In this article we will discuss potential tax liabilities for NFT transactions and also whether lack of regulations facilitates use of NFTs for money laundering.

What are Non-Fungible Tokens (NFTs)?

The technology behind NFT is blockchain. NFT is a digital token that operates on a public blockchain and represents a token of ownership of a unique item. One can imagine a blockchain as a continuously expanding list of data records in which each new data record (block) is linked to the respective preceding block by mathematical-cryptographic functions. This linking ensures that all earlier blocks in the chain are immutable, i.e., tamper-proof.[1] Therefore, the immutable nature of NFT is the key to authentication of its originality in the digital world; where anyone can create, share, trade, download and reproduce a piece of digital content.

Fungible means “interchangeable” and refers to tokens which exist in indeterminate or at least in larger numbers in the same form, i.e., do not differ in content from other fungible tokens of the same kind. The most prominent example of fungible tokens are Bitcoins.[2]

NFTs can be traded like any other property, by a virtual certificate of ownership, without any standard value. NFT can be tokenised and traded – not just pictures but sounds, fractions of video, tweets, clips from sports matches, even real estate. NFTs are not limited to the digital space; rather, they can also represent any type of physical asset, acting as a kind of ‘digital twin’ to anything existing in the real world. NFT works on accompanying smart contract which permits the seller to place conditions on the token holder’s ownership rights for generating automatic royalty payment to the original NFT creator at each subsequent sale i.e., the conditions of the underlying smart contract are designed to  operate automatically by NFT’s code on the blockchain mechanism. Thus, NFT can be, in essence, a collectible digital asset, which holds value in form of digital currencies and as a form of art or culture.

Popularly, most NFTs are part of Ethereum blockchain. Ethereum is a cryptocurrency, like bitcoin or dogecoin, but its blockchain also supports these NFTs, which store extra information that makes them work differently from, say, an Ethereum coin. This means that while blockchain is the underlying tech that provides a transaction system by enforcing a digital ledger and enforces rules of engagement via smart contracts, it also has extended tenets such as immutability, transaction record and transparency to facilitate verification and asset movement with an embedded trust system. The tokens can be for anything digital – this includes drawings, music but a lot of the current excitement is around using the technology to sell digital art. Nowadays, artisans, musicians, influencers and interested person use NFTs to monetize or commercialise digital records that have previously been available for less or no cost i.e., artists can make big money on NFT platform where typically they have failed due to cyber theft. With the record high appreciation in value of crypto-currencies, motivated investors speculate on NFT trading at an extraordinary price.

Tax treatment

The tax treatment of any commodity or service flows from the nature of underlying transaction. NFTs are under the scanner of taxable properties that are owned and traded. The cycle of NFTs from its origin, distribution and trading are new dimensions of digital transaction which raise a plethora of legal issues, many of which are still unresolved. The entire transaction takes place through a smart contract and payment is made directly between the parties to the transaction instead of through the intermediary NFT marketplace.

Income Tax – NFTs are traded on a speculative basis with motive of earning profit (like share trading) and the transaction creates a tax obligation. The profit earned by the seller can attract short term or long term capital gains as per the Income Tax Act, 1961

Will NFT platforms be construed as e-commerce platforms?

With effect from 1 October 2020, the Government of India through Finance Act, 2020[3] inserted the provision of Section 194-O of the Income Tax Act, 1961, imposing withholding tax obligations on e-commerce operators, at the time of credit of consideration to the resident seller, at the rate of 1%[4] of the gross amount of sale. In case the sale is facilitated by an e-commerce operator, but payment is made by the buyer directly to the resident seller, Section 194-O deems the e-commerce operator to have paid the resident seller such money and therefore be obligated to withhold income-tax at 1% on such sums as well. E-commerce participant is a person resident in India selling goods or providing services or both, including digital products, through digital or electronic facility or platform for electronic commerce and e-commerce operator means a person who owns, operates or manages digital or electronic facility or platform for electronic commerce.

In the absence of clear distinction between a resident and a non-resident e-commerce operator, the withholding obligations under Section 194-O may also apply to a non-resident e-commerce operator facilitating sale of goods or provision of service of a resident seller, hence, resulting in increasing the compliance burden for non-resident e-commerce operators. Therefore, it is possible that even though the non-custodial NFT marketplace does not credit the amount to the seller, it will be liable to deduct tax on the consideration paid directly to the seller through the smart contract.

Equalisation Levy – To regulate un-restricted expansion of the e-commerce sector, Government of India, through the Finance Act, 2020[5] expanded the ambit and scope of the equalization levy to be applicable on e-commerce operators. The amendment to Finance Act, 2016 was carried out by insertion of Section 165A which mandates that on and from the April 1, 2020, there shall be charged an equalisation levy at the rate of 2% of the amount of consideration received or receivable by an e-commerce operator from e-commerce supply or services made or provided or facilitated by it— (i) to a person resident in India; or (ii) to a non-resident in the specified circumstances as referred in sub-clause (iii); or (iii) to a person who buys such goods or services or both using internet protocol address located in India.

If NFT platforms are an e-market place, they may be subject to Equalisation Levy at rate of 2% if it receives consideration from e-commerce supply or services’.

Goods and Services Tax (GST) – NFT platforms offer a market place in capacity of intermediary to facilitate trading between buyers and sellers. The term intermediary is defined under section 2 (13)[6] IGST Act, 2017 as broker, an agent or any other person, by whatever name called, who arranges or facilitates the supply of goods or services or both, or securities, between two or more persons.

