Introduction
Non-Fungible Tokens (hereafter referred to as “NFTs”) are, in layman terms, digital blockchain tokens that indicate ownership and/or particulars of unique objects notwithstanding whether the objects are digital or physical in nature. The quintessential value proposition of NFTs stems from the dual-nature of NFTs: firstly, the authenticity guarantees and uniqueness of the object endorsed under the particular NFT and secondly, the advantage of using NFTs to facilitate sales using smart contracts [1] thereby improving the end-user experience by leaps and bounds. Furthermore, NFTs prima facie enable their creators to access the entire global market without the restrictions and legal implications associated with cross-border payments.
The fundamental aim of NFT technology is ensuring that “should the piece of digital content be duplicated or shared, the claim of the legal owner over the original remain clear and transparent.” [2] This additionally ensures that the value of the original asset is secured. NFT technology makes this process possible by maintaining a distributed ledger (also known as a blockchain) which records all the transactions details and ownership particulars of the digital asset. This recording of transactions by the blockchain with no conceivable expiry date also leads to the observation that artists may now monitor the value of their “on sale” work while also tracking future sales/auctions and any royalties owed to the artist in relation to their work.
The Energy Consumption and Climate Controversy Around NFTs and Cryptocurrency
There has been a growing sentiment which entails that NFTs are partially responsible for the millions of tons of carbon dioxide emissions generated by cryptocurrencies which are used for the sale and purchase of NFTs. In recent news, Artstation, an online platform for digital artists scrapped its plans to launch a platform for NFTs [3] after artists cited NFT technology as an “ecological nightmare pyramid scheme.” [4] According to estimates, it has been observed that the carbon footprint of the “Space Cat” NFT (which is a GIF of a cat in a rocket heading to the moon) is equivalent to an EU resident’s electricity usage for two months. [5] The question seeking exploration of the environmental impact of and energy consumption by cryptocurrencies, especially NFTs, surfaced following the sale of a mosaic by Beeple who claimed that his digital artwork will be either carbon neutral or negative. [6] It has been argued that when individuals create, buy or sell NFTs using popular cryptocurrencies such as Ethereum, these individuals are responsible for a portion of the greenhouse emissions generated as a result of “mining” for the cryptocurrency. It is also debatable whether the individuals interacting with NFTs are significantly increasing the greenhouse emissions or they are merely taking on a portion of the responsibility for emissions that would have been pinned on cryptocurrency miners anyway. [7]
Ethereum, a popular cryptocurrency used for NFT technology is built on a “proof of work” system. This “proof of work” system, while being highly energy inefficient, acts in a supervisory or watchdog capacity for cryptocurrencies as there does not exist any official authority which oversees cryptocurrency transactions. In pursuit of maintaining the sanctity and security of the transactions, the system requires high energy consuming machines to complex puzzles. These puzzles are solved by miners or users who add a new “block” of verified transactions to the decentralized blockchain. The miner is rewarded for solving the “puzzle” by means of specified units of cryptocurrency tokens or transaction fees. The average transaction of Ethereum, according to Digiconomist, consumes an average of 73 kWh of electricity that is equal to 35 kg CO2 emissions. [8] Based on reports, this is tantamount to an average household in Alberta using nearly 3.5 days of electricity. [9] This intensity of emissions is primarily attributable to the power needed in creating a consensus algorithm for cryptocurrencies such as Ethereum. Furthermore, Digiconomist estimated that Ethereum consumes approximately 34.84 TWh annually, meaning that it is the 61st greatest electricity consumer in the world. This entire security framework is highly energy inefficient on purpose as it is believed that using “inordinate amounts of electricity make it less profitable to muck up the ledger”.
