By Anand Kumar Rai
April 23, 2022
NFT stands for non-fungible token. An NFT is a digital cryptoasset that represents real-world objects, for example, artwork like music, painting, crafts, videos, game items, etc. They are sold and purchased online, frequently like cryptocurrencies, and they are generally encoded with the same underlying software as many cryptocurrencies.
Cryptocurrencies and physical money are “fungible,” which means they can be exchanged or traded for one another. They’re also equal in value—one dollar is always worth another dollar; one Bitcoin is always equal to another Bitcoin. But, NFTs are different, each NFT has a unique digital signature that makes it impossible for NFTs to be exchanged for each other or equal to one another (hence, non-fungible). For example, two persons A and B having different denominations of notes but having equal value could exchange their money the way we exchange when we need change. But both of them having two different art pieces with different digital signatures cannot exchange the same as both are two different digital tokens having different digital signatures.
Need for NFT:
The next question that arises is – what is the need for NFT?Anyone can view the bulk of images online for free. So why spend millions on something that could easily screenshot or downloaded? The answer is whenever we download or take screenshots, we don’t own the artwork. We don’t have rights over the artwork. NFT allows the buyer to purchase or sellthe ownership of the original item. It contains built-in authentication, which serves as proof of ownership. Collectors value these “digital bragging rights” more than the item itself.So, if we buy an oil painting via NFT, instead of getting an actual oil painting to hang on the wall, we will get a digital file instead.
Regulation and legal position of NFTs in India:
Transactions of NFT is risky business. An NFT’s value is entirely based on what someone else is willing to pay for it. Therefore, demand in the digital market will drive the price rather than the fundamental value of the asset, technical or economic indicators, which typically influence stock pricesover stock exchanges, and at least generally form the basis for investor demand. So, it is not guaranteed that if for example,we buy a piece of artwork for Rs 1000 having a perception that in future we will be able to sell it for a higher price, we will be able to do so, as there is a possibility that we will lose all of our money in case nobody wants to buy that particular artwork.
Since it is a new form of digital trading like cryptocurrency,there is no specific regulation or law that bans the trading ofNFTs in India. Also, there is no explicit definition that classifies NFTs as a type of cryptocurrency or a type of derivative. However, the government is planning to introducea law that will ban private trading of cryptocurrencies which is more focused towards criminalising the possession, issuance, mining, trading and transferring of crypto-assets. India is further planning to build a structure for introducing official digital currency, but it is a long way to go. But, as of now, there is no definition of crypto-assets in Indian legislation, so it’s intricate to decide whether NFTs fit into this category of an asset or not and will be banned along with other cryptocurrencies.
1. NFTs under Securities Contract (Regulation) Act, 1956:
In a parallel opinion, it is suggested that NFTs will be categorised as derivatives under the Securities Contract (Regulation) Act, 1956 (“SCRA“).
Section 2(a)(ac) of SCRA defines derivatives as:
(ac)] “derivative” includes–
(A) a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security;
(B) a contract which derives its value from the prices, or index of prices, of underlying securities]]
[(C) commodity derivatives; and]
[(D) such other instruments as may be declared by the Central Government to be derivatives;]
Section 18A of SCRA defines the condition for a derivative trading to be legal as:
18A. Contracts in derivatives
Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are
(a) traded on a recognised stock exchange;
(b) settled on the clearinghouse of the recognised [stock exchange; or] in accordance with the rules and bye-laws of such stock exchange.]
[(c) between such parties and on such terms as the Central Government may, by notification in the Official Gazette, specify,]
Looking into both the sections, the relevant information we take out is that contracts in derivatives will be valid and legal only if such contracts are traded on a recognised stock exchange and settled on the clearinghouse of the recognised stock exchange, in accordance with the bye-laws of such stock exchange. But in the case of NFT right now these two conditions are not being fulfilled. So, if NFTtrading is deemed to be a contract in derivative for the purposes of SCRA, then it would make the sale and purchase of NFTs in private illegal.
So, if government include the NFTs in the category of Derivatives without having any alternative platform like a recognized exchange or indexes that regulate NFT’s pricing on that particular exchange, then It will become Illegal.
The government has also prepared a draft to regulate the cryptocurrency and is likely to adopt, the ‘Banning of Cryptocurrency & Regulation of Official Digital Currency Bill’ of 2019 in 2021
The draft defines the cryptocurrency under section 2(1)(a) as:
“Cryptocurrency, by whatever name called, means any information or code or number or token not being part of any Official Digital Currency, generated through cryptographic means or otherwise, providing a digital representation of value which is exchanged with or without consideration, with the promise or representation of having inherent value in any business activity which may involve risk of loss or an expectation of profits or income, or functions as a store of value or a unit of account and includes its use in any financial transaction or investment, but not limited to, investment schemes;”
Under the above mentioned definition, it can be analysed that NFTs could be considered to be of the following value:1. Representation of value, which is exchanged with the inherent value in any business activity, for example, a proprietary code could be sold as an NFT to a business.2. As a store of value, for example, buying any artwork/art pieces.
