A Budding Issue in the NFT Space: Classifying and Taxing These Valuable Tokens

By April 15, 2021DApps
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The last few weeks have seen a number of cryptoasset milestones reach the mainstream press. One subset of cryptoasset in particular – Non-Fungible Tokens or “NFTs” – has made the headlines on seemingly countless occasions, as Christie’s recently sold their first purely-digital artwork in the form of Beeple’s nearly $70 million-generating “First 500 Days” compilation), the first digital NFT home – Krista Kim Studio’s futuristic “Mars house” – sold for 288 Ether (the equivalent of $514,558), and British artist Damien Hirst announced a project with Palm, the new “environmentally-focused” digital marketplace created by Ethereum co-founder Joe Lubin, which will see him offer up a series of 10,000 unique oil paintings tied to corresponding NFTs.

Like a cryptocurrency “coin,” an NFT is a unique token that exists on a blockchain, such as Etherium, and is governed by a smart contract that records its origins and transaction history. One of the key elements is that, unlike cryptocurrencies – or normal currencies, for that matter – NFTs are non-fungible, hence, the name. This means two NFTs can use the same smart contract but have different values, depending on their particular characteristics. That uniqueness is recorded in the NFT’s metadata, and it is part of what makes NFTs attractive as a secure way of tracking the provenance of physical luxury goods, such as paintings, sculpture or diamonds, essentially replacing paper certificates of authenticity.

Despite the allure of NFTs from a provenance-tracing perspective for rare or otherwise unique physical goods, this budding technology is also increasingly used to reflect digital assets that have no physical existence at all. This is achieved by including a “token ID” within the NFT metadata that points to a specific digital resource – such as, in true internet form, virtual kittens. The Dapper Labs-created, blockchain-based game, Crypotkitties – which has been likened to “a digital version of Pokemon cards but based on the Ethereum blockchain” – was, of course, one of the first recreational uses of NFTs when it launched in November 2017.

What’s the problem?

It has already been established that cryptocurrencies are both difficult to define and challenging to shoehorn into pre-existing legislative regimes designed to deal with fundamentally different assets. With that in mind, NFTs present some of the same difficulties as cryptocurrencies. It is possible for holders to remain anonymous, for instance. The assets themselves are prone to hybridity and mutability and, more fundamentally, there is so far no consensus on how to classify NFTs: are they intangible assets, commodities, financial instruments – or something else entirely?

And there is yet another layer of complexity. Unlike cryptocurrencies, which are indistinguishable from the value they represent, NFTs represent the holder’s right to claim a separate, distinguishable asset. Put another way, a cryptocurrency holder might lose access to their cryptocurrency wallet, in which case HMRC may allow them to crystallize a loss, but an NFT holder may find themselves holding a token that points to nothing at all. The underlying asset could be moved, duplicated, swapped, or even destroyed. Whether the NFT holder has any enforceable rights in that situation – and therefore, whether they can crystallize a loss in the same way – depends on the specific terms of the smart contract.

What’s this got to do with tax?

So, what does this have to do with tax? Simply put, when it becomes difficult to determine what an asset is, where it is, and how much it is worth, it also becomes pretty difficult to tax that asset – and while the NFT boom seems to be subsiding for the time being, digital assets are not going away any time soon. In fact, these questions are starting to appear before the commercial courts. Recent cases have determined that cryptocurrencies are indeed property, that speculating on cryptocurrencies is not inherently a business activity, and (albeit only at first instance and placing significant reliance on academic texts) that the lex situs of cryptocurrencies is the place of domicile of the holder. It’s also clear from the cryptoassets manual that the tax treatment will depend heavily on the characteristics of the particular cryptoasset in question – potentially even the specific token.

As cryptoassets become more widespread and more varied (and if, as seems likely, guidance struggles to keep up) it surely will not take too long for issues of this nature to begin to crop up before the courts in various jurisdictions.

Of course, the other element that may be relevant to how we tax NFTs is the impact on the environment. With a number of governments and international organizations discussing how best to use tax – whether as a stick or a carrot – to incentivize progress towards carbon neutrality, the higher carbon footprint of an NFT over a physical asset is likely to have a real tax impact on the nascent NFT economy.

Victoria Hine is a tax associate at Slaughter and May with a particular interest in employment and incentives taxation, corporate responsibility, and legal technology.

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