Section 2 (17)[7] of the IGST Act, 2017 further defined the term online information and database access or retrieval services (OIDAR) as services whose delivery is mediated by information technology over the internet or an electronic network and the nature of which renders their supply essentially automated and involving minimal human intervention and impossible to ensure in the absence of information technology. The situation mandates that for any supply to be taxable under GST, the place of supply in respect of the subject supply should be in India. In case, both the supplier of OIDAR Service and the recipient of such service is in India, the place of supply would be the location of the recipient of service i.e., it would be governed by the default place of supply rules. In other case, where the supplier of such service is located outside India and the recipient is a business entity (registered person) located in India, the reverse charge mechanism would get triggered and the recipient in India who is a registered entity under GST will be liable to pay GST under reverse charge and undertake necessary compliances.

Recently, Maharashtra Authority for Advance Ruling, while hearing an issue of classification of online gaming based on cloud data storage from outside India, during the clarification application filed by Mr. Amogh Ramesh Bhatawadekar, held that “e-goods” as commercially known in the market are “goods” as defined in the GST Act, have the same character and are amenable to levy of GST as per the provisions of the GST Act. However, the Authority for Advance Ruling in the instant case held that “e-goods” like online gaming will be covered under services under the Section 5(3) and 5 (4) of the IGST Act.

Therefore, under GST regime, an NFT marketplace may be considered to be an intermediary. NFT marketplaces should ensure that they clearly demarcate the various fees and consideration amounts that are to be paid by the buyer, so that their liability for intermediary services is limited only to the extent of their sales commission. Further, classification of the supplies for GST purposes would again depend on the nature of the underlying transaction. GST applicability would also depend on whether the NFT platform is located in India or outside. The GST regime also obligates electronic commerce operator to collect tax at source at a specified rate of the net value taxable supplies made through it by other suppliers where the consideration with respect to such supplies is to be collected by the operator.

Money laundering tool

There are three main steps to launder money – (i) placement, (ii) layering and (iii) integration. The most critical and the most complex aspect of money laundering is to ensure that source of the money becomes untraceable, i.e., layering the money. Ironically, buying art is the preferred vehicle of criminals to layer their ill-gotten gains, simply because of the fact that value of art is fundamentally subjective with no proper parameters or criteria and lack of regulations wherein most art dealers neither having to report transactions nor verify their clients. With the emergence of NFTs, the problem regarding money laundering is bound to worsen.

The most practical way to launder money with NFTs would be via what is called “trade-based money laundering” — deals that appear legit on the face but are meant to hide the flow of ill-gotten gains. Trade based money laundering is a process that disguises the proceeds of crime by moving value through several trade transactions in an attempt to conceal their origins often by misrepresenting a product’s price or quality. It can be understood in a way that digital art, is both newer and even more subjective in its pricing as collectors and financers struggle with a new set of questions surrounding how much an art work can be worth if it can never be physically viewed or stored. Given the exorbitant sum of money invested in NFTs, concerns have been raised about whether these transactions are being used to circumvent the money laundering regulations.

As sellers and buyers can determine the value of piece of work with little historical context to compare price, it provides an excellent cover to money launder by adding even more secrecy to an already challenging market where locations, identities and source of funds are often kept private.

The main concern for the investor is regarding the availability of the transaction on blockchain for any audit or investigation as crypto-currencies can be transferred to any person irrespective of their location and nationality without any documentation. The fact that a party can choose to remain anonymous on blockchain, may pose additional risk from a compliance perspective and will also create difficulties in investigating.

The Government of  India has introduced “The Cryptocurrency and Regulation of Official Digital Currency Bill, 2019”[9][10], which prohibits all forms of private cryptocurrencies in India having concurrent amendment in the provision of Prevention of Money Laundering Act, 2002. Interestingly, the Bill fails to reiterate what constitutes a categories of cryptocurrency and what aspects of the technology will continue to function in a situation of a blanket ban. If the bill does in effect pass and codifies into statutory law, it could prove to be isolation of India from the world of NFT before it is even fully introduced in India.

An attempt was made by Government of India through Ministry of Corporate Affairs by an amendment dated 24 March 2021, to ascertain liability in order to regulate transparent transactions of cryptocurrency dealings in India. MCA mandated that all companies disclose all transactions in cryptocurrencies or virtual currencies in their balance sheets in terms of the Schedule III of the Companies Act, 2013, which prescribes the form of financial statements, effective from 1 April 2021 by insertion  of item (xi) in Paragraph 5 of Part II of Schedule III of the Companies Act, 2013.The  amendment to Paragraph 5 of Part II of Schedule III has also enumerated the list of additional items that a company, irrespective of being listed or unlisted, has to disclose by way of notes regarding aggregate expenditure and income in their financial statement of profit and loss.

RBI in its May 31, 2021 Circular asked banks and financial institutions in digital currencies to follow the KYC and AML or Combating of Financing of Terrorism (CFT) compliance guidelines, as mandated in master circular of RBI dated July 1, 2013[11] and obligations of regulated entities under Prevention of Money Laundering Act, (PMLA), 2002 in addition to ensuring compliance with relevant provisions under Foreign Exchange Management Act (FEMA) for overseas remittances.

Conclusion

NFTs are attracting substantial interest for ‘lucrative’ investment opportunities, across the globe without any geographical barrier. NFTs should be seen as assets which will attract tax liabilities, sooner or later. So look out for that windfall gain and the taxman coming for his share. The players in this space should look out for other legal and practical restrictions as well, especially regarding enforceability, ownership and intellectual property rights.

Additionally, currently, there is no restriction or regulation on trading NFTs in India and while FEMA governs cross-border economic transactions in India, there are no guidelines from the RBI for NFTs. There are no KYC/AML regulations for NFTs (know your customer / anti-money laundering), unlike the transaction of crypto currencies which has to comply with KYC/AML processes as directed by the RBI to trace users. These are areas in which the regulator must act quickly before it’s too late and authorities are left to play catch up.