However, there is an exemption to this under Section 3(3) of the bill, as per Section 3(3) – Nothing in this Act shall apply to the use of Distributed Ledger Technology for creating a network to enable the delivery of any financial or other services or for creating value, without involving any use of cryptocurrency, in any form whatsoever, for making or receiving payment.
The only problem here with the above section is that it is unable to explicitly define whether NFTs would fall under the scope of services as laid down under the above exemption or not.
2. NFTs under Sale of Goods Act, 1930:
Unless the government doesn’t come up with an explicit definition and regulations defining NFTs, they can be considered as “goods” under the Sale of Goods Act, 1930.
Section 2(7) of the Act defines the Goods as:
(7 ) “goods” means every kind of movable property other than actionable claims and money; and includes stock and shares, growing crops, grass, and things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale;
The definition of goods provided under the sales of goods act doesn’t explicitly exclude NFT from its scope. With appropriate regulation from the side legislature in its very right, can include this term under the provisions of this Act.
3. NFTs under FEMA:
Currently, the marketplaces over which NFT transactions are performed are operated by entities established outside India. As the Foreign Exchange Management Act, 1999 (“FEMA”)governs cross-border economic transactions in India, but there are no explicit regulatory guidelines from RBI for crypto-assets or NFTs. If we consider existing provisions of FEMA, crypto-assets and NFTs could be considered as intangible assets like software and intellectual property under FEMA. However, determining the location of an NFT is an open question, the location where its owner resides or where the asset is physically present?
Since most of the NFT’s buyers and sellers as well as the operators of marketplaces are located outside India, Indian participants in the NFT purchase or selling could be seen as performing cross-border transactions. This will put a questionunder FEMA, that whether in these transactions there is an export or import of an intangible asset. Also, for a transaction to fall under the ambit of FEMA the transaction has to have a corresponding remittance of fiat currency done through authorised banking channels. Therefore NFT transactions are in an ambiguous position under FEMA.
4. NFT under Finance Act, 2020:
The Finance Act, 2020 expanded the ambit equalization levy (“EL”) and ensures its applicability on e-commerce operators at a rate of 2 per cent on the consideration received by such e-commerce operators from ‘e-commerce supply or services’ made. Accordingly, the NFT marketplaces may be subject to EL at a rate of 2% on consideration received by them fromtransactions made, if they are also considered as ‘e-commerce supply or services’ made to a person resident in India, a person using an Indian internet protocol (“IP”) address, or a non-resident in certain specified circumstances
But, applying this provision to the purchase of NFTs would lead to certain complications. 1. The definition of an e-commerce operator under the EL provision is very wide and may extend to any electronic service which may facilitate a buyer and a seller to carry out an NFT transaction, including the blockchain operators and not just the NFT marketplace. 2. At no point during the transaction does the NFT marketplace have access to the sale consideration of the NFT. This non-custodial feature results in a situation of impossibility where the marketplace would have to pay 2% of the entire consideration, even when it does not have access to the consideration amount. 3. It is unclear whether the gas fees, which goes neither to the seller nor the e-commerce operator but directly to blockchain miners, would be considered to be part of the tax base for levy of EL in the hands of the NFT marketplace. 4. It may be impractical or unfeasible for the e-commerce operator to keep track of the IP address or the location or residency of each buyer or seller for determining the applicability of EL.
5.NFT under GST:
Having no explicit definition of NFTs under the Indian legislation makes it difficult to levy GST on NFT transactions. Under the Goods and Services Tax (“GST”) regime, the NFT classification is very important to impose GST, it should be clearly classified into intangible assets and goods, as typically, the tax treatment under GST should generally follow from the nature of the underlying asset. For example, whether a digital art as NFT will be treated as an intangible asset or good for levying income tax and Goods and Services Tax (GST). GST applicability will also depend on whether the NFT platform is located in India or outside of India.
The GST regime also obligates an 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 (Section 52 of the CGST Act, 2017).In this regard, while the Tax Collected at Source (TCS)obligation under GST may apply to a normal marketplace wherein the consideration for the supply is collected by the marketplace. In the case of an NFT marketplace, the TCS obligation under GST should not apply, as the consideration for the supply is not collected by the NFT marketplace but, directly transferred between the parties through an automated contract.
In India, it is in the developing phase. It is up to the government how they have been regulated, the government has been trying to regulated cryptocurrencies also, similarly,NFTs would also expect to be regulated in a similar fashion. It is yet to see how government will react such instruments. Also, there are no guidelines from RBI for regulating NFTs and their transactions.
As of now NFTs are billed as digital art pieces and there is no particular regulation defining the position of NFTs, so we might have to rely on regular principles of the Indian Contract Act and the Sales of Goods Act, for the sale/purchase of NFTs.
Anand Rai is an associate at Sarvaank Associates. He advises and acts on transactions and corporate commercial work, with a special focus on corporate finance and policy. IDisclaimer: The views or opinions expressed are solely of the author.