Technology

Demystifying the conundrum surrounding non-fungible tokens

“This is the whole point of technology.  It creates an appetite for immortality on the one hand.  It threatens universal extinction on the other. Technology is lust removed from nature.”

Don DeLillo

During the early days of Indian Parliament’s Budget Session in 2021, all eyes widened, and heads turned on the proposal to ban cryptocurrency trading in the world’s fastest growing economy. The bill was not passed by the government, but it did give hope to investors for a proper regulatory framework. Starting from April 1st, 2021, i.e. the beginning of India’s fiscal year it has become mandatory for companies dealing in cryptocurrencies to disclose their crypto holdings through their financial statements to the government. Over the past few years’ cryptocurrencies have really picked up the pace in the currency market and there is a lot of value created around it, more than any investment has ever witnessed. From bitcoins to dogecoin, cryptocurrencies have crescendoed over the past few years. Amidst these developments, the rise of fractional and whole non-fungible tokens has been attracting a variety of investors spending millions of dollars on collectibles for reasons like upliftment of women and LGBTQ communities and receiving donations for helping India in the apocalyptic situation it finds itself in.

Non-fungible tokens (NFTs) are unique blockchain-based tokens that can be utilized to obtain rights over digital collectibles. Like the name suggests, it is an asset that cannot be replaced or more precisely be exchanged for anything else in return. Non-fungible tokens represent merely digital possession of collectibles as opposed to actual physical possession. It is mostly prominent in the fields of art and games but also extends to tokenizing physical properties. NFTs made their fashionable debut in 2017 on the Ethereum network very soon after which CryptoPunks, a collection of pixel arts, became extremely valuable after it was fractionalized into millions of tokens that were sold at exorbitantly high bids. NFTs attract all kinds of legal issues ranging from financial markets to intellectual property and contractual obligations under existing regulations.

NFTs are similar to bitcoin and cryptocurrency only in context with the programming technology on which they function. They are usually mistaken for other cryptocurrencies, however, there lies a vast difference among them. NFTs are indivisible storage tokens that house a significant amount of data in a smart contract, that are automatically executed upon the occurrence of a set of predetermined conditions. It provides proof of authenticity and ownership. These smart contracts determine the rights of the buyer with respect to the digital asset they invested in. It is not necessary that every such digital contract gives the buyer non-exclusive license of non-commercial use along with the IP rights attached to the asset, unless mentioned expressly. Most of these licenses are air-tight to avoid the buyer from making modifications to the existing work in order to protect its authenticity. It cannot eliminate duplication of work by 100% but can surely minimize it by securing the original work. The hype about NFTs is its ability to allow a person to hold complete ownership of an asset in a digital setup. In the beginning, it was more of a collectible than something that contains a lot of value, but with time and expansion in different assets it is starting to gain some actual monetary value for the owner.

Digital art is the most profitable field currently as it is volatile and succumbs to piracy quite often, almost 100% of the times. NFTs add a lot of value by curtailing the practice of piracy in the areas involving digital arts, such as music and videos and paintings. It gives an edge to artists to monetize on their work, either by selling it directly to a customer as NFT or through royalties as and when profits are made by sale to a new owner. This does not usually happen in the primary market where the artwork attracts not much earnings, whereas, in the crypto marketspace it will allow artists to gain from re-sale of their artwork. Artists like Snoop Dogg and Lindsay Lohan and Kings of Leon have already started trading their artworks and memoirs as NFTs.

In India, NFTs are relatively new and booming, but they lack a proper regulatory framework that does not make them outright legal to trade in. NFTs are treated as derivatives as per the Securities Contract Regulation Act. Accordingly, trade of NFTs is not legally allowed in the country. However, there is no regulation or notification by the government putting a blanket ban on trading in NFTs. Since the majority of NFT marketplaces are operational outside India, investments by Indian residents are treated as cross-border economic transactions governed by the Foreign Exchange Management Act, 1999 (FEMA). After the landmark judgment in the case of Tata Consultancy Services v. State of Andhra Pradesh, where a certain software was interpreted as goods under the relevant Act irrespective of the fact that the good might be intangible, the regulatory authorities interpreted NFTs to be goods within the meaning of FEMA.

These transactions under FEMA where transfers happen with residents outside India are treated as Current Account Transactions as Payment for NFTs to a resident abroad for acquiring the cryptocurrency are considered as payments only in context of foreign trade under FEMA.

It is established that NFTs are goods for the purpose of transactions under FEMA, but they are still violative of Export Regulations. For every cross-border transaction involving an NFT, which is an intangible asset, a good that is being either exported or imported, the transaction lacks remittance of fiat currency through banking channels authorized by the government.

Other grey areas in the intellectual property and taxation arena are even more complicated when it comes to NFTs. For example, sale of NFT to Indian buyers by offshore sellers will be subjected to a 2% equalization levy, i.e on the gross value of the NFT and the income of the NFT marketplace from Indian buyers. However, if the sale of NFT was made by Indian resident through a foreign platform, the treatment of commission or income of the platform is unclear. But the crux of the matter is still that such transactions are per se illegal or at least not explicitly legal in the Indian financial regime.

Some of the most bizarre instances of investments in NFTs recently include the first ever tweet by Jack Dorsey, twitter’s CEO, sold for $2.9 million and Everydays: The first 5000 days by Mike Winkelmann (Beeple) sold for $69 million. From intangible assets having a notional value to physical assets, NFTs are expanding their horizon. In a span of two days, Indian crypto-asset entrepreneurs raised over $1 million in a fundraising activity for the cause of providing financial aid to fight Covid-19. The largest of which was funded by Vitalik Buterin, co-founder of Ethereum, amounting to $600,000. It did beat the traditional banking system routes that would not have been able to compete with cryptocurrency in cross-border payments. But there is a lot of ambiguity on the treatment of NFTs and cryptocurrencies, in general, which needs to be addressed since it is a booming marketplace now and without proper regulations in place every transaction within or outside India is a violation of laws.


ABOUT THE AUTHOR

Richa Seth

Richa is an Associate Solution Advisor at Deloitte. She is an avid reader and has interest in writing about contemporary legal issues.

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