Esya Center Sheds Light on Exodus of Market Capital in India

A new report studied the impact of India’s tax policy on centralized Virtual Digital Asset (VDA) exchanges, which was announced on Feb. 1, 2022, during the Union Budget 2022-23. At the time, the government announced a levy of a flat 30% tax on gains from VDA trade applicable from Apr. 1, 2022, which is one of the highest tax rates implemented.

There is also a levy of 1% tax deducted at source (TDS) on transactions above INR 10,000 from Jul. 1, 2022, but no country, except India, imposes a TDS on VDA transactions. 

On top of that, the Indian government has included a provision disallowing the offsetting of losses applicable from Apr. 1, 2022, which acts as a “disincentive as trading risks cannot be hedged against profits.” 

This is unlike most other countries that allow offsetting of losses, except for Japan and Brazil. But not only Brazil has a lower tax rate, but it also offers gains up to USD 7,300 per month as tax-free, while Japan covers gains from VDA as taxable income. 

With this policy stance, the Indian government aims to track VDA transactions by resident Indians and their corresponding sources of income, discourage speculation and trading on VDAs, and build guardrails for financial stability.

This move, however, is hurting the country’s crypto industry. It has caused a notable fall in the volumes of each of the three Indian VDA exchanges, as per the report titled “Virtual Digital Asset Tax Architecture in India: A Critical Examination,” published in January 2023 by Esya Centre.

The sharp decline in volume saw the trading volume on Indian VDA exchanges falling from 0.57% of foreign VDA exchanges in Jan 2022 to just 0.03% in Oct 2022. This represents a 97.1 percent volume loss compared to the corresponding period in Jan 2022, while foreign exchanges have only lost 36.3% of volume during the same time frame.

The Findings: Loss of $1.2 trillion Trading Volume

The report found that following the announcement of a new tax regime in India, there was a shift of cumulative trade volume of around USD 3,852 million (~INR 32 thousand crores) from domestic centralized VDA exchanges to foreign ones during Feb-Oct 2022. Of this, a total volume of USD 3,055 million (~INR 25.3 thousand crores) was offshored within six months of the current financial year.

According to a sample of 5436 peer-to-peer traders and industry estimates, the total trade volume contributed by Indians on foreign centralized VDA exchanges was about USD 9,670 million (INR 80 thousand crores) between July and Oct 2022, the report found. 

All of this means in the two months following the announcement of the Union Budget 2022; domestic centralized VDA exchanges lost 15% of their trading volumes. In the three months following the implementation of the flat 30% tax, they lost another 14% of their trading volumes. Finally, in four months following the implementation of the 1% TDS, Indian VDA exchanges, yet again, lost a whopping 81% of their trading volumes.

The report estimates that many Indian VDA users might be switching from domestic to centralized foreign exchanges — a trend seen from Feb 2022 after the Union Budget announcement. 

Meanwhile, VDA adoption by Indians, measured by mobile app downloads, fell by 16% on a month-on-month basis for domestic exchanges, in contrast to increasing by the same amount for foreign exchanges, during Jul-Sep 2022, as per the report.

The report noted that the current tax treatment of VDAs in India is “regressive” compared to other countries with high VDA adoption rates, such as the US, UK, South Africa, Brazil, Philippines, and Vietnam. 

For instance: the tax rate ceiling of 37% in the US impacts the wealthiest 4% population in the country, while in countries like the UK, Canada, South Africa, Japan, and the Philippines, the tax rate above 30% impacts only a small fraction of high-income traders.

“Most countries have a progressive tax structure either on trade gains or on the value held at the end of the financial year,” stated the report. 

According to the document, the current tax architecture may result in a loss of about USD 1.2 trillion (INR 99.3 lakh crores) of local exchange trade volume over the next four years if the government doesn’t put any measures into place to improve the situation. This would be relative to a pro-market scenario where TDS on VDAS is at par with that on securities; tax policy allows for the set-off of losses; and taxation of gains from VDAs is internationally competitive, the report said.

Recommendation: A Progressive Tax Structure

Overall, the report has found that the current tax regime in India diminishes the efficacy of the tax policy, deters international investors, reduces the competitiveness of Indian VDA exchanges, and poses greater risks to financial stability by prompting investors to evade tax through increased grey market trading. 

The report concludes that the flat 30% tax on gains from VDA transactions is high without the provision of loss offsetting. Then there is a levy of 1% TDS, which makes India uncompetitive in the VDA ecosystem. This is also causing VDA investors to offshore their liquidity, which is important for concurrent economic value creation in the country. 

To mitigate the negative effects of the current VDA tax architecture, the report recommended the Indian government consider lowering the TDS rate to curb the distortionary effect it has on the industry, particularly since any rate of TDS can meet the transaction tracking purpose. 

According to the report, the government should collect data on the optimal tax rate for the VDA market through Laffer-Curve analysis to generate revenue and improve the VDA ecosystem’s contribution to the economy.

Esya further recommends the government consider a progressive tax structure with different rates for short-term and long-term gains, as has been adopted by other countries. It said that this would likely lead to increased tax revenue from frequent and higher speculative gains without crowding out market liquidity.

In addition to tax measures, the report stated that high volumes of P2P trade suggest that India also needs to enhance its international coordination along with institutional oversight on VDA exchanges. One way to do this would be to implement an appropriate licensing scheme. “The G20 platform offers an opportunity to learn from international best practices towards both,” the report said.

Is Italy adopting similar tax rules?

As countries across the globe debate digital currency regulations, Italy has passed a budget law that describes cryptocurrencies as virtual, electronically distributed ledger-based wealth that can be stored and transferred. 

The 2023 budget law defines the circumstances under which cryptocurrencies will be taxed. However, the law specifies that “the exchange between crypto assets having the same characteristics and functions does not constitute a taxable event.”

According to a report, Italy has about 1.3 million crypto holders, nearly 2.3 % of its population. Most of these crypto users were between the ages of 28 and 38 as of July 2022. 

Late last month, the Italian Parliament gave the green light to a 26% capital tax on cryptocurrency gains as part of the 2023 budget law. This tax rate applies to gains from crypto trading exceeding 2,000 euros per tax period. Previously, crypto was treated as foreign currencies in the country, with lower taxes. 

The new law, however, offers incentives for taxpayers to declare their cryptocurrency holdings, proposing a “substitute tax” of 3.5% for undeclared crypto held before Dec. 31, 2021, and a 0.5% fine for each additional year.

Additionally, the budget law includes another incentive that will allow taxpayers to cancel their capital gains tax at 14% of the value of crypto assets held on Jan. 1, 2023, instead of the cost at the time of purchase. Investments in crypto that result in a loss of more than 2000 euros can also be deducted from any profits made and carried over to the next tax period.

With this move, Italy is following in the footsteps of Portugal, which has also implemented a capital gains tax on cryptocurrency at a rate of 28%. This proposal, which was revealed in October, included taxes on the free transfer of crypto and on the commissions charged by crypto exchanges and other operations that facilitate cryptocurrency transactions.

Italy’s legislation also follows the approval of the European Union’s MiCA bill, which aims to establish a consistent regulatory framework for cryptocurrency. The MiCA bill, approved by the 27 member countries, is expected to come into effect in 2024.