UPSC Prelims 2022 Q69: Non-Fungible Tokens (NFTs) — Explained
With reference to Non-Fungible Tokens (NFTs), consider the following statements:
1. They enable the digital representation of physical assets.
2. They are unique cryptographic tokens that exist on a blockchain.
3. They can be traded or exchanged at equivalency and therefore can be used as a medium of commercial transactions.
Which of the statements given above are correct?
- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Answer: (a) 1 and 2 only
Statement-wise explanation
- 1: correct — An NFT is a record on a blockchain that certifies who owns one specific item. The item can be digital, such as artwork, music, a video clip or an in-game object. It can also be physical, such as real estate, a luxury good or a collectible, with the token acting as its digital title or certificate. Using tokens to stand in for real-world assets is called tokenisation. India's tax rules also recognise this link: CBDT Notification 75/2022 (30 June 2022) leaves out of the tax definition those NFTs whose transfer legally transfers ownership of an underlying tangible asset.
- 2: correct — Each NFT carries a unique identifier and metadata. It is created ('minted') through a smart contract on a blockchain such as Ethereum, and its ownership history is recorded on that public ledger. The ledger is secured by cryptography and is tamper-resistant. That is why it can prove that a token is authentic and who owns it.
- 3: incorrect — 'Fungible' means interchangeable unit for unit, like one ₹100 note for another or one bitcoin for another. NFTs are non-fungible by definition. No two are equal, so they cannot be traded 'at equivalency'. An NFT can be bought and sold for money or cryptocurrency, but its uniqueness stops it from working as a common medium of exchange. That role needs identical, interchangeable units.
How to eliminate
The name gives away most of the answer. 'Non-fungible' means 'not interchangeable'. Statement 3 says NFTs 'can be traded or exchanged at equivalency', which is the definition of fungibility. It contradicts the term itself, so strike it out. That removes every option containing Statement 3 and leaves only '1 and 2 only'. Statement 2 is basic awareness: NFTs are known as blockchain tokens. Note the trap in Statement 3. It mixes a true idea (NFTs are bought and sold) with a false one (one-for-one equivalence, use as money). The word to remember: fungible means interchangeable, non-fungible means unique.
Know more
Fungibility is the property of being interchangeable unit for unit. Money must be fungible to work as a medium of exchange. Any ₹500 note settles a ₹500 debt.
NFTs are unique tokens minted through smart contracts on a blockchain, usually Ethereum under the ERC-721 standard. Fungible tokens on Ethereum follow ERC-20. An NFT usually stores a link to the file rather than the file itself. Owning an NFT does not automatically mean owning the copyright in the underlying work.
| Feature | Fungible token (e.g. bitcoin, ether, stablecoin) | Non-fungible token |
|---|---|---|
| Interchangeable | Yes, 1 unit = 1 unit | No, each is unique |
| Divisible | Yes, into fractions | Generally no |
| Use as money | Possible | Not suited |
| Typical use | Payments, store of value | Art, collectibles, gaming items, tickets, title to physical assets |
Indian position
- Union Budget 2022-23 (1 February 2022) created a separate tax regime for virtual digital assets (VDAs). Section 2(47A) of the Income-tax Act defines VDAs to include NFTs.
- Income from transferring a VDA is taxed at a flat 30% (Section 115BBH). Only the cost of acquisition can be deducted. Losses cannot be set off against other income.
- 1% TDS applies on VDA transfers above a threshold (Section 194S, from 1 July 2022).
- CBDT Notification 75/2022 left out of this definition those NFTs whose transfer legally transfers ownership of a tangible asset.
Do not confuse: crypto-assets are private and unregulated as legal tender. The CBDC (e₹) is legal tender issued by the RBI. Asset tokenisation records ownership of real assets such as bonds or property as tokens.
In the news
NFT sales boomed worldwide in 2021. The Union Budget of 1 February 2022 then brought 'virtual digital assets', explicitly including NFTs, under a 30% tax with 1% TDS. NFTs were therefore a live current-affairs topic just before the June 2022 Prelims.
NCERT Concepts to Revise
- Non-Fungible Token: The core term of the question; its definition bears on all three statements about representation, uniqueness and exchange.
- Blockchain: Statement 2 depends on what a blockchain is and how it records token ownership.
- Asset tokenisation: Statement 1 asks whether tokens can represent real-world assets, which is what tokenisation describes.
- Cryptocurrency: Comparing NFTs with interchangeable cryptocurrency units is the key to judging Statement 3's claim about equivalency.