Nonetheless, there are some ways suggested by experts in which these energy consumptions and carbon emissions by NFTs can be controlled. Some of them are- making informed decisions after seeking estimates of the carbon footprints related to NFTs from marketplaces, [10] creating energy-efficient Ethereum algorithms, offsetting GHG emissions (which emit from the electricity grid that supplies energy to the infrastructure that allows these transactions to occur) through carbon offsets and promoting the implementation of renewable-powered electricity generation. [11]
Regulating NFTs and their Cross-Border Transactions in India
As of today, there exists no explicit regulation or legislation by the Government of India that prohibits or restricts an Indian resident from buying and/or selling NFTs. This is partly due to the fact that the treatment of NFTs in the eyes of the law would depend on how the underlying digital or physical asset is classified. For now, NFTs may be regarded as a “digitally-signed certificate for the underlying asset”. [12]
However, the regulatory status of NFTs might potentially change with the introduction of the long-awaited cryptocurrency bill (“Cryptocurrency Bill”). The draft of the Cryptocurrency Bill of 2019 has been titled “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill” [13] and Section 2(a) of the Cryptocurrency Bill defines “cryptocurrency” as:
“Any information or code or number or token not being part of any Official Digital Currency, generated through cryptographic means or otherwise, providing a digital representation of value which is exchanged with or without consideration, with the promise or representation of having inherent value in any business activity which may involve risk of loss or an expectation of profits or income, or functions as a store of value or a unit of account…”
The above definition of “cryptocurrency” might encompass NFTs as NFTs could potentially “be considered to be both a representation of value that is exchanged on the basis of having an inherent value in business activity”. [14] On the other hand, Section 3(3) of the Cryptocurrency Bill seemingly lays down a proviso to Section 2(a) as it stipulates that the use of Distributed Ledger Technology would be permissible in instances of “creating a network for delivery of any financial or other services or for creating value, without involving any use of cryptocurrency, in any form whatsoever, for making or receiving payment.” Ultimately, there is still ambiguity as to whether NFTs would fall under the scope of ‘services’ as laid out in Section 3(3). Experts question whether NFTs are cryptocurrencies or virtual currencies, and if they would be affected by any future law restricting or prohibiting crypto-asset transactions? If an all-inclusive definition of cryptocurrencies and/or virtual currencies includes NFTs, it is argued that NFTs should be excluded from this all-inclusive definition as NFTs are non-fungible in contrast to both traditional and crypto currencies which are fungible in nature. Furthermore, crypto-assets like Bitcoin are primarily used as tradable assets and means of exchange whereas NFTs being unique are generally used to “collect” and retain specific digital or physical assets.
Ambiguities in relation to the nature of NFTs might also arise under the Foreign Exchange Management Act, 1999 (“FEMA”). The treatment under the current FEMA regime would largely depend on the classification of the underlying asset, physical or digital, being exchanged via the NFT. In the currently operational Indian NFT marketplaces, it is observed that even though FEMA governs cross-border transactions vis-à-vis India, the country’s central bank, Reserve Bank of India (“RBI”) remains silent on the issues and ambiguities pertaining to digital assets such as NFTs and cryptocurrencies. Experts have stipulated that upon extrapolation of the provisions under the existing FEMA regime, crypto-assets and NFTs maybe classified as intangible assets, for instance, like intellectual property.
Intellectual Property and NFTs
Legal professionals across India and throughout the world are contemplating the issues pertaining to intellectual property rights (“IPR”) and obligations in relation to NFTs. IPR protection strategies are needed to holistically secure the digital asset, inter alia, the licensing, assignment and transfer of holding rights of IPR of the digital asset. [15] This new shift towards innovative IPR protection strategies is the result of the non-fungible nature or uniqueness of NFT technology. IPR professionals state that these strategies are pre-emptively necessary as they expect potential infringement issues to increase once third-party IPR are at a crossroads with the first creator of the NFT. Furthermore, it might be necessary to establish and develop a framework for the possession rights and first holding terms of NFTs as “the rights granted by an associate NFT marketer depend upon whether the rights were transferred via a license or an assignment, and these will vary with each NFT”. [16]
Depending upon the underlying agreement, the mere ownership of the NFT may not grant the ownership of the underlying content/art or the associated IPR which would result in a scenario where the NFT “owner” may not be permitted to “breed, distribute copies, publicly perform, display, or build by-product works of the first work” [17] as the owner of the copyright may exclusively retain such rights. The NFT industry might propose solutions pertaining to these issues, however, stakeholders have not settled on a standardized “best practice” making it difficult for buyers of NFTs to assess which NFTs safely store data in the long term. [18]
NFTs and Taxation
It is a plausible contention that under India’s taxation system, the tax classification of NFTs would be based on the nature and characteristics of the underlying asset. For example, a NFT of digital art could potentially be classified as an “intangible asset” or “good” in terms of income tax and goods and services tax (“GST”). The cross-border and digital nature of transactions involving NFTs leads to the contention that there may exist additional tax issues along the way. For instance, sales of NFTs by offshore sellers through an offshore NFT marketplace to Indian buyers may be subject to a 2% equalization levy on the gross value of the NFT and the income of the marketplace from Indian customers. [19] Furthermore, sales of NFTs by Indian resident sellers through foreign platforms may get excluded from the equalization levy and additional questions in relation to the platform’s income/commission exclusion in such scenarios are still unanswered.
