CRYPTOCURRENCIES: TRAPPED IN THE LABYRINTH OF LEGAL CORRIDORS (Part – 1)

A cryptocurrency is basically a virtual currency which is very secure. It is based on a cryptic algorithm / code (hence, the name cryptocurrency) which makes counterfeiting very difficult. The most important part about a VC is that no Government has issued it and hence it is not Fiat Money. It is a privately-issued currency which is entirely digital in nature. There are no paper notes or coins. Everything about it is digital. Further, it is based on blockchain technology, meaning that it is stored over a network of servers. Hence, it becomes difficult to say where exactly it is located. This also makes it very complicated for any Government to regulate VCs. This has been one of the sore points for the Indian Government. The fear that VCs would lead to money-laundering and financing of illegal activities is one of the key concerns associated with cryptocurrencies.

Many people associate cryptos (as they are colloquially known) only with Bitcoins. Yes, Bitcoins were the first cryptos launched in 2009 and remain the most popular, but now there are several other VCs such as Tethers, Litecoins, Binance Coins, Bbqcoins, Dogecoins, Ethereum, etc. At last count, there were about 200 VCs! VCs are bought and sold on crypto exchanges. Several such virtual currency exchanges operate in India, for example, WazirX, CoinDCX. Tesla, the US-based electric vehicle manufacturer, announced that it had bought US $1.5 billion worth of Bitcoins and that it would accept Bitcoins as a means of payment. It is estimated that there are over ten million crypto users in India and over 200 million users worldwide. In spite of such a huge market, it is unfortunate that neither the Indian tax nor the Indian legal system has kept pace with such an important global development.

While dealing with VCs one should also know about Non-Fungible Tokens (NFTs). These are units of data stored on a blockchain ledger and certify a digital asset. NFTs are useful in establishing fractional ownership over assets such as digital art, fashion, movies, songs, photos, collectibles, gaming assets, etc. Each NFT has a unique identity which helps establish ownership over the asset. NFTs have even entered the contractual space. For example, in 2019 Spencer Dinwiddie, a basketball player in the US, tokenised his player’s contract with the National Basketball Association, so that several investors could invest in the same. These NFTs could then be traded on a virtual exchange. These tokens carry an interest coupon and the amount raised from the token is given to the person creating the token, e.g., the basketball player. At the end of the maturity period, the token would be redeemed and they may or may not carry a profit-sharing in the revenues earned by the token creator. The payments for buying these tokens can also be made by using cryptocurrencies.

Recently, El Salvador became the first country in the world to legalise cryptocurrencies as legal tender. Thus, residents of El Salvador can pay for goods, services, taxes, etc., using virtual currencies like Bitcoins.

Let us try to analyse cryptocurrencies and understand the fast-changing and confusing regulatory and tax environment surrounding them in India. Since there has been a great deal of flip-flop on this issue, this Feature would cover all the key developments on the subject to clear the fog. There is a great deal of misinformation and ignorance on this front and hence all key regulatory developments have been analysed below, even if they were proposals which never got formalised.

CHEQUERED LEGAL BACKGROUND

FM’s 2018 speech
The Finance Minister in his Speech for Budget 2018-19 said that the Government did not consider cryptocurrencies as legal tender or coins and that all measures to eliminate the use of these currencies in financing illegitimate activities or as part of the payment system will be taken by the Government. However, he also said that the Government will explore the use of blockchain technology proactively for ushering in a digital economy.

RBI’s 2018 ban
The RBI had been cautioning people against the use of ‘Decentralised Digital Currency’ or ‘Virtual Currencies’ right since 2013. Ultimately, in April 2018, by a Circular the RBI banned dealing in virtual currencies in view of the risks which the RBI felt were associated with them:

• VCs being in digital form were stored in electronic wallets. Therefore, VC holders were prone to losses arising out of hacking, loss of password, compromise of access credentials, malware attacks, etc. Since VCs are not created by or traded through any authorised central registry or agency, the loss of the e-wallet could result in the permanent loss of the VCs held in them.
• Payments by VCs, such as Bitcoins, took place on a peer-to-peer basis without any authorised central agency which regulated such payments. As such, there was no established framework for recourse to customer problems / disputes / chargebacks, etc.
• There was no underlying or backing of any asset for VCs. As such, their value seemed to be a matter of speculation. Huge volatility in the value of VCs has been noticed in the recent past. Thus, the users are exposed to potential losses on account of such volatility in value.
• It was reported that VCs such as Bitcoins were being traded on exchange platforms set up in various jurisdictions whose legal status was also unclear. Hence, the traders of VCs on such platforms were exposed to legal as well as financial risks.
• The absence of information of counterparties in such peer-to-peer anonymous / pseudonymous systems could subject the users to unintentional breaches of anti-money-laundering and combating the financing of terrorism (AML / CFT) laws.

