What Is Bitcoin and How Does It Work? – Forbes

Bitcoin is a decentralized digital currency that is exchanged between two parties without involving intermediaries like banks or other financial institutions.

As defined in a whitepaper released by the hidden inventor of Bitcoin, Satoshi Nakamoto, Bitcoin is a purely peer-to-peer version of electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution.

To understand Bitcoin, one needs to understand the underlying structure, the manner of operation of the Bitcoin ecosystem and the extent of usage of the same in India.

Bitcoin achieves elimination of intermediaries with the help of its underlying technology, blockchain.

Currently if you have to transfer funds to someone, one of the possible ways is by giving cash or alternatively use a trusted intermediary (example, a bank). Both the mechanisms, whether it be physical cash (with the central bank of the country as the guarantor) or electronic transfer, involve an intermediary (in the later case, a bank or another financial institution). When intermediaries are involved, there are transaction costs.

How the blockchain technology helps achieve elimination of intermediaries is by replacing trust that intermediaries bring to the table with cryptographic proof by the use of CPU computing power.

This cryptographic trust is built into Bitcoin through a wallet, a public key and a private key in the program.

Anyone can create a Bitcoin wallet for free by downloading the Bitcoin program. Each wallet contains a public key and a private key.

The public key is like an address or an account number via which any person can receive Bitcoins.

A private key is like a digital signature via which a person can send Bitcoins. The name suggests that private keys should be only held and known by the owner and public keys can be shared with anyone for receiving Bitcoins. That is where you would have heard in the news about Bitcoins being lost either due to a private key not being accessible or stolen by hackers.

Owners of Bitcoin addresses are not explicitly identified, but all transactions on the blockchain are public.

Since the inception of Bitcoin in 2009, each and every transaction that has occurred is stored in a ledger, which is considered immutable, non-tamperable and irreversible.

Bitcoin transactions are verified via telecommunication network nodes through cryptography and are then recorded in a decentralized distributed ledger called blockchain. This is one of the distinguishing aspects of Bitcoin from some other crypto assets, where there is centralized exchange (like the stock exchange) through which all transactions need to be routed or validated.

In the Bitcoin ecosystem, there is a network of miners who use their CPUs to process transactions.

The program is built in such a way that the ledger or the blockchain is automatically updated.

As per the original whitepaper on Bitcoin, the probability of hackers tampering the blockchain is next to zero due to the copy of updated ledger each miner carries. If someone is trying to tamper or hack the ledger by any means to gain unfair advantage, then immediately the miner is considered invalid and fails to process transactions until they have a copy of the untampered ledger.

It is debatable whether Bitcoin is a currency at all and why any country would want to replace it with their existing currency as Bitcoin does not have any intrinsic value of its own.

By definition, a currency is a system of money in general use in a particular country, or the fact or quality of being generally accepted or in use. Currently, there is some traction in the number of companies using Bitcoin as a mode of payment, however, no major country or economy has accepted it as money in general use. An exception is El Salvador, which adopted Bitcoin as a legal tender in September 2021 and became the first country to do so.

One of the important reasons for the remarkable evolution of Bitcoin is the tightening of the know your customer (KYC) and anti-money laundering (AML) regulations by banks and financial institutions. There is now a much greater cross-border exchange of information between the countries about the transactions through the banking system.

As a result, it is also claimed that Bitcoins are widely used as a parallel mechanism for the transactions, which would otherwise be illegal in several countries.

Another important aspect is the acceptability of Bitcoin as a global payment mechanism, which is not linked to any particular countrys currency and hence, not directly impacted by the developments within a particular country.

On the regulatory front, India saw two major developments this year:

In February 2022, in India, the Indian government proposed to introduce taxation on virtual digital assets, which would imply a taxation system for cryptocurrencies, but there is no clarity on whether the Indian government finds cryptocurrencies legal either as asset or currency.

Indias Finance Minister has categorically stated since then that taxing cryptocurrencies doesnt mean legalizing them. This indicates the government is still evaluating all the factors associated with cryptocurrencies and it would be early to make any assumptions on their legality.