Regulatory Architecture of NFTs in Foreign Jurisdictions
As of now, there are relatively very few global regulatory guidelines on whether NFTs fall within the existing crypto-asset regulations. Although several countries have implemented or announced plans for the broader regulation of crypto-assets, most of them have not yet established anything expressly applicable to NFTs. In the European Union, NFTs are not currently regulated officially. However, the features of any proposed NFT issuance would have to be evaluated alongside various existing regimes, including the ones related to securities, electronic money and crowdfunding, to ensure that these are not triggered. The European Commission, on 24 September 2020, published the Markets in Crypto-assets Regulation (MiCA), which proposes to regulate crypto assets, including NFTs, and their service providers under a single licensing regime. MiCA is anticipated to take effect from 2024 and is expected to pave way for regulated and secured NFT transactions in the Union. [20]
In the UK, crypto-assets are classified as e-money tokens, security tokens and unregulated tokens under the 2019 Guidelines published by the UK Financial Conduct Authority (FCA). It is likely that the majority of NFTs would be classified as unregulated tokens on the basis of the current FCA guidelines. However, if an NFT displays features similar to the e-money or a security token, a specific NFT may fall under the current regulatory perimeter. Therefore, it is suggested that an investigation must be carried out on a case-by-case basis with regard to the structure and nature of the subject NFT in order to identify the classification of the individual NFT which will subsequently help in their registration and supervision of money-laundering activities. [21]
In the UAE, the Abu Dhabi Global Market (ADGM) has developed its own regulation for ‘virtual asset’ for digital trade and it licenses regulated businesses to operate. However, these rules are improbable to apply for NFTs as the “virtual asset” definition does not include the “representation of ownership”. Moreover, the Finance Services Regulatory Authority of ADGM only permits firms to operate for an “acceptable virtual asset” which has to satisfy a number of criteria (including maturity and market capacity). It is doubtful that NFTs will satisfy these conditions. [22]
China, though, has taken some proactive steps in regulating cryptocurrencies but does not expressly penalize the possession of cryptocurrencies. The Circular on Preventing Risks related to Initial Coin Offerings (ICO) (2017) introduced limitations on crypto assets which are in practice even today. Thereafter, in May 2021, the National Internet Finance Association of China, the China Banking Association and the Payment and Clearing Association of China issued a joint statement reiterating the position in the ICO Circular and further specific restrictions and risk alerts, including around cryptocurrency exchange, investment and trading. But despite these prohibitions, there is no clear-cut definition of cryptocurrency or crypto asset under their existing laws and whether an NFT qualifies as such may require a substance analysis. As of today, none of the regulations in China explicitly prohibit trading or investing in NFTs, but only remind people of the risks associated with them. [23]
Moving towards the American regime, regulators, as of yet, have not provided explicit official guidance in relation to NFTs, however, there is a contention that it may be possible that NFT might be classified as a “commodity” under the Commodity Exchange Act (“CEA“), which defines the term to include several enumerated items and a catch-all for “all other goods and articles”. The Commodity Futures Trading Commission (“CFTC“) has also confirmed that the expression “commodity” includes cryptocurrencies, in addition to renewable energy credits, emission allowances, and other intangible items. technology. [24] If NFTs are classified as commodities, the CEA may apply in one of two possible ways. Firstly, the CEA’s general prohibitions on deceptive and manipulative trading may apply to NFT transactions, which are affected on a “spot” basis, i.e., fully-funded, unleveraged transactions. However, if NFTs are offered on a margined or leveraged basis, additional requirements may apply which include the requirement to trade the NFT solely on registered derivatives exchange unless the transaction results in the “actual delivery” of the NFT within 28 days. [25]
It is argued by some that numerous NFTs available on the market may not be deemed as “securities” under the American Federal securities laws. NFTs may be considered as securities, “if it was designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such”. [26] One potential example of such an arrangement could be a “fractional” NFT (“f-NFT”), where an investor would share a partial interest in an NFT with others. If an NFT (or f‑NFT) is considered a security, then the common securities law issues would exist including, the registration or exemption of the offerings, sellers, marketplace, the securities law liability for material omissions or misstatements and insider trading; the restrictions on short sales and market stabilization around an initial offering among others.
