FinTechInclusion of Virtual Digital Assets under PMLA – A step towards curbing illegal digital transactions

INTRODUCTION

The FinTech industry in India as a result of profound customer demand, Digital India initiative, favorable demographics, and enabling Government policies has witnessed exponential growth in India over the past few years.

The FinTech Industry in India has become one of the fastest-growing sector in the entire world bringing development in a plethora of sectors such as Digital Lending, Peer to Peer Lending, Digital Payment, Banking etc., Virtual Digital Assets (“VDAs”) are the most recent technological advancements, they are causing revolutionary paradigm shifts in the financial services sector.

The Indian Government, in their Memorandum for explaining the provisions in the Finance Bill, 2022, proposed to insert a new clause (47A) in Section 2 of the Finance Act to define the term “virtual digital asset”

A VDA, according to the proposed new clause, is defined as –

(a) any information or code or number or token (not being Indian currency or foreign currency), generated through cryptographic means or otherwise, by whatever name called, providing a digital representation of value exchanged with or without consideration, with the promise or representation of having inherent value, or functions as a store of value or a unit of account including its use in any financial transaction or investment, but not limited to investment scheme; and can be transferred, stored or traded electronically;

(b) a non-fungible token or any other token of similar nature, by whatever name called;

(c) any other digital asset, as the Central Government may, by notification in the Official Gazette specify.

The value of the digital asset economy to India’s GDP will grow at a 43.1 % compounded annual growth rate from $5.1 billion in 2021 to $261.8 billion in 11 years, resulting in a $1.1 trillion contribution to the country’s economy.

However, with the rapid growth of the VDA in India, the concerns with respect to its security are also rising, the cryptocurrency market is unregulated and decentralized due to which there are higher risks involved and they are highly prone to manipulation.

In this article we attempt to discuss about the need for regulating VDAs in India, the current regulatory framework, the inclusion of the VDAs within the ambit of Money Laundering provisions and what will be its implication on VDA market in India. 

THE CURRENT LEGAL FRAMEWORK 

In 2018, the RBI released a circular directing all banking and financial institutions to not deal in virtual currencies or provide services for facilitating any person or entity in dealing with or settling virtual currencies however this came to be challenged in the Supreme Court and resulted in being struck down in Internet Mobile Association v Union of India [MANU/SC/0264/2020].

The IMA case serves an important role though as here the Supreme court noted that cryptocurrencies are a digital representation of value that is capable of functioning as a medium of exchange, unit of account, or store of value

Post the verdict laid out in the IMA case the government sought to mandate companies to disclose cryptocurrency transactions in their balance sheets vide MCA notification dated 24.03.2021. However, since the Government had no way to trace the transactions it is unlikely that this notification saw any reasonable enforcement.

Pursuant to above, The Cryptocurrency and Regulation of Official Digital Currency Bill, 2021 (“the Bill, 2021”) was introduced in the Parliament in January of 2021, the Statement of purpose stated that the Bill to promote the underlying technology of cryptocurrencies and provide a framework that will make it easier to create an official digital currency issued by the RBI. However, no further action has been taken on the Bill yet and it continues to stay pending in the Lok Sabha.

The latest legal development that the crypto sector saw however, was a substantial one. The Central Government, announced a 30% tax on income from VDA (particularly aiming at Cryptocurrencies), as a result of which, crypto traders started beginning to hold their assets for the long term and stopped daily trading to minimize the tax liability, this trend, in turn, hurt domestic crypto exchanges’ volumes and revenue.

THE NEED

Recently more and more countries are realizing the need to pass laws regulating trade and transactions in VDA’s. In broad strokes there are many reasons why this needs to be done such as worries about boost in illegal activities being supported by VDA’s, increase in cross border illegal transactions which would result in illegal loss of capital by the payee’s country.

However, the clear outlier out of all these is privacy. Virtual currencies are based on blockchain technology which is highly secure due to being decentralized and thus unsusceptible to alterations. People with assets in the form of crypto have their own wallets which are linked to a private key rather than the person itself, which makes it difficult for the Governments to trace the origin of a transaction and as such, it gives crypto the extremely high potential for being used for illegal activities.

From the point of view of the securing investor a major concern is that since crypto currencies are not backed or regulated by Government or any commodity and thus their value is extremely volatile to market shifts.

THE AMENDMENT 

The Ministry of Finance, considering the urgent need to monitory the transaction undertaken with the help of VDA effectively brought all cryptocurrency transactions into the foray of the Money laundering Act vide by amending the Prevention of Money Laundering Act, 2002 (“PMLA”) vide Notifications bearing no. S.O. 1072(E) dated 07.03.2023.

