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Feasibility of Non-Fungible Tokens in anticipation of the Cryptocurrency Bill, 2021

Introduction

Non-Fungible Tokens (“NFTs”) are, in simple terms, digital blockchain tokens that indicate ownership of objects, digital or physical in nature, which could be a photograph, painting or music. There is a lot of excitement around this innovation as use of NFTs have dual benefits: firstly, the authenticity and uniqueness of the object is endorsed under the particular NFT, and secondly, NFTs facilitate sales using smart contracts thereby improving the end-user experience. NFTs prima facie enable their creators to access the entire global market without the restrictions and legal implications associated with cross-border payments.1 NFT technology maintains a distributed ledger (also known as a blockchain) which records all the transactions details and ownership particulars of the digital asset. This recording of transactions by the blockchain with no conceivable expiry date also enables the artists to monitor the value of their “on sale” work while also tracking future sales/auctions and any royalties owed to the artist in relation to their work.

NFTs and Cross-Border Transactions in India

As of today, there exists no explicit regulation or legislation in India that prohibits or restricts an Indian resident from buying and/or selling NFTs. The treatment of NFTs would depend on the underlying digital or physical asset being considered. For now, NFTs may be regarded as a “digitally-signed certificate for the underlying asset”.2

However, the regulatory status of NFTs might potentially change with the introduction of the long-awaited Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (“2021 Bill”). The cryptocurrency and NFT supporters across the globe have been eagerly waiting for this 2021 Bill which is proposed to be introduced in the winter session of the Indian Parliament. Over the last few years, mixed signals have been given by the Indian regulatory authorities. The Reserve Bank of India (“RBI”) has repeatedly flagged the risks associated with cryptocurrency and the threat to macroeconomic and financial stability (refer our article here)3 while the Indian Government’s emerging view is that crypto cannot be permitted as a currency but may be “regulated” as an asset under the 2021 Bill. It is expected that the proposed 2021 Bill is likely to be aligned with the Financial Action Task Force guidance which includes updates on key definitions of virtual assets and virtual asset providers, risks and tools to address money laundering and terror financing risks.

Earlier, the “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill”4  (“Cryptocurrency Bill”) was introduced in the budget session of the Indian Parliament in early 2021 which proposed banning of cryptocurrency (refer our article here).5 The Cryptocurrency Bill defined “cryptocurrency” as:

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…

The above definition of “cryptocurrency” may have encompassed NFTs as NFTs could potentially be considered to be a representation of value that is exchanged with the promise of having an inherent value in business activity.6 Cryptocurrency Bill had also stipulated that the use of Distributed Ledger Technology would be permissible in instances of “creating a network for 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.” Ultimately, there is still ambiguity as to whether NFTs would fall under the scope of ‘services’ as defined above or qualify as cryptocurrencies or virtual currencies and be affected by any future law restricting or prohibiting crypto-asset transactions.

Ambiguities in relation to the nature of NFTs might also arise under the Foreign Exchange Management Act, 1999 (“FEMA”). The treatment under the current FEMA regime would largely depend on the classification of the underlying asset, physical or digital, being exchanged via the NFT. Even though FEMA governs cross-border transactions vis-à-vis India, the RBI had released a circular in 2018 requiring banks not to deal with or provide any services to entities dealing in cryptocurrency. This circular was struck down by the Supreme Court of India7 in February 2020 on a petition filed by the Internet and Mobile Association of India (refer our article here).8

NFTs and Taxation

Tax classification of NFTs would be based on the nature and characteristics of the underlying asset. For example, a NFT of digital art could potentially be classified as an “intangible asset” or “good” in terms of income tax and goods and services tax and be subjected to direct and indirect taxes. The cross-border and digital nature of transactions involving NFTs could lead to additional tax issues. For instance, the question whether there will be an exposure of 2% equalization levy on the gross value of the NFT and the income of the marketplace from Indian buyers on sale of NFTs by offshore sellers through an offshore NFT marketplace to Indian buyers needs to be addressed.

Intellectual Property Issues And NFTS

Another interesting aspect related to NFTs pertains to the intellectual property rights (“IPR”) and obligations in relation to NFTs. Considering that NFT is non-fungible in nature, IPR protection strategies will need to be devised to secure the digital asset and aspects related to licensing, assignment and transfer of the IPR in the digital asset. Depending upon the underlying agreement, the mere ownership of the NFT may not grant the ownership of the underlying art, music or the associated IPR creating a scenario where the NFT “owner” may not be allowed to circulate reproductions, publicly perform/display the work, or develop associated products/versions of the original work as the owner of the copyright may exclusively retain such rights. Thus, the underlying contract (which would need to be in writing) would determine the scope and extent of license or assignment and the rights transferred. Changes in the IPR laws would also be needed to address this unique situation.

Conclusion

Considering that the concept of NFTs has taken the world by storm, it can be argued that NFTs are here to stay. However, even though the concept of “tokenizing” property rights will facilitate sale transactions and maintenance of NFTs, the Indian regulations and regulatory authorities such as RBI and the Ministry of Finance will need to address the issues in relation to permitting or regulating fungible and non-fungible digital assets. As the number of Indian buyers and sellers of NFTs increase over the years, the legal regime addressing the myriad issues including anti-money laundering regulations, tax implications, financial regulations, intellectual property issues, etc. will gradually emerge. The Indian regulators can observe the evolving legal regimes pertaining to NFTs in countries like US, UK, China etc. while drafting and finalising its own set of regulations, inter alia, related to classification of NFTs in various categories; related regulatory, legal and tax implications; protection of investors from multiple originals of a work; protection of artists and owners themselves from violation of their intellectual property rights; modification of the copyright laws and supplementing the contracts with suitable clauses specifically drafted for NFTs.

 

Endnotes: –

1 Priyam Raj Kumar, “The Future of Non-Fungible Tokens in India”  (IJPIEL, 25 August 2021) (https://ijpiel.com/index.php/2021/08/24/the-future-of-non-fungible-tokens-in-india/)

2 Id.

3Seema Jhingan & Tanmay Mohanty, “End Of The Road For Private Cryptocurrencies In India – The Proposed Ban”, Mondaq (https://www.mondaq.com/india/fin-tech/834006/end-of-the-road-for-private-cryptocurrencies-in-india-the-proposed-ban)

4 Draft Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019, PRS Legislative Research,

(https://prsindia.org/files/bills_acts/bills_parliament/Draft%20Banning%20of%20Cryptocurrency%20&%20Regulation%20of%20Official%20Digital%20Currency%20Bill,%202019.pdf.)

5 Seema Jhingan, “The Proposed Prohibition Of Cryptocurrency In India”, Mondaq (https://www.mondaq.com/india/fin-tech/1036746/the-proposed-prohibition-of-cryptocurrency-in-india)

6 Id.

7 Internet and Mobile Association of India (IAMAI) v. Reserve Bank of India (Writ Petition (Civil) No.528 of 2018) (https://main.sci.gov.in/supremecourt/2018/19230/19230_2018_4_1501_21151_Judgement_04-Mar-2020.pdf)

8 Seema Jhingan & Dhruv Manchanda, “Can Virtual Currency Platforms Operate In India – Supreme Court’s Recent Judgement”, Mondaq (https://www.mondaq.com/india/fin-tech/907368/can-virtual-currency-platforms-operate-in-india-supreme-court39s-recent-judgement)