The Financial Crimes Enforcement Network (“FinCEN“), the regulatory authority tasked with the responsibility of combating money laundering under the Bank Secrecy Act (“BSA“), is yet to issue guidance specific to NFTs and has only published general guidance with reference to virtual currencies (that may or may not apply to NFTs). It needs to be considered whether FinCEN sees NFTs as “value that substitutes for currency.” If this indeed is the view and NFTs are considered substitutes for currency, then the FinCEN may direct that NFTs shall be subject to the BSA and FinCEN regulations. Since many NFTs are more like digital representations of ownership in unique assets than a value that substitutes for currency, however, it seems that many NFTs available on the market should not be subject to FinCEN’s oversight.
The Office of Foreign Assets Controls (“OFAC“) administers most of the American sanctions’ programs. Like FinCEN, OFAC has not provided guidance specific to NFTs, but it has stated that American sanctions apply to digital transactions and currencies in ways similar to traditional activities. Interestingly, OFAC has pursued enforcement actions involving cryptocurrency transactions and blockchain technology and the possibility of individuals being subject to U.S. sanctions for participating or benefitting, directly or indirectly, from activities involving NFTs exists and seems to be the primary avenue of risk exposure for individuals. However, the potential lack of transparency and decentralization associated with the use of blockchain technologies may present difficulties in preventing and/or restricting sanctioned persons from participation in NFT transactions. Lastly, it is believed that NFTs may present similar issues to the scenarios associated with artwork whereby there is a high degree of anonymity, role of intermediaries, concealability of the asset, and subjective valuation of the artwork. [27]
Conclusion
Keeping in view the regulation of NFTs in the global marketplace, it can be argued that NFTs are here to stay as considering that the current transfer of real estate ownership is labor-intensive and expensive, it is likely that NFTs will be applied to solve these transfers. The concept of “tokenizing” property rights will facilitate the sale and maintenance of NFTs in the long run. In the Indian context, laws and regulatory authorities such as RBI will need to address the issues in relation to permitting fungible and non-fungible digital assets to provide censorship resistance, worldwide participation, and the elimination of trusted third parties within the decentralized ecosystem. [28] Furthermore, it is stated that as the system matures, the underlying blockchain infrastructure applied to NFTs will provide “performant, inexpensive transactions/settlement, immutability of contracts, and execution of smart contracts to handle ownership, authenticity, certification, governance, royalty payments, and a host of other ecosystem functionality”. [29] The decentralized ecosystem transparency would support and provide for price and market efficiency. Furthermore, decentralization will grow via the network effect, as the rise of innovation, performance and resulting participation will elevate a vibrant global ecosystem of applications. However, the negative associations such as the climate controversies with respect to NFTs still remain unanswered.
Lastly, it is suggested that the legal challenges in relation to NFTs are likely to become more pronounced over the coming months or years as the regulators and media increasingly focus and divert their attention into the fintech space. It is important to understand that the NFT or even digital assets regulatory framework is in its fetal stages and is to evolve and mature over time. As the number of Indian buyers and sellers of NFTs increases over the years, the legal regime addressing the myriad issues (discussed above) including anti-money laundering regulations, tax implications, financial regulations, intellectual property issues, etc. shall gradually emerge. India can take learnings from the evolving legal regimes pertaining to NFTs in countries like US, UK, China, etc. while drafting its own set of regulations for the same. For e.g., introduction of licensing obligations for services related to NFTs as done under the current German Banking Act [30]; classification of NFTs (like in Russia and UK) in various categories on a case-by-case basis to analyse the related regulatory, legal and tax implications; protection of investors from multiple originals of a work by modifying the copyright laws and supplementing the contracts with suitable clauses specifically drafted for NFTs, etc. can make NFTs more secure and regulated. It should be noted that NFTs have the potential of providing a stable online market for the investors and digital developers, therefore, it becomes all the more essential to treat it like an asset with special regulations.
About the Author
Priyam Raj Kumar is an Associate at LexCounsel, Law Offices.
Editorial Team
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Preferred Method of Citation
Priyam Raj Kumar, “The Future of Non-Fungible Tokens in India” (IJPIEL, 25 August 2021)
<https://ijpiel.com/index.php/2021/08/24/the-future-of-non-fungible-tokens-in-india/>
Endnotes
[1] Jaideep Reddy, Meyyappan N & Vaibhav Parikh, Status and future of NFTs and crypto art in India, The Economic Times, (Apr 08, 2021, 05: 57PM), https://economictimes.indiatimes.com/tech/catalysts/the-status-and-future-of-nfts-and-crypto-art-in-india/articleshow/81970883.cms.
[2] Aman Nair, India Shouldn’t Throw Out the NFT Baby With the Crypto Bathwater, The Wire (Apr. 04, 2021), https://thewire.in/tech/india-nft-cryptocurrency-digital-content-royalties-regulation.
