Bitcoin is a decentralized digital currency that is exchanged between two parties without involving intermediaries such as banks or other financial institutions.
As defined in a whitepaper published by the hidden inventor of Bitcoin, Satoshi Nakamoto, Bitcoin is “a pure peer-to-peer version of electronic cash that will allow online payments to be sent directly from one party to another without going through a financial institution”.
To understand Bitcoin, one needs to understand the underlying structure, workings of the Bitcoin ecosystem and the extent of usage of the same in India.
How does Bitcoin work?
Bitcoin achieves the elimination of intermediaries using its underlying technology, blockchain.
If you currently need to transfer money to someone, one of the possible ways is to give cash or alternatively use a trusted intermediary (such as a bank). Both mechanisms, whether physical cash (with the country’s central bank as guarantor) or electronic transfer, involve an intermediary (in the latter case a bank or other financial institution). When intermediaries are involved, there are transaction costs.
How blockchain technology helps eliminate intermediaries is by replacing the trust that intermediaries bring to the table with cryptographic proof using CPU computing power.
This cryptographic trust is built into Bitcoin through a wallet, a public key and a private key in the program.
Anyone can create a Bitcoin wallet for free by downloading the Bitcoin program. Each wallet contains a public key and a private key.
The public key is like an address or an account number through which any person can receive Bitcoins.
A private key is like a digital signature through which a person can send Bitcoins. The name suggests that private keys should only be held and known by the owner, and public keys can be shared with anyone to receive Bitcoins. That is where you would have heard in the news about Bitcoins being lost either because a private key is not available or stolen by hackers.
Owners of Bitcoin addresses are not explicitly identified, but all transactions on the blockchain are public.
Since the inception of Bitcoin in 2009, every single transaction that has occurred is stored in a ledger, which is considered immutable, non-manipulable and irreversible.
Bitcoin transactions are verified via telecommunications network nodes through cryptography and then recorded in a decentralized distributed ledger called blockchain. This is one of the distinguishing aspects of Bitcoin from some other cryptoassets, where there is a centralized exchange (like the stock exchange) through which all transactions must be routed or validated.
How does Bitcoin Mining work?
In the Bitcoin ecosystem, there is a network of miners who use their CPUs to process transactions.
- When a user intending to send Bitcoin enters the public address, the number of Bitcoins to send and attaches the private key to generate the signature, the encrypted information is sent to the network of miners who are tasked with verifying whether there is sufficient balance to transfer and authenticate the transaction.
- The faster the miner’s CPU, the more likely they will verify and the miner will be rewarded in Bitcoins for facilitating the transfer.
- Here, the miner’s job is only to provide CPU power, which automatically runs the Bitcoin program to validate Bitcoin transfers. There is no manual intervention by the Bitcoin miner.
- Once the transaction is processed by a Bitcoin miner, this number of transactions is broadcast to the network of miners who get the copy or download of the same block.
- These blocks through a timestamp mechanism are stored in a sequential or chronological order and form a blockchain. Every miner in the network is supposed to have the updated and complete copy of the ledger or blockchain if they want to facilitate transfer and earn Bitcoins.
The program is built in such a way that the ledger or blockchain is automatically updated.
According to the original Bitcoin white paper, the probability of hackers manipulating the blockchain is almost zero due to the copy of updated ledger each miner has. If someone tries to tamper or hack the ledger in any way to gain unfair advantage, the miner is immediately considered invalid and fails to process transactions until they have a copy of the untampered ledger.
Can Bitcoin be considered a real currency?
It is debatable whether Bitcoin is a currency at all, and why any country would want to replace it with its existing currency, as Bitcoin has no intrinsic value.
By definition, a currency is “a system of money in general use in a particular country,” or “the fact or quality of being generally accepted or in use.” Currently, there is some traction in the number of companies using Bitcoin as a payment method, but no major country or economy has accepted it as money in general use. An exception is El Salvador, which adopted Bitcoin as legal tender in September 2021 and became the first country to do so.
One of the important reasons for the remarkable development of Bitcoin is the tightening of know your customer (KYC) and anti-money laundering (AML) regulations by banks and financial institutions. There is now a much greater cross-border exchange of information between the countries about the transactions through the banking system.
As a result, it is also claimed that Bitcoins are widely used as a parallel mechanism for the transactions, which would otherwise be illegal in several countries.
Another important aspect is the acceptance of Bitcoin as a global payment mechanism, which is not linked to any particular country’s currency and thus not directly affected by developments in a particular country.
Regulation of Bitcoin in India
On the regulatory front, India saw two major developments this year:
In February 2022, in India, the Indian government proposed to introduce taxation on virtual digital assets, which would entail a taxation system for cryptocurrencies, but there is no clarity on whether the Indian government finds cryptocurrencies legal either as “assets” or “currency” .