In view of the potential financial, operational, legal, customer protection and security-related risks associated with dealing in VCs, the RBI’s Circular stated that entities regulated by the Reserve Bank, e.g., banks, NBFCs, payment gateways, etc., should not deal in VCs or provide services for facilitating any person or entity in dealing with or settling VCs. Such services were defined as including, maintaining accounts, registering, trading, settling, clearing, giving loans against virtual tokens, accepting them as collateral, opening accounts of exchanges dealing with them and transfer / receipt of money in accounts relating to purchase / sale of VCs. This diktat from the RBI came as a body-blow to the fast-expanding cryptocurrency industry in India.

IMC’s 2019 criminalisation sword
In 2019, an Inter-Ministerial Committee (IMC) of the Government presented a Report to the Government recommending a ban on all VCs. It proposed that not only should VCs be banned but any activity connected with them, such as buying / selling / storing VCs should also be banned. Shockingly, the IMC proposed criminalisation of these activities and provided for a fine of up to Rs. 25 crores and / or imprisonment of up to ten years. It categorically held that a VC is not a currency. Fortunately, none of the recommendations of this IMC Report saw the light of day.

Supreme Court’s 2020 boon
This Circular of the RBI came up for challenge before the Apex Court in the case of Internet and Mobile Association of India vs. Reserve Bank of India, WP(C) No. 528/2018, order dated 4th March, 2020 (SC). The ban was challenged by the Internet and Mobile Association of India, an industry body which represented the interests of the online and digital services industry along with a few companies which ran online crypto assets exchange platforms. A three-Judge Bench in a very detailed judgment assayed the RBI Circular. The Court examined three crucial questions.

Question #1: Are VCs currency under Indian laws?
• The Court noted that the word ‘currency’ is defined in section 2(h) of the Foreign Exchange Management Act, 1999 to include ‘all currency notes, postal notes, postal orders, money orders, cheques, drafts, travellers’ cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments as may be notified by the RBI.’ The expression ‘currency notes’ was also defined in FEMA to mean and include cash in the form of coins and banknotes. Again, FEMA defined ‘Indian currency’ to mean currency which was expressed or drawn in Indian rupees. It also observed that the RBI had taken a stand that VCs did not fit into the definition of the expression ‘currency’ under section 2(h) of FEMA, despite the fact that the Financial Action Task Force (FATF) in its Report defined virtual currency to mean a ‘digital representation of value that can be digitally traded and functions as (1) a medium of exchange; and / or (2) a unit of account; and / or (3) a store of value, but does not have legal tender status.’ According to this Report, legal tender status is acquired only when it is accepted as a valid and legal offer of payment when tendered to a creditor.

• Neither the Reserve Bank of India Act, 1934 nor the Banking Regulation Act, 1949, the Payment and Settlement Systems Act, 2007, or the Coinage Act, 2011 defined the words ‘currency’ or ‘money’.

• The Prize Chits and Money Circulation Schemes (Banning) Act, 1978 defined money to include a cheque, postal order, demand draft, telegraphic transfer or money order.

• Section 65B of the Finance Act, 1994, inserted by way of the Finance Act, 2012, defined ‘money’ to mean ‘legal tender, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, travellers’ cheque, money order, postal or electronic remittance or any other similar instrument, but shall not include any currency that is held for its numismatic value’. This definition was important, for it identified many instruments other than legal tender which could come within the definition of money.

• The Sale of Goods Act, 1930 did not define ‘money’ or ‘currency’ but excluded money from the definition of the word ‘goods’.

• The Central Goods and Services Tax Act, 2017 defined ‘money’ under section 2(75) to mean ‘the Indian legal tender or any foreign currency, cheque, promissory note, bill of exchange, letter of credit, draft, pay order, travellers’ cheque, money order, postal or electronic remittance or any other instrument recognised by RBI, when used as a consideration to settle an obligation or exchange with Indian legal tender of another denomination but shall not include any currency that is held for its numismatic value.’

