Authored By: Ishika Agrawal
Lloyd Law College
Abstract
The regulation of cryptocurrency and decentralized finance (DeFi) in India has undergone a transformative journey over the past half-decade—from judicial interventions striking down banking prohibitions, to the imposition of a stringent tax regime, to the recent crystallization of a comprehensive anti-money laundering framework. This article examines the evolution of India’s regulatory approach to virtual digital assets (VDAs), analysing the tripartite framework that has emerged: the taxation architecture under the Income Tax Act, the anti-money laundering (AML) regime through the Prevention of Money Laundering Act (PMLA), and the parallel development of the Reserve Bank of India’s Central Bank Digital Currency (CBDC), the Digital Rupee. The article critically evaluates the 2026 Budget’s introduction of penalty provisions for non-compliance, juxtaposed against the unchanged tax structure that industry participants argue stifles liquidity and innovation. It examines the complex application of PMLA obligations to decentralized finance protocols, arguing that the “activity-based” approach adopted by Indian regulators creates significant compliance challenges for DeFi projects. Through analysis of recent judicial decisions, the article traces how courts have navigated the tension between individual liberty, regulatory oversight, and the limits of judicial intervention. The article concludes by evaluating the implications of this evolving framework for innovation, financial inclusion, and India’s position in the global digital asset economy.
Introduction: The Indian Crypto Paradox
India presents a paradox in the global cryptocurrency landscape. With over 100 million crypto users, it represents one of the largest digital asset markets worldwide. Yet, for years, this participation occurred within a regulatory vacuum a space characterized by judicial interventions, central bank hostility, and legislative silence. The result was widespread adoption alongside profound regulatory uncertainty.
This paradox is now resolving into a structured, if contentious, regulatory architecture. The past three years have witnessed a decisive shift from ambiguity to oversight. The government has moved on multiple fronts simultaneously: imposing taxation through the Income Tax Act, extending anti-money laundering obligations under the Prevention of Money Laundering Act (PMLA), and developing its own digital currency through the Reserve Bank of India. The result is a tripartite framework that seeks to integrate virtual digital assets (VDAs) into India’s financial compliance architecture while simultaneously maintaining a punitive tax regime that industry participants argue drives innovation and capital offshore.
The Union Budget 2026-27 represents a significant milestone in this evolution. By introducing explicit penalty provisions for non-compliance including a ₹200 per day fine for delays and a ₹50,000 penalty for inaccurate disclosures—the government has signalled that crypto is being formally absorbed into India’s financial compliance framework. This “compliance-first” approach validates platforms that remained onshore despite regulatory uncertainty but leaves unchanged the most contentious aspects of India’s crypto tax regime: the 1 per cent tax deducted at source (TDS), the flat 30 per cent capital gains tax, and the prohibition on setting off losses.
The Evolution of India’s Crypto Regulatory Framework
From Hostility to Structured Oversight
India’s regulatory journey with cryptocurrency has been characterized by dramatic shifts in approach. The Reserve Bank of India’s April 2018 circular, which prohibited regulated entities from dealing with crypto businesses, represented the high-water mark of regulatory hostility. Challenged before the Supreme Court, this circular was struck down in Internet and Mobile Association of India v. Reserve Bank of India (2020), with the Court holding that the prohibition was disproportionate to any perceived threat.
The period following the Supreme Court’s judgment was one of regulatory ambiguity. In February 2022, the Union Budget introduced a taxation framework for “virtual digital assets”—a term defined broadly to encompass cryptocurrencies, NFTs, and similar assets. This marked the first formal recognition of VDAs within India’s statutory framework.
The next major shift occurred in March 2023, when the Ministry of Finance issued a notification bringing entities providing VDA services within the ambit of the Prevention of Money Laundering Act, 2002 (PMLA). This notification identified five specific activities subject to regulatory oversight: exchange between VDAs and fiat currencies; exchange between different forms of VDAs; transfer of VDAs; safekeeping or administration of VDAs; and participation in financial services related to VDA offerings. Each of these activities, when conducted “for or on behalf of another person in the course of business,” triggered comprehensive compliance obligations.
The PMLA Framework: Reporting Entity Status
The classification of VDA service providers as “reporting entities” under the PMLA carries profound implications. It mandates compliance with a comprehensive set of obligations: customer due diligence (CDD), maintenance of records, reporting of suspicious transactions, and registration with the Financial Intelligence Unit-India (FIU-IND). The framework applies regardless of whether the entity is based in India—offshore platforms serving Indian users have been subject to show-cause notices, URL blocking, and penalties for non-compliance. In FY 2024-25 alone, penalties totalling nearly ₹28 crore were imposed on non-compliant virtual asset service providers, with Binance fined ₹18.82 crore and Ku Coin ₹34.5 lakh for failing to register with the FIU-IND.
The January 2026 FIU Guidelines: Compliance Becomes Non-Negotiable
On 8 January 2026, the FIU substantially revised its guidelines for crypto players, marking a decisive shift from principle-based advisory guidance to directive, enforcement-first regulation. The revised guidelines introduce several significant requirements:
Principal Officer Requirements: The Principal Officer must now be a full-time, India-based AML professional with sufficient seniority and independence.
