Here's how tax clarification on set-off of cryptocurrency gains and losses affects investors

The legal mandate on bringing digital assets under the ambit of taxation in this year’s budget speech was indeed a welcome and motivating move for the entire digital asset industry and Web 3.0 market.

While a flat tax rate of 30% on gains from trading in virtual digital assets (VDA) announced by the Finance Minister appeared to be a cause of some concern (but not a deterrent in trading and investing) at that stage, the government has stepped up to give cryptocurrencies/VDAs some form of recognition as an asset class for the purposes of taxation, even though the sector otherwise remains largely unregulated.

In addition, while responding to the queries on the said subject matter by one of the Parliamentarians, the Government, on March 21, clarified that “as per the provisions of the proposed Section 115BBH to the Income-tax Act, 1961, loss from the transfer of a VDA will not be allowed to be set-off against the income arising from the transfer of another VDA”.

This essentially implies that each VDA in an investor’s portfolio, i.e, crypto coins or non-fungible tokens (NFT), will be treated as a separate asset class, and the gain or loss against the transfer of a particular VDA cannot be set off/adjusted against the loss or gain, respectively, in any other VDA.

In simple words, if an investor trades in Coin A and Coin B, the gains in Coin A in a particular financial year will only be allowed to be reduced/adjusted against the losses incurred while trading in Coin A (not Coin B).

By way of an example (hypothetically), let us say X invested Rs 1,000 in Coin A and Rs 1,000 in Coin B.

When X sold the VDAs (both Coin A and Coin B), gains from Coin A were Rs 500, losses from Coin B were Rs 600, and the remaining capital was as follows:

Coin A: Rs 1,000 + Rs 500 (gains) = Rs 1,500

Coin B: Rs. 1,000 – (Rs 600) = Rs 400

Remaining Capital = Rs 1,900

While X suffered an overall loss of Rs 100, as per the government's clarification, since each VDA is required to be treated separately for the purposes calculating gains /losses, X will have to pay tax on the capital gains from trading in Coin A. That is to say, he will have to pay Rs 150 as tax (30 percent of the Rs 500).

Though the government’s position on including VDA under the ambit of tax incidence was positive and reaffirming for the industry and market participants, this recent clarification on disallowing the setting off of losses against the income arising from transfer of another VDA is concerning and is likely to dampen the influx of retail investment and participation of investors in this asset class.

Mining cost will not be allowed as expenses

Further, if one were to engage in mining of the VDA, which requires a substantial investment, the Government has clarified that such costs will not be allowed to be adjusted against the gains, as the same is a capital investment. However, depreciation may be allowed to be claimed against capital investment in IT systems acquired for the purposes of mining VDAs.

Considering this clarification by the Government, it is likely that the onus to make relevant disclosures will be put on both crypto exchanges as well as investors, and a KYC process is likely to be mandated along with transactions in fiat currency presumably being linked to PAN and Aadhaar.

Apart from a few leakages in collection of data (which also exist while dealing with fiat currency), the discovery of transactions in VDA can be effected by bringing in relevant rules and regulations mandating market participants to make and share relevant disclosures with the Government.