India’s finance minister has categorically stated since then that “taxing cryptocurrencies does not mean legalizing them”. This indicates that the government is still considering all the factors related to cryptocurrencies and it would be early to make any assumptions about their legality.
Taxation of Bitcoin in India
Although India has not specified its position on the legality of investments in Bitcoin, the recently announced Budget 2022 vide Finance Bill 2022 proposes to introduce a framework for taxation of virtual digital assets. Once the finance bill has been ratified into law, the aforementioned framework will come into force for the financial year 2022-2023 and beyond.
The taxation under the Budget 2022 proposal will be the taxation of gains at a rate of 30% when transferring Bitcoin.
The Government has proposed to introduce a new section 115BBH in the Income Tax Act 1961 (the “IT Act”) for the taxation of income from the transfer of virtual digital assets. In accordance with the said section, where the total income includes any income from the transfer of virtual digital assets, the said income will be subject to a tax rate of 30%, and such rate will be augmented by an applicable additional rate, if any, and a health- and educational offers.
According to Section 2 (47) of the IT Act, virtual digital assets shall mean any information, code or number or token (not Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name, which provides a digital representation of value exchanged with or without consideration, with the promise or representation of having intrinsic value or serving as a store of value or unit of account, including use in any financial transaction or investment, but not limited to investment scheme and may be transferred, stored or traded electronically.
Thus, the definition of virtual digital assets is quite broad to include all forms of cryptocurrencies including Bitcoin.
It is therefore safe to understand that any gain from the transfer of Bitcoins will be subject to a tax rate of 30% (plus the applicable additional rate and health and education allowance), which could result in an effective tax rate ranging from 31.2% to 42, 7%.
Eligibility to claim deductions for expenses for acquiring Bitcoin
The proposed provisions specifically state that any deduction for expenditure (other than acquisition cost) incurred by the assessee in respect of such digital assets will not be allowed in computing the gain on transfer of such assets. Simply put, only the cost of acquiring the digital assets i.e. Bitcoin will be allowed as a deduction.
In case a person acquires a Bitcoin with the help of mining, the same can be treated as self-generated capital assets. However, the provisions in section 55 of the IT Act, which allow for the calculation of the costs of acquiring self-generated assets, do not specifically provide for such a calculation method for cryptocurrency.
Clarification is therefore required with regard to the calculation of the acquisition cost of Bitcoins when they are obtained through mining.
Also, if a person acquires a Bitcoin as a gift, the recipient of the Bitcoin will be liable to tax in India and accordingly the definition of “property” under Section 56(2)(x) has been revised to include virtual digital assets within its ambit . The provision further restricts the taxpayer or investor from offsetting the loss on the transfer of virtual digital assets against any other income.
Application of withholding tax at a rate of 1% in accordance with Section 194S
Budget 2022 also proposed to impose withholding tax on the transfer of virtual digital assets in accordance with Section 194S of the IT Act. Accordingly, with effect from 1 July 2022, any person liable to pay a resident an amount as consideration for transfer of a virtual digital asset i.e. Bitcoin will deduct withholding tax of 1% at the time of crediting such amount to the resident’s account or at the time of payment, whichever is earlier.
Such retention will be subject to the following monetary limits:
No clarity on taxation of virtual digital assets transferred before 1 April 2022
The provisions for taxation of virtual digital assets (excluding TDS) are proposed to come into force from 1st April 2022 i.e. the financial year 2022-23 onwards. However, there is no clarity regarding the taxation of crypto-assets that the taxpayers would have transferred or sold or gifted up to the financial year 2021-22.
Several taxpayers have treated Bitcoins as an asset and treated the capital gain as short-term or long-term (with indexation benefit) depending on the holding period and paid tax based on the concessional tax rate or normal slab rates, as the case may be.
What happens if I invest in Bitcoin in India?
Although there is a lot of uncertainty and volatility surrounding the prices of Bitcoin and its legality in India, it is certain that blockchain technology promises a lot of innovation and the way transactions are settled.
If you want to invest in Bitcoin, keep in mind that only those investors who have a high risk appetite should consider part of their portfolio to be invested in Bitcoins. This is due to downside price risk, high tax on gains from the sale of Bitcoins in India, a possible Goods and Services Tax (GST) exposure and the uncertainty arising from the legal status of Bitcoins in India.
As for investors who already have Bitcoins, there is no need to panic, as even in the event of a regulatory ban, it is likely that transitional provisions for sales will be made. Those who had invested in Bitcoins and sold the same but have not reported the profits in their income tax return must go ahead and declare their investments.
