The GoI’s decision is well intentioned. It intends to broaden the tax base and capture the details of transactions involving VDAs. As the Minister of Finance told Parliament, “TDS (tax withheld at source) is more for monitoring. It is not an additional tax, nor a new tax. It is a tax that will help people track it, but at the same time the taxpayer can still reconcile it with the total tax payable to the government. Its consequences, however, go far and introduce obstacles to the ability of Indian cryptocurrency exchanges and VDA traders to conduct business in the country. TDS can have a big impact on the liquidity of Indian crypto markets. It also poses an existential threat to crypto exchanges, dramatically reduces the working capital of VDA traders, and cripples their ability to generate profits.
Indian crypto exchanges rely on professional VDA traders to provide liquidity for trading pairs (like rupee-bitcoin) at a margin. The margins of these traders are thinly sliced, usually in lower decimal fractions of one percent. So, they have to make multiple transactions – think double or triple digits – to generate a profit and be able to run their business. Furthermore, these professional VDA traders are the main drivers of liquidity in the Indian cryptocurrency markets and account for a very large volume of overall crypto trade.
If TDS is imposed, professional VDA traders, whose profits are squarely dependent on the volume of trades they make, end up with less trading capital after each trade. The calculations on the back of the envelope suggest that a trader will end up with 60% of their initial capital after TDS over 50 trades. This sucks liquidity from the crypto ecosystem.
The dwindling liquidity is having a ripple effect on Indian crypto exchanges and market participants. This calls into question the ability of exchanges to keep up with demand and artificially inflates VDA prices. This, in turn, discourages crypto enthusiasts from participating in crypto markets, leading to lower trading.
This, therefore, means less revenue for the Treasury (than it could have generated without TDS). It also puts Indian crypto exchanges, which are among India’s most promising startups, at a competitive disadvantage. More worryingly, TDS may unwittingly encourage VDA trading on unregulated offshore trading channels. This is why stronger engagement with the Indian crypto ecosystem and a review of TDS may be a more cautious approach for the government.
Indian courts have struck down tax and tax rules in cases where such rules have deprived citizens of working capital or thwarted their ability to generate profits. In ‘Avante Tablewares v. to continue their business. He concluded that the refusal imposed an unreasonable restriction on the merchants’ ability to carry on their trade and business and violated section 19(1)(g) of the Constitution.
Do Not Do Crypto Crawlies
Similarly, in the 2010 case “Suman Enterprises v. State of Karnataka”, the Karnataka High Court ruled that the TDS on iron and steel sales, which deprived traders of working capital and forced them to meet their tax liability on nominal profits, had failed to pass the test of constitutionality. The Supreme Court has also held on numerous occasions that a restriction on the right of citizens to carry on their trade or business must be proportionate – that is, the restriction must have a legitimate aim and must be appropriate to reach this goal.
The restriction must also fulfill the condition that there are no less invasive alternatives and that there is an appropriate relationship between the importance of achieving the objective and the limitation of citizens’ rights. The Supreme Court reiterated this principle in March 2020 in the judgment of the Internet and Mobile Association of India (IAMAI) in which it struck down the April 2018 circular of the Reserve Bank of India (RBI) prohibiting banks and other regulated entities to service virtual currency businesses.
If the Indian government’s intention in the TDS on the transfer of VDAs is to broaden the tax base, the jury is still out on whether the TDS (and its high rate of 1%) goes too far. For example, the securities transaction tax in India is 0.1%. And if the intention is to have greater visibility into VDA transactions, surely there must be better (and less invasive) measures for that. It is well known that VDA transactions are recorded on decentralized blockchains. They leave a permanent and immutable mark. It is possible to design systems that allow the government to have transparent and traceable access to these records. The Indian crypto ecosystem needs to proactively engage with the GoI and explore suitable alternative approaches to achieve its goals.