The Supreme Court ultimately held that nothing prevented the RBI from adopting a short circuit by notifying VCs under the category of ‘other similar instruments’ indicated in section 2(h) of FEMA, 1999 which defined ‘currency’ to mean ‘all currency notes, postal notes, postal orders, money orders, cheques, drafts, travellers’ cheques, letters of credit, bills of exchange and promissory notes, credit cards or such other similar instruments as may be notified by the Reserve Bank.’ Promissory notes, cheques, bills of exchange, etc., were also not exactly currencies but operated as valid discharges (or the creation) of a debt only between two persons or peer-to-peer. Therefore, it held that it was not possible to accept the contention that VCs were just goods / commodities and could never be regarded as real money!

Question #2: Did RBI have power to regulate VCs?
The Apex Court observed that once it was accepted that some institutions accept virtual currencies as valid payments for the purchase of goods and services, there was no escape from the conclusion that the users and traders of virtual currencies carried on an activity that fell squarely within the purview of the Reserve Bank of India. The statutory obligations that the RBI had, as a central bank, were (i) to operate the currency and credit system, (ii) to regulate the financial system, and (iii) to ensure the payment system of the country to be on track, and would compel them naturally to address all issues that are perceived as potential risks to the monetary, currency, payment, credit and financial systems of the country. If an intangible property could act under certain circumstances as money then RBI could definitely take note of it and deal with it. Hence, it was not possible to accept the contention that cryptocurrency was an activity over which RBI had no power statutorily. Hence, the Apex Court held that the RBI has the requisite power to regulate or prohibit an activity of this nature. The contention that the RBI was conferred only with the power to regulate, but not to prohibit, did not appeal to the Court.

The Supreme Court further held that the RBI’s Circular did not impose a total prohibition on the use of or the trading in VCs. It merely directed the entities regulated by the RBI not to provide banking services to those engaged in the trading or facilitating of the trading in VCs. Section 36(1)(a) of the Banking Regulation Act, 1949 very clearly empowered the RBI to caution or prohibit banking companies against entering into certain types of transactions or class of transactions. The prohibition was not per se against the trading in VCs. It was against banks, with respect to a class of transactions. The fact that the functioning of VCEs automatically got paralysed or crippled because of the impugned Circular was no ground to hold that it was tantamount to a total prohibition.

It observed that so long as those trading in VCs did not wish to convert them into currency in India and so long as the VC enterprises did not seek to collect their service charges or commission in currency through banking channels, they will not be affected by this Circular. Peer-to-peer transactions were still taking place without the involvement of the banking channel. In fact, those actually buying and selling VCs without seeking to convert currency into VCs or vice versa, were not at all affected by the RBI’s Circular. It was only the online platforms which provided a space or medium for the traders to buy and sell VCs that were seriously affected by the Circular, since the commission that they earned by facilitating the trade was required to be converted into fiat currency.

Various regulatory events from 2013 to 2018 showed that RBI had been brooding over the issue for almost five years before taking the extreme step of issuing the Circular. Therefore, the RBI could not be held guilty of non-application of mind. The Apex Court held that if RBI took steps to prevent the gullible public from having an illusion as though VCs may constitute a valid legal tender, the steps so taken were actually taken in good faith. The repeated warnings through press releases from December, 2013 onwards indicated a genuine attempt on the part of the RBI to safeguard the interests of the public. Therefore, the impugned Circular was not vitiated by malice in law and was not a colourable exercise of power.

Thus, the RBI had the power to regulate and prohibit VCs.

Question #3: Was RBI’s Circular excessive and ultra vires?
The Supreme Court then held that citizens who were running online platforms and VC exchanges could certainly claim that the Circular violated Article 19(1)(g) of the Constitution which provides a Fundamental Right to practice any profession or to carry on any occupation, trade or business to all citizens subject to Article 19(6) which enumerated the nature of restriction that could be imposed by the State upon the above right of the citizens. It held that persons who engaged in buying and selling virtual currencies just as a matter of hobby could not take shelter under this Article since what was covered was profession / business. Even people who purchased and sold VCs as their occupation or trade had other ways such as e-Wallets to get around the Circular. It is the VC exchanges which, if disconnected from banking channels, would perish.

The Supreme Court held that the impugned Circular had almost wiped the VC exchanges out of the industrial map of the country, thereby infringing Article 19(1)(g). The position was that VCs were not banned, but the trading in VCs and the functioning of VC exchanges were rendered comatose by the impugned Circular by disconnecting their lifeline, namely, the interface with the regular banking sector. It further held that this had been done (i) despite the RBI not finding anything wrong about the way in which these exchanges functioned, and (ii) despite the fact that VCs were not banned. It was not the case of RBI that any of the entities regulated by it had suffered on account of the provision of banking services to the online platforms running VC exchanges.