Enhanced KYC Processes: Platforms must now deploy “selfie with liveness detection,” requiring users to perform random actions such as blinking and head movement to establish physical presence.
Geo-Tagging and Device Fingerprinting: Platforms must capture latitude and longitude data, IP addresses, and device identifiers at onboarding.
Restrictions on Anonymity-Enhancing Tools: Transactions involving mixers or tumblers are now outrightly prohibited.
Unhosted Wallet Scrutiny: Unhosted wallet transfers are treated as inherently high-risk, with VASPs expected to obtain sender and receiver information.
The Taxation Architecture: Revenue Imperatives Versus Innovation Incentives
The 2022 Framework
India’s crypto taxation framework, introduced in February 2022, represents one of the most stringent regimes globally. Three features define its approach:
30% Flat Capital Gains Tax: Income from the transfer of VDAs is taxed at a flat 30 per cent, regardless of the holding period or the nature of the gain.
1% Tax Deducted at Source (TDS): Every transfer of VDAs attracts a 1 per cent TDS on the transaction value.
Prohibition on Loss Offset: Losses from VDA transactions cannot be set off against any other income, creating an asymmetrical regime where gains are taxed but losses are not recognized.
The 2026 Budget: Penalties Added, Taxes Unchanged
The Union Budget 2026-27 maintained this framework unchanged while introducing new penalty provisions for non-compliance. Under amendments proposed in the Finance Bill, 2026, entities required to report VDA transactions face monetary penalties for lapses: ₹200 per day for delays and a flat ₹50,000 penalty for incorrect information.
Industry leaders have responded with warnings about the consequences. Ashish Singhal of CoinSwitch noted that “the current tax framework presents challenges for retail participants by taxing transactions without recognising losses, creating friction rather than fairness.” Nischal Shetty of WazirX warned that “these measures continue to impact liquidity, participation and India’s competitiveness in the global digital asset landscape.”
The most significant concern is the migration of activity to offshore platforms. Singhal warned that “these measures risk driving Indian capital toward non-compliant offshore platforms, leaving users vulnerable to legal and financial scrutiny.” This creates a paradox: the very tax regime designed to capture revenue from crypto activity may be pushing that activity beyond the reach of Indian tax authorities.
The DeFi Challenge: Regulating Decentralized Finance
The Conceptual Challenge
The application of India’s AML framework to decentralized finance presents profound conceptual challenges. Traditional financial regulation is built around identifiable intermediaries banks, exchanges, money service businesses that can be licensed and monitored. DeFi protocols, by contrast, operate through smart contracts on distributed ledgers, often without any identifiable legal entity exercising control.
The PMLA VASP Notification attempts to address this challenge through an activity-based approach. It defines VASPs by reference to the services they provide rather than their corporate structure. The critical qualifying phrase is “for or on behalf of another person in the course of business.” This formulation attempts to capture intermediation functions regardless of the technology through which they are delivered.
However, the critical question is how this qualifier applies to protocols that facilitate peer-to-peer transactions without any identifiable intermediary. Self-identifying as “DeFi” is not sufficient to remain outside the scope of regulation. Hybrid or semi-decentralized protocols remain particularly exposed due to identifiable points of control such as admin keys, off-chain infrastructure, or user-facing interfaces.
Factors Indicating Control
The presence of control mechanisms is critical to regulatory analysis. Factors that indicate control include: admin or multiset keys that enable certain parties to alter protocol behaviour; upgrade or pause authority that allows interventions in otherwise autonomous systems; and the ability to set economic parameters such as interest rates or collateral requirements. Each of these elements can operate within the “instruments enabling control” limb of the PMLA notification.
Custodial elements embedded in design are often reflective of functional administration. Smart contract escrows temporarily hold user assets, liquidity pools aggregate user deposits, and bridges require assets to be locked before minting representations on another chain. In each case, user assets are being held or managed by the protocol, amounting to a form of “safekeeping or administration.”
For DeFi projects with sufficient indicia of control to fall within the PMLA framework, the compliance burden is substantial. They must register with FIU-IND, appoint India-based Principal Officers, implement customer due diligence, and report suspicious transactions. The January 2026 guidelines add layers of technological complexity that many DeFi protocols are not designed to accommodate.
Judicial Approaches
The Foundational Judgment: Internet and Mobile Association v. RBI (2020)
The Supreme Court’s judgment in Internet and Mobile Association of India v. Reserve Bank of India (2020) remains the foundational judicial pronouncement on cryptocurrency in India. The Court struck down the RBI’s April 2018 circular prohibiting regulated entities from dealing with crypto businesses, holding that the measure was disproportionate to any perceived threat. It noted that the RBI had not produced any evidence of damage to regulated entities or the banking system from crypto activities. The judgment had the effect of legitimizing crypto activity to the extent that it could not be excluded from the banking system.