[3] ArtStation Team, A Statement from ArtStation, Art Station Magazine (Mar. 08, 2021)
https://magazine.artstation.com/2021/03/a-statement-from-artstation/.
[4] Justine Calma, The Climate Controversy Swirling Around NFTs, The Verge (Mar 15, 2021, 09:51 AM),https://www.theverge.com/2021/3/15/22328203/nft-cryptoart-ethereum-blockchain-climate-change.
[5] Id.
[6] The $69 M. Beeple Bonanza, Caligula Mosaic Comes Home, and More: Morning Links from March 12, 2021, Artnews (Mar. 12, 2021) https://www.artnews.com/art-news/news/beeple-69-million-christies-stolen-roman-mosaic-morning-links-1234586616/
[7] Id.
[8] Ethereum Energy Consumption Index, Digiconomist, (May 27, 2017),https://digiconomist.net/ethereum-energy-consumption.
[9] ATCO https://www.atco.com/en-ca/for-home/energy-101.html
[10] Supra note 8.
[11] Andre Buiza, Are Non-fungible Tokens Ruining Our Environment?, BlueSource (April 30, 2021), https://www.bluesource.com/blog/blockchain-environment-nft-carbon-neutral/
[12] Id.
[13] Draft Banning of Cryptocurrency & Regulation of Official Digital Currency Bill, 2019, PRS Legislative Research, https://prsindia.org/files/bills_acts/bills_parliament/Draft%20Banning%20of%20Cryptocurrency%20&%20Regulation%20of%20Official%20Digital%20Currency%20Bill,%202019.pdf.
[14] Id.
[15] The Cryptocurrency and IPR enigma, RNA, Technology and IP Attorneys (July, 20, 2021), https://rnaip.com/the-cryptocurrency-and-ipr-enigma/?utm_source=rss&utm_medium=rss&utm_campaign=the-cryptocurrency-and-ipr-enigma
[16] Id.
[17] Id.
[18] Brady Dale, It’s an NFT Boom. Do You Know Where Your Digital Art Lives?, Coin Desk (Feb. 23, 2021), https://www.coindesk.com/its-an-nft-boom-do-you-know-where-your-digital-art-lives?amp=1&__twitter_impression=true.
[19] Id.
[20] Daniel Klingenbrunn, Alexander Glos, Non-fungible tokens – a case for German or European financial regulation?, Freshfield Bruckhaus Deringer (April 20, 2021) https://technologyquotient.freshfields.com/post/102gw07/non-fungible-tokens-a-case-for-german-or-european-financial-regulation
[21] Pascal Bine and others, Regulatory Approaches to Nonfungible Tokens in the EU and UK, Skadden Arps, Slate, Meagher & Flom LLP (June 15, 2021) https://www.skadden.com/insights/publications/2021/06/regulatory-approaches-to-nonfungible-tokens
[22] Non-Fungible Tokens: The Global Legal Impact, Clifford Chance https://www.cliffordchance.com/content/dam/cliffordchance/briefings/2021/06/non-fungible-tokens-the-global-legal-impact.pdf
[23] NFTs are Catching on in China, but Regulations May Stand in the Way of Large-Scale Adoption, The Fashion Law (April 12, 2021) https://www.thefashionlaw.com/nfts-are-catching-on-in-china-but-regulations-may-stand-in-the-way-of-large-scale-adoption/
[24] NFTs: Key U.S. Legal Considerations for an Emerging Asset Class, Jones Day (Apr. 2021),https://www.jonesday.com/en/insights/2021/04/nfts-key-us-legal-considerations-for-an-emerging-asset-class.
[25] Id.
[26] Id.
[27] David B. Hoppe , United States: Legal And Regulatory Challenges Related To Non-Fungible Assets, Mondaq (May.18, 2021),https://www.mondaq.com/unitedstates/fin-tech/1062494/legal-and-regulatory-challenges-related-to-non-fungible-assets.
[28] M. Ridgway Barker, United States: Non Fungible Tokens: US Legal Issues To Be Considered, Mondaq (Jun. 10,2021), https://www.mondaq.com/unitedstates/fin-tech/1078114/non-fungible-tokens-us-legal-issues-to-be-considered.
[29] Id.
[30] Legal challenges of “non-fungible tokens” (NFTs), CMS Law-Now (April 22, 2021), https://www.cms-lawnow.com/ealerts/2021/04/legal-challenges-of-non-fungible-tokens-nfts?cc_lang=en
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