THE POLICY LAB (TPL) - 55
NOVEMBER 20, 2024

By J B Mohapatra

A: NEITHER in section 115BBH of Income Tax Act (ITA) which proceeded to tax surplus on trading in virtual digital assets (VDA) nor in 194S, the TDS provision applicable to trading VDA, that there is any reference to trade being conducted at an 'exchange'. Language of both the provisions, particularly section 194S, makes the transaction resulting in an income from VDA as purely bilateral - between an identified and willing seller and an identified and willing buyer. The provision reads as follows:

194S. (1) Any person responsible for paying to any resident any sum by way of consideration for transfer of a virtual digital asset, shall, at the time of credit of such sum to the account of the resident or at the time of payment of such sum by any mode, whichever is earlier, deduct an amount equal to one per cent of such sum as income-tax thereon:

The only reference to an 'exchange' including a definition of an 'exchange' under the provisions of ITA appears in Circular 13 of 2022 dated 22-6-22 wherein certain guidelines were issued by CBDT under powers vested to it in terms of section 194S (6) of ITA. Operative part of that circular below:

For the purpose of this circular-

(i) The term "exchange" means any person that operates an application or platform for transferring of VDAs, which matches buy and sell trades and executes the same on its application or platform."

B: Another measure at recognising exchanges dealing in VDA for specific regulatory purpose came about through Department of Revenue's (DoR) Notification dated 7-3-23 which reads as below:

S.O. 1072(E).- In exercise of the powers conferred by sub-clause (vi) of clause (sa) of sub-section (1) of section 2 of the Prevention of Money-laundering Act, 2002 (15 of 2003) (hereinafter referred to the as the Act), the Central Government hereby notifies that the following activities when carried out for or on behalf of another natural or legal person in the course of business as an activity for the purposes of said sub sub-clause, namely:-

(i) exchange between virtual digital assets and fiat currencies;

(ii) exchange between one or more forms of virtual digital assets;

(iii) transfer of virtual digital assets;

(iv) safekeeping or administration of virtual digital assets or instruments enabling control over virtual digital assets; and

(v) participation in and provision of financial services related to an issuer's offer and sale of a virtual digital asset.

Explanation:- For the purposes of this notification "virtual digital asset" shall have the same meaning assigned to it in clause (47A) of section 2 of the Income-tax Act, 1961 (43 of 1961).

FIU-IND in its AML & CFT Guidelines dated 10-3-23 with reference to the newly introduced set of "person carrying on designated business or profession" undertaking or affording the VDA related services as per DoR notification dated 7-3-23 laid out the requirements for disclosure of appropriate policies and procedures for prevention of ML, TF and PF, client acceptance and client due diligence measures, KYC norms for client participation as part of record keeping and reporting obligations for virtual digital asset providers (VASP).

Thereafter, FIU-IND in its letter dated 4-7-23 made registration of virtual digital asset service providers with FIU-IND as a pre-requisite condition for on-boarding the entity- evidently in compliance with DoR's notification dated 7-3-23 and its own guidelines dated 10-3-23.

C: To say that definition of an 'exchange' for conducting VDA related services in terms of the CBDT circular or the reporting requirements as per DOR notification should suffice for all other purposes needs to be considered in the backdrop of legislative and administrative precedents laying down the imperatives behind organisation of few other 'exchanges' in other areas. Some examples below:

D: Stock exchanges dealing in securities in order to be recognised for the purposes of Securities Contract Regulation Act, 1956 (SCRA) have to satisfy the central government, among other requirements provided in section 3 of the Act, the integrity of the protocol whereby the exchanges can enforce the 'regulation and control of contracts'. Central government while granting recognition to stock exchanges as per section 4 necessarily has to ensure that "(a) that the rules and bye-laws of a stock exchange applying for registration are in conformity with such conditions as may be prescribed with a view to ensure fair dealing and to protect investors;" Central government inter alia holds the power to to call for periodical returns and annual reports of stock exchanges as also to inquire into any of the affairs of a recognised stock exchange. Under section 5 of the Act, recognition is liable to be withdrawn in the 'interest of the trade or in the public interest'.

E: Commodity exchanges likewise earlier regulated by the Forward Market Commission under the Forward Contracts (Regulations) Act, 1952 and since 28-8-15 regulated by SEBI under the SEBI Act, are necessarily to demonstrate that the exchange's organisation, systems and practices are in accordance with the SCRA 1956 and rules framed thereunder, and that the exchange has implemented the directions, guidelines and instructions issued by the SEBI from time to time. That the shareholding limits are in terms of Regulations 17 to 19 of Securities Contracts (Regulations) (Stock Exchanges and Clearing Corporations) Regulations, 2018 ; and that the 'requirement and criteria of fit and proper' under Regulation 20 is applicable to the exchange, its shareholders, Directors and key management personnel at all time.

F: Authorisation for making available greater access to foreign exchange facilities to residents etc through full fledged money changers under section 10(1) of FEMA,1999 is on the basis of a due diligence exercise by RBI, the licence so obtained liable to be withdrawn if it were in public interest to revoke that or the licensee contravenes any of the conditions of licence or violates any of the applicable provisions of the Act or the Regulations.

G: Power exchanges as an approved market place to undertake making and discharging of contracts for sale and purchase of electricity or renewable energy certificates or energy saving certificate are granted approval in terms of Regulation 12 of Central Electricity Regulatory Commission (Power Market) Regulations, 2021 by the CERC only when CERC is satisfied about the entity's net worth conditions, ownership structure, governance and management structures, risk management procedure and clearing and settlement processes. CERC also inter alia under Regulation 35 is competent to revoke the licence if the functioning of the power exchange is in violation of any of the terms and conditions of the Regulations, or the exchange is found engaged in market manipulation or insider trading or its met worth falls below the specified amount as per the Regulations or the licence conditions.

H: While exchanges dealing in VDA are undoubtedly Virtual Digital Asset Service providers (VASP) within the meaning of the notification of DOR or the guidelines of FIU-IND, the exchanges dealing in VDA are known to undertake all or many of the following activities: (i) exchange of virtual/fiat (ii) exchange of virtual/virtual (iii) transfer (iv) safekeeping and/or administration and (v) participation in and provision of financial services, and thus include many operational areas not within the ambit of exchanges in traditional areas of say securities or commodities or electricity.

I: Definition of an exchange for VDA in a CBDT circular thus might suffice for the purpose of taxation. So does FIU IND's guidelines for VASP for reporting measures under and for the purposes of PMLA. However the critical areas of risk and its mitigation; whether arising from leverage or credit or liquidity or maturity transformation or risks arising from technology or concerns relating to management or governance framework etc of a VDA exchange are not addressed either in the CBDT circular or the FIU IND guidelines. Greater, more complex and nuanced are the risks, when VDA exchanges not just facilitate transactions, but undertake settlement and clearing, non-custodial and custodial wallet provisioning, lending and borrowing, and direct trading through the very same exchange they have constituted.

J: As our recent history has shown, any legislation on matters of VDA will be fraught with competing versions on financial stability implications, monetary sovereignty, capital flow management measures, bank's ability to mobilise deposits, and in short dangers of cryptoisation of an economy, and hence will be long and contentious. But looking at the existing reality of 20-odd large VDA exchanges operating in India and nearly 20 million Indian investors in VDA, and recent international experience with exchanges such as FTX where the management preyed upon the systemic vulnerabilities of its own exchange to perpetuate a fraud on its own investors, there is every merit in putting in place an interim set of measures to regulate the VDA exchanges till such time an appropriate regulatory policy through legislation is brought into effect.