession in the preceding financial year. The TDS payment must be made electronically within 40 days from the end of the month in which it is deducted, using Form 26QE. The deductor must issue Form 16E to the payee within 15 days of filing Form 26QE.

Direct taxation issues

While the Finance Act 2022 has clarified many aspects of VDA taxation, certain areas remain ambiguous. For instance, trades involving the exchange of an NFT for cryptocurrency could be considered a transfer under Section 115BBC, even though no liquidity is created for the investor. Additionally, the cost of acquisition for entities involved in minting tokens or mining coins is subject to interpretation. Detailed guidelines from the IT Department could help mitigate disputes and foster a transparent tax regime.

Indirect taxes

Under the Goods and Services Tax (GST) framework, the supply of currency or securities does not constitute the supply of goods or services. However, VDAs, being intangible assets, may not enjoy the same classification. This ambiguity makes VDAs potentially liable for GST, unlike currencies and securities that are exempt. In contrast, several countries, including the UK, Norway, Australia, and Switzerland, have exempted cryptocurrencies from GST/VAT, setting a global precedent. The absence of explicit guidelines in India's indirect tax laws could lead to varied interpretations by tax authorities and potential disputes. To avoid this, the Finance Ministry should consider notifying a comprehensive set of rules for the indirect taxation of VDAs, like the clarity provided for direct taxes.

Conclusion

The evolving landscape of digital asset taxation in India requires businesses and investors to stay informed and adaptable. The recent amendments under the Finance Act 2022 provide a framework for the direct taxation of VDAs, but ambiguities remain, especially concerning indirect taxes. As the government continues to refine its approach, maintaining detailed records and seeking expert guidance will be essential for compliance and optimal tax planning in the dynamic world of digital assets.

Final thoughts

As we approach a new era in finance, digital assets are not just a fleeting trend but a transformative force reshaping financial interactions. The future of digital assets is one of boundless potential, where traditional financial systems may be augmented, or even replaced, by decentralized, efficient, and transparent digital solutions. Blockchain technology, the backbone of digital assets, promises to introduce unprecedented levels of security and trust in transactions, potentially reducing fraud and enabling faster, more cost-effective global payments.

The integration of digital assets into mainstream finance could revolutionize asset management, lending, and investment strategies, offering diversification benefits and new opportunities for yield generation. Moreover, the tokenization of real-world assets could unlock liquidity and democratize access to investments previously reserved for the affluent. As regulatory frameworks evolve to accommodate these changes, we can expect a surge in institutional adoption, further cementing the role of digital assets in the financial landscape.

However, with great innovation comes the need for vigilance and adaptability. The rapid pace of change in digital asset management necessitates a proactive approach to education and engagement with the latest developments. It is imperative for individuals and institutions alike to stay informed about the evolving regulatory environment, technological advancements, and emerging risks associated with digital assets.

Therefore, I urge you, the reader, to embrace this wave of change with an open mind and a willingness to learn. Engage with the community, participate in educational forums, and seek advice from experts. By staying at the forefront of digital asset management, you can navigate the complexities of this new frontier with confidence and seize the opportunities that lie ahead.