Under the new amendment, activities by a person carrying on designated business or profession under Section 2(1) (sa) of the PMLA, 2002, shall also include the following activities –

1. 1. exchange between virtual digital assets and fiat currencies;
   2. exchange between one or more forms of virtual digital assets;
   3. transfer of virtual digital assets;
   4. safekeeping or administration of virtual digital assets or instruments enabling control over virtual digital assets; and
   5. participation in and provision of financial services related to an issuer’s offer and sale of a virtual digital asset.

In addition to this the government passed the PMLA (Maintenance of Records) Amendment Rules, 2023 (“Rules, 2023”) vide notification S.O. 1074(E) dated 07.03.2023, made it mandatory for the entities trading in VDA’s to verify the identity of clients as well as the beneficial owners.

These new Rules also lay emphasis on maintenance of records of transactions for five years from the date of transaction. They must maintain records of identity, files and correspondences of clients for five years from the end of the business relationship or closure of account, whichever is later.

THE IMPLICATION

The step of inclusion of all transactions involving VDAs under the purview of the PMLA is a welcoming step, as the Government has been struggling since a long time to formulate an appropriate regulatory response to deal with the upsurge in advertisements soliciting investment in virtual assets as well as reports of actual investment.

These new developments have made waves across the Cryptocurrency traders and entities dealing in the same, as in light of the recent amendments form now onwards the crypto exchanges will be required to report any suspicious activity related to trading in cryptocurrency to the Financial Intelligence Unit – India (“FIU-IND”).

Since, the VDA service providers/businesses i.e., Crypto Exchanges have now become the ‘Reporting Entities’ under PMLA, and they have to follow similar reporting standards and KYC norms as the other regulated entities like banks, securities intermediaries, payment system operators, etc.

The FIU-IND is India’s premier central national agency responsible for receiving, processing, analyzing and disseminating information relating to suspect financial transactions. It reports directly to the Economic Intelligence Unit which is headed by the Finance Minister.

On receiving the complaint, the FIU-IND will then begin and investigation by collecting all the transactional information that it thinks relevant and come up with an analysis. In case the FIU-IND finds that the trader has indulges in any illegal activity, it will alert the Enforcement Directorate.

The Enforcement Directorate (“ED”) is one of the apex national investigative bodies of India in charge of investigating offenses related to economic crimes and violations of foreign exchange laws. It is also tasked with enforcing the provisions of the PMLA and thus has discretionary powers to search and seize suspected property without any judicial permission under Section 5 and 8(4) of the PMLA.

In light of Section 4 of PMLA, those found to be guilty of money laundering can be held liable for rigorous imprisonment for a period from not less than 3 years but which may be extendable up to a maximum period of 10 years.

FOREIGN PORTFOLIO INVESTORS

In addition to the above, the amendments will have implications on Foreign Portfolio Investors (“FPIs”) as well. FPIs are entities or individuals engaged in the practice of trading and transacting in cryptocurrency on behalf of their client who own the crypto being traded (“beneficial owners”).

The threshold for the definition of beneficial owners has also been reduced to any individual or group holding 10 per cent ownership in the client of a ‘reporting entity‘ will now be considered as beneficial owner  against the ownership threshold of 25 per cent applicable earlier.

AMLEGALS REMARKS

The move from the government to bring VDA’s under regulation might hurt the trading platforms and traders in the short run, but it is made with noble intentions and strives to promote trading of VDA’s acquired using legal, white money.

This is in line with the global trend of requiring digital-asset platforms to follow anti-money laundering much like those followed by other regulated entities. This is of importance as the practice of buying and holding non-fiat currency assets as a way to invest and retain illegally earned, black money has been prevalent since a long time.

These amendments signify that the Crypto industry in India is slowly but surely are moving towards a regulated crypto ecosystem. Entities dealing in crypto are will now be required under law to conduct enhanced due diligence under the PMLA and thus the trading patterns and those investors interested in entering the crypto markets will dissuaded from the same.

However, the amendment brought in by the Central Government has not given enough time to the entities to comply with the amendment. Furthermore, in the absence of a central regulatory body crypto entities could end up dealing directly with enforcement agencies like the ED.

– Team AMLEGALS, assisted by Mr. Jason James (Intern)

For any query or feedback, please feel free to get in touch with tanmay.banthia@amlegals.com or himanshi.patwa@amlegals.com