FEMA Guidelines and Cryptocurrency Legality in India

Legal Recognition and Definition of Virtual Digital Assets (VDAs)

The regulatory landscape in India does not recognize cryptocurrencies as legal tender or foreign currency. However, the Finance Act, 2022, introduced specific provisions within the Income Tax Act, 1961, to define and tax "Virtual Digital Assets" (VDAs). This legislative step provides a framework for their treatment for tax purposes, classifying them as an asset class rather than currency.

As per Section 2(47A) of the Income Tax Act, a VDA is defined broadly to include any information or code or number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration, with the promise or expectation of a digital representation of value having inherent value, or acts as a store of value or a unit of account, including its use in any financial transaction or investment, but not limited to, NFTs and tokens derived from them. This definition aims to encompass a wide array of digital assets.

Taxation of Virtual Digital Assets (VDAs) under the Income Tax Act, 1961

Income derived from the transfer of Virtual Digital Assets is subject to a specific tax regime under the Income Tax Act, 1961. Section 115BBH stipulates that income from the transfer of VDAs shall be taxed at a flat rate of 30%, irrespective of the individual's or entity's income slab.

A critical aspect of this taxation is the disallowance of deductions. No deduction is permitted for any expenditure (other than the cost of acquisition, if treated as trading stock) or allowance or set-off of any loss. Furthermore, any loss arising from the transfer of a VDA cannot be set off against any other income, nor can it be carried forward to subsequent assessment years. This means that each VDA transaction is treated independently for gain calculation, without netting off losses from other VDA transfers or other income sources. Gifts of VDAs are also taxable in the hands of the recipient under Section 56(2)(x) of the Income Tax Act, subject to specific exemptions.

Tax Deducted at Source (TDS) on Virtual Digital Asset Transfers

To ensure traceability and compliance, Section 194S of the Income Tax Act mandates Tax Deducted at Source (TDS) on the transfer of Virtual Digital Assets. This provision applies to any person responsible for paying to any resident any sum by way of consideration for the transfer of a VDA.

The TDS rate is 1% of the consideration paid for the transfer of a VDA. This deduction is applicable if the value or aggregate value of consideration for the transfer of a VDA during the financial year exceeds certain prescribed thresholds. The responsibility for deducting TDS depends on the payer. If the consideration is payable by a "specified person" (an individual or HUF whose sales, gross receipts or turnover from business or profession exceeds prescribed limits or any other person not falling under that category), a lower threshold applies for TDS applicability. For other individuals or HUFs, a higher threshold applies.

In transactions facilitated by a Virtual Digital Asset Service Provider (VDASP), such as an exchange, the VDASP is generally responsible for deducting the TDS. For peer-to-peer (P2P) transactions, if the payer is a "specified person," they are obligated to deduct TDS. If the payer is not a "specified person" and the transaction occurs without an exchange, the responsibility for deducting and remitting TDS can be complex and typically falls on the person making the payment, provided the thresholds are met.

Foreign Exchange Management Act (FEMA) and VDAs

The regulatory stance under the Foreign Exchange Management Act (FEMA), 1999, is crucial for understanding cross-border transactions involving VDAs. VDAs are not recognized as 'foreign currency' under FEMA. Consequently, any outward remittance from India specifically for the purpose of purchasing VDAs abroad is generally restricted. The Liberalised Remittance Scheme (LRS) allows resident individuals to remit funds up to a certain limit for permissible current or capital account transactions, but the acquisition of VDAs is not explicitly listed as a permissible purpose under the LRS.

However, holding VDAs acquired through legitimate means outside India is not directly prohibited, provided the acquisition did not involve unauthorized outward remittance of Indian currency or contravention of FEMA provisions. For instance, VDAs received as payment for services rendered abroad, or acquired while residing outside India, may be held. Resident individuals holding foreign assets, including VDAs acquired legitimately, are required to report these assets in Schedule FA (Foreign Assets) of their Income Tax Return (ITR). Failure to do so can lead to penalties under FEMA. Contraventions of FEMA, such as unauthorized overseas acquisition or remittance for VDAs, can result in significant penalties, including up to three times the amount involved in the contravention.

Financial Intelligence Unit – India (FIU-IND) Regulations

To counter money laundering and terrorist financing risks associated with Virtual Digital Assets, the Indian government has brought Virtual Digital Asset Service Providers (VDASPs) under the purview of the Prevention of Money Laundering Act (PMLA), 2002. This notification, issued by the Ministry of Finance, designates VDASPs as "reporting entities" for FIU-IND.

As reporting entities, VDASPs have stringent obligations, including:

• Customer Due Diligence (CDD): Implementing comprehensive Know Your Customer (KYC) procedures for all users.
• Record-Keeping: Maintaining records of all transactions for a specified period.
• Reporting Obligations: Filing various reports with FIU-IND, such as:
  • Suspicious Transaction Reports (STRs) for transactions suspected to involve proceeds of crime or financing of terrorism.
  • Cash Transaction Reports (CTRs) for transactions exceeding certain thresholds.
  • Cross-Border Wire Transfer Reports (CBWTRs) for cross-border transfers.
  • Reports on transactions with Designated Non-Financial Businesses and Professions (DNFBPs).

These regulations mandate that VDASPs identify and verify their clients, monitor transactions, and report suspicious activities to FIU-IND, thereby enhancing the transparency and regulatory oversight of the VDA ecosystem in India. Non-compliance by VDASPs can lead to severe penalties.