It almost goes without saying that this growing area of Web3 economic activity is triggering significant volumes of taxable events, and despite high levels of uncertainty and complexity, NFTs are by no means immune to direct taxation and the associated demands of regulation and compliance.
Organizations planning their own NFT drop should therefore consider the following five questions around direct taxation.
1. What assets underlie the NFT?
In its simplest form, an NFT is an entry in a digital ledger consisting of a few lines of code. Each NFT is immutable (meaning it cannot be altered) and the ledger is distributed across the blockchain – but this is ultimately the limit of an NFT’s value. The greater value lies in the asset underlying the NFT. This determines both the buyer’s and seller’s direct tax exposure.
Early NFT use cases included underlying assets, such as unique digital artworks, and collectables such as virtual trading cards. NFTs have evolved rapidly, however, and now widely feature tangible underlying assets, such as clothing, vehicles, physical artworks and real-world experiences, such as admission to events and concerts. To add more complexity to the mix, it is also now common for individual NFTs to feature a mix of assets (known as bifurcation), which are both tangible and intangible.
“A typical example of bifurcation could be a multi-asset NFT issued by a luxury fashion brand,” explains Dennis Post, EY Global Blockchain Tax Leader. “Such an NFT could entitle the owner to an item of physical clothing or jewelry and a digital representation of that product. That same NFT could also include admission to an exclusive event or party.”
To make sense of this underlying asset mix and calculate tax exposure, Post says that organizations selling such NFTs need to conduct a process of revenue attribution. This involves identifying each underlying asset, splitting them into tax buckets, calculating their individual value using comparable transactions, and determining tax treatment according to the respective jurisdictions in which they are distributed and/or sold.
2. How will you overcome the challenge of allocating direct tax income?
NFTs are stored and processed across multiple servers and in multiple jurisdictions simultaneously. This makes it virtually impossible to identify a single jurisdiction where an NFT transaction takes place. When determining substance, it is therefore necessary to focus on the location of the legal entities involved in each transaction. This can also be challenging, however, because NFTs are bought and sold using anonymous crypto wallets. A logical solution could be for NFT sellers to request customer ID information, such as country of residence, but this is not common market practice, and it could deter some customers.
Widespread enforcement of anti-money laundering regulation, (such as MiCA, The European Commission’s Markets in Crypto-assets regulation and FATCA, the US’s Foreign Tax Account Compliance Act) may offer a solution. These regulations would compel parties to share specific “know your customer” (KYC) and anti-money laundering (AML) data.
Roland Häussermann, Partner International Tax Services at Ernst & Young GmbH Wirtschaftsprüfungsgesellschaft, says that adherence to KYC and AML regulations may not yet be a standard feature of NFT transactions, but that reflects the immaturity of the market, and it is unlikely to remain for long.
“Blockchain is not a regulation-free area,” says Häussermann. “All regulations, to a certain extent apply. AML and KYC regulations may not have been updated to accommodate all the specific requirements of NFT technology, but organizations should still comply with them. No serious operator would consider doing otherwise. AML and KYC regulations may not be a perfect fit at the moment, but that doesn’t mean they don’t apply to NFTs.”
3. How can royalty payments open secondary markets and prove product provenance?
NFT royalty payments present a compelling revenue stream for brands that would otherwise be unable to participate in, or benefit from, activity in secondary markets.
When brands link an NFT to an underlying physical product, they not only provide a virtual certificate of authenticity – which can be transferred to future owners – they can also embed a smart contract into that NFT, which could automatically pay them a percentage of the sale price every time it is resold.
This would be particularly advantageous for businesses such as art dealerships and luxury goods brands whose products retain or even increase in value over time due to scarcity, but who can also struggle proving their provenance in secondary markets.
4. Is it necessary to hold cryptocurrency and will this increase direct tax exposure?
While it is possible to buy some NFTs using conventional fiat currencies, most NFT marketplaces trade using cryptocurrencies, with Ethereum being the most popular. In many ways crypto transactions are exposed to the same risks associated with conventional cross-border foreign exchange deals. The big difference with cryptocurrencies, however, is that they are significantly more volatile than fiat currencies and therefore capital gains and losses can be significantly higher. Also, organizations may not be familiar with using crypto which could cause additional risk.
5. What steps should organizations take to manage NFT transfer pricing?
The distributed nature of NFTs means that organizations have, in theory, the freedom to establish a legal entity in whatever jurisdiction they see fit. To manage their direct tax approach, however, organizations must first ask themselves some important questions and overcome some key challenges.
“For example, it may make sense for organizations to create a specific legal entity responsible for NFT activity if companies are serious about embedding NFTs into their operating model and sales channels, because of the legal and tax risks involved,” says Post.
“From a transfer pricing perspective, it is important to consider the functions, assets and risks involved. Such an analysis will inform you on how profits from the NFT company should be allocated.”
Informal partnerships, collaboration and support between blockchain companies can also present challenges. “It is often difficult to agree on a single representation of a bilateral business relationship, because there is no legal contract,” explains Magnus Jones, EY Nordic Blockchain & Innovation Leader. “To make transfer pricing work, participants have to agree whether their relationship is a civil law partnership or in fact some kind of service transaction.”