The Finance Bill 2022, presented as part of union budget 2022, introduced section 115BBH and section 194S to tax crypto transactions. Here is a summary of sections 115BBH and 194S.

• 1.  The bill defines, “Virtual Digital Asset” or VDA, that includes crypto currencies, and NFT.
• 2.  Section 115BBH: Income from VDA will be taxed at 30%.
• 3.  Section 194S: A 1% transaction tax on purchase of VDA either through INR or another VDA i.e., crypto to crypto trades. This tax has to be deducted by the payer before crediting the seller, commonly called as Tax Deduction at Source or TDS. This is applicable when the sum of transactions exceeds INR 50,000 in a financial year.
• 4.  Income can not be offset by losses and losses can not be carried forward to subsequent financial years.

The scope of section 115BBH is broad enough to include all forms of income from crypto such as airdrops, staking, yield farming and so on.

While this brought clarity and legitimacy to crypto assets, it created a logistic challenge for investors by way of having to pay and keep track of 1% transaction tax. A vast majority of crypto assets in India are traded on centralized exchanges such as Binance, WazirX. It is not uncommon for investors to trade a few dozen crypto coins in a day. Further, the VDA being sold on an exchange could be owned by the exchange, an intermediary or other retail investor. The buyer may not even know who the seller is. So deducting tax, tracking it and paying it for each transaction creates a big friction for retail investors. In view of this the Central Board of Direct Taxes released a circular, titled Circular No 13 of 2022, to reduce the burden of TDS logistics for retail investors.

The circular issued new guidelines pertaining to section 194S i.e., 1% TDS on VDA transactions. The guidelines apply only for VDA transactions taking place on exchanges. As far as retail investors are concerned nothing changes; they will have to incur 1% TDS on VDA transactions over INR 50,000 in a financial year. Just that the guidelines state that exchanges could take the onus of TDS deduction and discharging the tax collected to the government.

Below we go through different scenarios to understand how the crypto exchanges are impacted should they choose to handle TDS logistics.

A common use case of retail investors is to convert INR into stable coins (called on-ramp), trade stable coins for other coins and periodically take the profit off the exchange back to INR (called off-ramp). Each of these legs will incur 1% TDS. In case of on-ramp and off-ramp where one leg of the transaction is in INR it is straightforward to collect and discharge TDS. However, crypto-to-crypto transactions form the vast majority of volume in an exchange.

The guidelines in case of crypto-to-crypto transactions are as follows:

• 1.  Both the counterparties act as buyers and sellers and hence both will incur 1% TDS resulting in 2% net TDS. So the exchange will collect and discharge 2% TDS.
• 2.  Since the tax can only be discharged in INR the guideline stipulates the following mechanism.
• 3.  The 1% TDS collected from both the crypto currencies must be converted into one of Primary VDAs which include BTC, ETH, USDT, and USDC. This has to be done during the transaction and the conversion is done by selling the transacting currencies in an open market. For example if the transaction is 10 MATIC and for 20 BNB then 1 MATIC and 2 BNB must be sold in exchange for one of Primary VDA.
• 4.  On a daily basis the TDS accumulated in primary VDAs must be converted into INR which then is discharged to the government. This must be sold in an open market and the exchange itself can not be the buyer of these primary VDAs.

The guidelines also introduce reporting requirements for exchanges. Presumably these reports will be collated and the data will flow into 26AS to make it convenient for retail investors at the time of filing their tax returns.

The Circular No 13 is a big relief for retail investors who trade on exchanges. However there are some interesting second order effects here.

Retail investors can always trade crypto currencies off exchanges. In this case the burden of TDS rests squarely on the transacting parties. While circular No 13 is about exchanges it makes it clear that peer-to-peer exchanges are still subjected to TDS as usual.

The circular uses a broad definition of exchange. It is worth quoting it.

The term “Exchange” means any person that operates an application or platform for transferring of VDAs, which matches buy and sell trades and executes the same on its application or platform.

The circular doesn’t explicitly mention centralized or decentralized exchanges (DEX); we believe the definition is generic enough to encompass both. None of the DEXes are equipped to handle TDS so in all likelihood the onus of TDS calculation, deduction and discharge will be on retail customers. But most of the wallets participating in DEXes are not KYCd so it’s not clear if TDS even if done right is acceptable by the tax authorities because there’s no regulatory mechanism to prove the ownership of wallets.

A crucial implication of TDS on crypto-to-crypto transactions is forced conversion of crypto to fiat (INR). The more demand for a coin the more it’ll be converted to fiat. For instance, if BNB were to become popular and 10 million coins were traded then 1 million would be converted to INR. Exchanges have to sell these 1 million BNB in domestic market putting downward pressure on BNB prices. As the circular gets into full force we will witness many such interesting higher order effects.

A big attraction of decentralized finance is their promise of good returns through yield farming. This includes direct participation through protocols such as Aave, Compound etc.,. and indirectly through exchanges such as Binance and yield promising products. The TDS however will eat into a good chunk of the returns. For example, to participate in Compound one has to traverse the chain of INR ➞ USDC ➞ AAVE. And then AAVE ➞ USDC ➞ INR to book profits in INR. This results in 4% of TDS thus reducing the overall returns; then there’s a further 30% income tax on the overall gains.