The Supreme Court’s 2026 Observation
A February 2026 Supreme Court judgment in Jagtar Singh v. State of Punjab addressed the intersection of crypto disputes and criminal law. The case arose from a commercial dispute involving cryptocurrency investments. In restoring bail, the Bench remarked: “Don’t use the criminal law for settling accounts.” This observation reflects a broader judicial concern about the weaponization of criminal process in commercial disputes.
The Delhi High Court’s 2026 Ruling
In February 2026, the Delhi High Court delineated the limits of judicial intervention in crypto disputes. In Rana Handa v. Bitbns, the petitioner sought fund release and investigation against the exchange. The Court dismissed the petition, holding that disputes involving private exchanges are contractual matters to be resolved through civil suits or consumer forums, not through writ jurisdiction. This clarifies that while the crypto ecosystem is regulated, individual grievances against private platforms remain outside the scope of constitutional court intervention.
The RBI’s Digital Rupee: A Parallel Development
Alongside crypto regulation, the Reserve Bank of India has been developing its Central Bank Digital Currency (CBDC)—the Digital Rupee. Launched in pilot phases in late 2022, the Digital Rupee represents the RBI’s vision for digital currency: state-issued, centrally controlled, and fully compliant with existing monetary policy frameworks.
The Digital Rupee operates on a distributed ledger but differs fundamentally from cryptocurrencies. It is legal tender, issued by the central bank, and carries the same value as physical currency. Transactions are recorded but traceable, addressing the anonymity concerns that have driven regulatory scrutiny of private cryptocurrencies.
The coexistence of a CBDC with regulated private crypto creates an interesting dynamic. The RBI has consistently distinguished between CBDCs, which it supports, and private cryptocurrencies, which it views with suspicion. As the Digital Rupee gains traction, it may reshape the terms of debate, offering a state-sanctioned alternative that could reduce demand for private crypto while providing the technological benefits of digital currency.
Implications for Innovation and Competitiveness
India’s evolving regulatory framework carries significant implications for innovation and the country’s position in the global digital asset economy. The combination of a punitive tax regime and comprehensive compliance requirements create a high-barrier environment that may favour established players over startups.
The migration risk is real. When compliance costs rise and tax treatment disadvantages onshore participation, users and entrepreneurs may move to jurisdictions with more favourable regimes. This “regulatory arbitrage” could see Indian talent, capital, and innovation flowing to Singapore, Dubai, or other crypto-friendly hubs.
However, regulatory clarity itself has value. The uncertainty that characterized the pre-2023 period was itself a barrier to institutional participation. With clear rules now in place—however stringent institutional investors and established businesses may find India more navigable than before. The compliance-first approach validates platforms that remained onshore and may attract serious players willing to meet regulatory standards.
The challenge for policymakers is to calibrate the framework to achieve regulatory objectives without sacrificing competitiveness. This requires attention to the specific provisions that create friction: the 1 per cent TDS, which impacts liquidity; the no-loss-offset rule, which creates asymmetrical treatment; and the compliance burden on smaller players. As SB Seker of Binance noted, India should move “towards a fuller license-and-supervise one” rather than a “tax-and-deter regime.”
Conclusion and Recommendations
India’s regulatory framework for cryptocurrency and DeFi has matured significantly, moving from ambiguity to structured oversight across three dimensions: taxation, AML compliance, and central bank digital currency. The PMLA notification of 2023, the FIU guidelines of 2026, and the Budget 2026 penalty provisions together create a comprehensive compliance architecture. The Digital Rupee offers a state-sanctioned alternative that may reshape the digital currency landscape.
Yet significant challenges remain. The taxation regime continues to draw criticism for its impact on liquidity and participation. The application of AML requirements to DeFi protocols remains conceptually unresolved, with hybrid and semi-decentralized projects facing particular uncertainty. The migration of activity to offshore platforms threatens to undermine regulatory objectives. And the shortage of skilled personnel for blockchain forensic analysis limits enforcement capacity.
To address these challenges, several calibrated reforms merit consideration:
First, the TDS rate on VDA transactions should be reduced from 1 per cent to 0.01 per cent, with the threshold raised to ₹5 lakh for small investors. This would preserve compliance while reducing friction.
Second, loss offset provisions should be introduced to create symmetrical treatment of gains and losses, aligning crypto taxation with other asset classes.
Third, clear guidance should be issued on the application of PMLA requirements to DeFi protocols, adopting a principles-based approach that recognizes the spectrum of decentralization.
Fourth, investment in blockchain forensic capacity should be prioritized, both within regulatory agencies and through partnerships with private sector experts.
Fifth, international coordination should be strengthened to address the cross-border nature of crypto activity, including information-sharing agreements with major crypto hubs.
India has moved from regulatory ambiguity to structured oversight. The next phase must focus on refinement calibrating the framework to achieve regulatory objectives while retaining talent, capital, and innovation within India’s borders. The goal should be a regime that protects users and prevents illicit finance without sacrificing India’s competitiveness in the global digital asset economy. The foundations are laid; the task now is to build upon them wisely.
