This week on March 21, the government clarified that losses from the transfer of virtual digital assets cannot be set off against gains from another. Neither can mining costs be treated as acquisition cost for tax deduction.

With no headway being made on a bill to regulate cryptocurrencies, it’s still not clear whether digital currencies are legal. Although investors say the tax provisions have effectively legalised crypto trading, Finance Minister Nirmala Sitharaman has said that taxing cryptocurrencies does not mean it has been legalised – that matter is still being considered.

Tracing VDAs

Taxation and legality issues apart, there are concerns over the enactment of certain provisions that show up in the finer details.

“From the perspective of crypto exchanges, the biggest challenge the many platforms will face is traceability of cryptocurrencies and VDAs,” said Gauri. “With the government putting the onus of this aspect on the exchanges, it’ll be a real challenge to balance innovation in the crypto world along with efforts to keep things private.”

Among the challenges in implementing the crypto tax provisions will be the monitoring of investor activity and preventing them from accessing more favourable crypto markets abroad. The crypto regulations that are in the offing and the severe tax incidence will be detrimental to the development of India’s crypto ecosystem, experts said.

“February 1, 2022, marked another day that the crypto industry and the crypto community would like to roll back,” said Raj Kapoor, founder of India Blockchain Alliance. “The community has taken strong exception to the government’s clarification on the taxation of cryptocurrencies as it is sure to have a stymieing impact. The lack of a provision to offset losses will drive away investors from KYC-compliant exchanges and will leave them literally with the devil’s alternative of accessing grey markets and offshore havens, completely defeating the very purpose of the tax.”

The proposed taxation measures will discourage retail investment in the emerging asset class because it denies them the benefit of setting off losses. Investors could cough up a heavy tax even if their trading activity suffers an overall loss.

Experts said there could be a flight of funds, restrained retail participation, and novel ways to circumvent these provisions, defeating the very purpose of taxing VDAs.

Aliasgar Merchant, developer relations engineer at Ignite, which works in the blockchain space, said the idea put forward by the government is tricky and does not take into consideration all aspects of crypto trading.

Instead of the offset regulation placing an unnecessary burden on the retail investor, a solution could be to have taxes based on exchanges and not individual VDAs, just as profit and loss are cumulatively treated for equity transactions across stock exchanges, Merchant said.

Looking for loopholes

“Another aspect totally overlooked by the Indian government is the presence of decentralised crypto exchanges as these platforms are out of the reach of government entities, making it difficult to audit and control transactions that take place through them. Such stringent laws which are heavily flawed will open doors to people looking for loopholes and may spark a move to decentralised crypto exchanges,” Merchant added.

Additionally, for those engaged in mining of VDAs, the government has clarified that all costs and investments towards equipment can’t be adjusted against any gains. Such expenses will be treated as a capital investment and only depreciation may be allowed to be claimed against them.

The measures may constrain India’s potential to develop into a global hub for crypto activity – in the way local information technology companies did – and extend use-cases of VDAs, experts said.

“While the Ministry of Finance works actively on regulating crypto, it’s crucial to understand that despite the various challenges, the industry holds immense potential,” said Raghav Gupta, founder of Equidei, which operates a decentralised finance platform.

Need for innovation

According to Gupta, it’s equally pertinent to incentivise innovation. Blockchain-based technology must be cultivated by providing developers ample space to grow so that India doesn’t miss the Web3 revolution.

Web3 refers to the next version of the internet where services run on blockchain and are decentralised.

Anndy Lian, Asia chairman of BigONE Exchange, a crypto trading platform, said it will be quite a task keeping track of VDAs.

“My question to the Indian government is: how are you going to account for each and every VDA? There are almost a few new coins every day in the market,” he said. “Assuming they bought 50 new coins each year, the effort for the investor to report tax and the regulators to monitor it would be a big issue. I urge the government to take progressive steps for crypto taxation. By doing so, you will see healthier trades and more foreign investments flowing into the country.”

All eyes will now be on the long-awaited cryptocurrency bill, although recent developments may be a reason for tempering hopes with caution.