Even though India has not specified its stand on the legality of investment in Bitcoin, the recently announced Budget 2022 vide Finance Bill 2022 proposes to introduce a framework for taxation of virtual digital assets. Once, the Finance Bill is ratified into an Act, the said framework would be made effective for Financial Year 2022-2023 onwards.

The taxation as per the Budget 2022 proposal would be taxation of gains at the rate 30% on transfer of Bitcoin.

The Government has proposed to introduce a new section 115BBH in the Income Tax Act, 1961 (the IT Act) for taxation of income from transfer of virtual digital assets. In accordance with the said section, where the total income includes any income from transfer of any virtual digital assets, the said income would be subjected to a tax rate of 30% and such rate would be enhanced by an applicable surcharge rate, if any, and a health and education cess.

As per Section 2 (47) of the IT Act, virtual digital assets would mean any information, 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.

Thus, the definition of virtual digital assets is quite wide so as to include all forms of cryptocurrencies including Bitcoin.

Hence, it is safe to comprehend, any gains derived from the transfer of Bitcoins would be subject to a tax rate of 30% (plus applicable surcharge rate and health and education cess), which can result in an effective tax rate ranging from 31.2% to 42.7%.

The proposed provisions specifically states that any deduction in respect of expenditure (other than cost of acquisition) incurred by the assessee in relation to such digital assets will not be allowed while computing the gains from transfer of such assets. In simple terms, only the cost of acquiring the digital assets i.e. Bitcoin will be allowed as a deduction.

In case a person obtains a Bitcoin by way of mining, the same may be treated as self-generated capital assets. However, the provisions of Section 55 of the IT Act, which provides for computation of cost of acquisition of self-generated assets does not specifically provide for such a computational method for cryptocurrency.

Thus, clarification with respect to computation of acquisition cost of Bitcoins when obtained through mining is required to be provided.

Also, if a person obtains a Bitcoin as a gift, the recipient of the Bitcoin will be liable to tax in India and accordingly the definition of property under Section 56(2)(x) has been revised to include virtual digital assets within its ambit. The provision further restricts the taxpayer or the teh investor to set off the loss from transfer of virtual digital assets against any other income.

The Budget 2022 also proposed to impose withholding tax on transfer of virtual digital assets under Section 194S of the IT Act. Accordingly, with effect from July 1, 2022, any person responsible for paying to a resident any sum by way of consideration for transfer of a virtual digital asset i.e. Bitcoin, will deduct tax at source of 1% at the time of credit of such sum to the account of the resident or at the time of payment, whichever is earlier.

Such withholding would be subject to the following monetary limits:

The provisions for taxation of virtual digital asset (except TDS) are proposed to be effective from April 1, 2022 i.e. Financial Year 2022-23 and onwards. However, there is no clarity with respect to the taxation of crypto assets which the taxpayers would have transferred or sold or gifted upto the financial year 2021-22.

Several taxpayers have treated Bitcoins as an asset and treated the capital gain as short term or long term (with indexation benefit) depending on the period of holding and paid tax based on the concessional tax rate or normal slab rates, as the case may be.

While there is a lot of uncertainty and volatility over the prices of Bitcoin and its legality in India, it is certain that the blockchain technology promises a whole lot of innovation and way in which transactions are settled.

If you are looking to invest in Bitcoin, you need to bear in mind that only those investors who have a high-risk appetite should consider a part of the portfolio to be invested in Bitcoins. This is due to downside price risk, high tax on the gains from sale of Bitcoins in India, a possible goods and services (GST) tax exposure and the uncertainty arising out of the legal status of Bitcoins in India.

In case of investors who already hold Bitcoins, there is no need to panic as even in the case of any regulatory ban, it is likely that transitional provisions for sale would be made. Those who had invested in Bitcoins and sold the same but have not reported the profits in their tax returns must go ahead and declare their investments.

Excerpt from:
What Is Bitcoin and How Does It Work? - Forbes