Therefore, the Court concluded that the petitioners were entitled to succeed and the impugned RBI Circular was liable to be set aside on the ground of being ultra vires of the Constitution. One of the banks had frozen the account of a VC exchange. The Court gave specific directions to defreeze the account and release its funds. Accordingly, the Supreme Court came to the rescue of Indian VC exchanges.

Along with the above Supreme Court decision, another decision which merits mention is that of the Karnataka High Court in the case of B.V. Harish and Others vs. State of Karnataka (WP No. 18910/2019, order dated 8th February, 2021. In this case, based on the RBI’s Circular, the police had registered an FIR against the directors of a company for running a cryptocurrency exchange and a VC ATM. The Karnataka High Court relied upon the decision of the Supreme Court explained above and quashed the chargesheet and other criminal proceedings.

Recently, the RBI in a Circular to banks and NBFCs has stated that certain entities are yet cautioning their customers against dealing in virtual currencies by making a reference to the RBI Circular dated 6th April, 2018. The RBI has directed that such references to the abovementioned Circular were not in order since it had been set aside by the Supreme Court. However, the RBI has added that banks / entities may continue to carry out customer due diligence processes in line with regulations governing standards for Know Your Customer (KYC), Anti-Money Laundering (AML), Combating of Financing of Terrorism (CFT) and obligations of regulated entities under Prevention of Money Laundering Act (PMLA), 2002, in addition to ensuring compliance with relevant provisions under FEMA for overseas remittances.

Finance Minister’s interviews
In February / March, 2021 in reply to questions raised in the Rajya Sabha as to whether the Central Government was planning to issue strict guidelines on cryptocurrency trading and whether the Government was doing anything to curb clandestine trading of VCs, the Finance Minister stated that a high-level Inter-Ministerial Committee (IMC), constituted under the Chairmanship of the Secretary (Economic Affairs) to study the issues related to VCs and propose specific actions to be taken in the matter, had recommended in its report that all private cryptocurrencies, except any cryptocurrency issued by the State, be prohibited in India. The Government would take a decision on the recommendations of the IMC and the legislative proposal, if any, would be introduced in the Parliament following the due process.

Recently, in March, 2021, the Finance Minister has said that the Government was not closing its mind and that they were looking at ways in which experiments could happen in the digital world and cryptocurrencies. She has also stated that ‘From our side, we are very clear that we are not shutting all options. We will allow certain windows for people to do experiments on the blockchain, bitcoins or cryptocurrency… A lot of fintech companies have made a lot of progress on it. We have got several presentations. Much work at the state level is happening and we want to take it in a big way in IFSC or Gift City in Gandhinagar.’

MCA’s 2021 Rules for companies
In March, 2021 the Ministry of Corporate Affairs has mandated all companies to disclose certain additional information in their accounts from 1st April, 2022. One such important information pertains to details of cryptocurrency or virtual currency.

Where the company has traded or invested in cryptocurrency or virtual currency during the financial year, the following details have to be disclosed in its Balance Sheet:
(a) profit or loss on transactions involving the cryptocurrency or virtual currency, (b) amount of currency held as at the reporting date, (c) deposits or advances from any person for the purpose of trading or investing in cryptocurrency / virtual currency.

Similarly, the Profit & Loss Statement of such a company must carry the following additional details:
(i) profit or loss on transactions involving cryptocurrency or virtual currency, (ii) amount of currency held as at the reporting date, and (iii) deposits or advances from any person for the purpose of trading or investing in cryptocurrency or virtual currency.

CRYPTOCURRENCY BILL, 2021
The Government had proposed to table ‘The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021’ during the January to March, 2021 session of the Lok Sabha. However, it was not introduced. The purport of this Bill states that it aims to create a facilitative framework for creation of the official digital currency to be issued by the Reserve Bank of India. The Bill also seeks to prohibit all private cryptocurrencies in India; however, it allows for certain exceptions to promote the underlying technology of cryptocurrency and its uses. It would be interesting to see the contours of this Bill when it is tabled. However, it seems quite clear that the Government is considering introducing its own digital currency to be issued by the RBI. One aspect which is worrying is that it seeks to prohibit all private VCs. Does this mean that the Government would get over the Supreme Court verdict by this law?

(To be continued)