A burgeoning downside within the NFT area: classification and taxation of those worthwhile tokens

In the past few weeks, several milestones from Cryptoassets have hit the mainstream press. In particular, a subset of cryptoassets – non-fungible tokens or "NFTs" – has made headlines on countless occasions when Christie & # 39; s recently released their first all-digital work of art in the form of Beeples "First 500 Days" with sales of nearly 70 Million dollars sold. Compilation), the first digital NFT house – Krista Kim Studio's futuristic "Mars House" – which sold for 288 ethers (US $ 514,558), and British artist Damien Hirst announced a project with Palm, the new " eco-friendly digital marketplace by Joe Lubin, co-founder of Ethereum, who will offer a range of 10,000 unique oil paintings tied to appropriate NFTs.

Like a cryptocurrency coin, an NFT is a unique token that resides on a blockchain like Etherium and is governed by a smart contract that records the origin and transaction history. One of the key elements is that, unlike cryptocurrencies – or regular currencies – NFTs are not fungible, hence the name. This means that two NFTs can use the same smart contract but have different values ​​depending on their respective characteristics. This uniqueness is recorded in the metadata of the NFT and is part of what makes NFTs attractive for securely tracking the origin of physical luxury goods such as paintings, sculptures or diamonds and essentially replacing the certificates of authenticity made from paper.

Despite the attraction of NFTs from a tracing perspective for rare or otherwise unique physical goods, this emerging technology is also increasingly being used to mirror digital assets that have no physical existence at all. This is achieved by including a “token ID” in the NFT metadata that points to a specific digital resource – for example, in real Internet form, to virtual kittens. The blockchain-based game Crypotkitties developed by Dapper Labs, which has been compared 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 hit the market in November 2017.

What is the problem?

It has already been established that cryptocurrencies are both difficult to define and difficult to integrate into existing legislative provisions designed to deal with fundamentally different assets. With that in mind, NFTs have some of the same difficulties as cryptocurrencies. For example, owners can remain anonymous. The assets themselves are prone to hybridity and variability, and basically there is no consensus yet on how to classify NFTs: are they intangible assets, commodities, financial instruments – or something else entirely?

And there is another level of complexity. Unlike cryptocurrencies, which are indistinguishable from the value they represent, NFTs represent the right of the holder to claim a separate, distinguishable asset. In other words, a holder of a cryptocurrency may lose access to their cryptocurrency wallet. In this case, the HMRC may crystallize a loss, but an NFT holder may be holding a token that does not refer to anything. The underlying asset can be moved, duplicated, swapped, or even destroyed. Whether the NFT owner has enforceable rights in this situation – and therefore whether they can crystallize a loss in the same way – depends on the specific terms of the smart contract.

What does this have to do with taxes?

What does this have to do with taxes? Put simply, when it becomes difficult to determine what an asset is, where it is, and how much it's worth, it also becomes quite difficult to tax that asset – and while the NFT boom seems to be fading for the time being, digital assets aren't disappear so quickly. In fact, these questions arise in the commercial courts. Recent cases have established that cryptocurrencies are actually owned, that speculation about cryptocurrencies is not inherently a business activity and (if only in the first instance and to a significant extent relying on academic texts) is the seat of the owner of the Lex Situs of cryptocurrencies. The manual for cryptoassets also shows that the tax treatment depends heavily on the characteristics of the respective cryptoassets – possibly even on the specific token.

As cryptoassets become more widespread and diverse (and if the guidelines are likely to have trouble keeping up), it certainly won't be too long before problems of this nature show up in the courts of different jurisdictions.

The other element that can be relevant to taxing NFT is, of course, the environmental impact. With a number of governments and international organizations debating how taxes – whether as a stick or a carrot – can best be used to make progress towards carbon neutrality, the larger carbon footprint of an NFT compared to a physical asset has likely real tax implications for the nascent NFT economy.

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

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