Tax authorities worldwide are deciding how to tax non-fungible tokens. Now is the time to get clarity on this quickly evolving phenomenon.
A non-fungible token is a digital certificate of ownership and authenticity of an asset. Each asset represented by an NFT is unique and irreplaceable (non-fungible). Each digital certificate written on the blockchain is immutable. Simply put, an NFT is indisputable proof of ownership and originality of the purchased product.
Proof of ownership and scarcity give NFTs value. Therefore, a marketplace of buyers and sellers emerged after the first NFT was created in 2014, and where there is a marketplace, there are taxes. Though tax authorities have been slow to publish guidance on the taxation of NFTs, taxes can and do apply to many NFT transactions. The current framework for taxing NFTs is:
- Determine whether the underlying asset is on or off the blockchain.
- Examine the economic substance of the transaction.
- Examine the terms and conditions of the smart contract executed with the NFT sale.
- Determine which tax applies.
1. Determine whether the underlying asset is on or off the blockchain.
Though NFTs are digital, an NFT asset can be either digital or physical. A digital asset is anything created and stored digitally. A physical asset is tangible.
When a digital asset and all its metadata are stored on a blockchain, the NFT is on-chain. The
An example of an off-chain digital asset is the famous
Physical assets are always off-chain. Generally, the digital token is linked to its physical counterpart with a unique identifier, such as a QR code or chip-embedded identification card, that automatically updates when the NFT is purchased or sold.
2. Examine the economic substance of the transaction.
The "look-through doctrine" is used in taxation to validate the economic reasons for an exchange between parties. In the context of an NFT, this rule of law requires that you look at the substance of the transaction rather than the form. What product or service did the buyer purchase? Was the product or service digital or physical?
In July 2022, the Washington Department of Revenue issued
To illustrate, consider the sale of a digital artwork NFT. Since the object of the purchase is the digital artwork rather than the token, and since Washington taxes digital works of art, the NFT would be subject to Washington sales tax. The same would apply to digital NFT photographs, videos and music sold in Washington.
Italy also recommends using the look-through approach for NFT taxation. In June, Italy issued a proposed regulation positing that the NFT is just the vehicle for transferring goods, services, and associated rights. The proposal holds that on-chain NFTs are electronically supplied services subject to a Value Added Tax (VAT), while off-chain NFTs are subject to VAT only if the underlying asset is subject to VAT. Under this framework, the sale of digital NFT videos and music, and physical diamonds are subject to VAT in Italy.
However, unlike Washington, Italy is proposing an exemption for original on-chain digital works of art with all NFT rights assigned by the NFT creator (original artwork not sold by the creator is subject to tax). The proposed exemption stems from a section of the Italian VAT decree that excludes from the definition of electronically supplied services transfers made by the authors. You can learn more about that exemption
3. Examine the terms and conditions of the smart contract executed with the NFT sale.
Every blockchain transaction involves a smart contract — a program stored on the blockchain that runs whenever predetermined conditions are satisfied. Smart contracts are beneficial because they automate the sale agreement, avoiding the involvement of third parties and associated loss of time. With a smart contract, all parties know with certainty the terms of the sale. Among other things, the smart contract governs access, use and enjoyment of the NFT — specifically copyright, licensing and royalties.
To give you an idea of how this can affect tax, let's assume the creator of a digital artwork retains the right to royalties for future sales of the NFT. With each sale, the smart contract executes and generates royalty payments to the creator. In Washington state, where digital art is subject to sales tax and royalty payments are subject to Business and Occupation (B&O) taxes, sales tax would apply each time the digital artwork is sold, and B&O taxes would apply to all royalties received.
The smart contract also ensures that Italian VAT would apply to the resales of the work of art. Royalty payments indicate a secondary market sale, and Italy's proposed exemption does not apply to second-hand exchanges of digital artwork.
4. Determine which tax applies.
Sourcing rules dictate which jurisdiction can levy and collect tax on a transaction, but identifying the source of an NFT sale is extremely difficult. Fortunately, Washington NFT sourcing rules are instructive as the rules are analogous to most U.S. jurisdictions. The state has five different options: If the first sourcing rule does not work, you move on to the second, and so on.
The first rule sources the sale to the business location if the purchaser received the goods there — think brick-and-mortar retailer. Receiving the NFT at a store location is an unlikely NFT sale scenario, but it is possible if the product sold is an NFT for off-chain physical goods.
The second rule sources the sale to where the purchaser received the product, essentially the home or business delivery address.
If the first and second rules are not applicable, the third rule sources the sale to the address available from the business records.
If the third rule does not apply, the fourth rule sources the sale to the address obtained during the transaction. If the purchaser does not provide an address at checkout, the seller may use the address associated with the payment instrument. In essence, the third and fourth rules source the sale to any valid address obtained during the sale process or maintained as part of the customer engagement.
Unfortunately, the second through fourth sourcing rules are problematic for sourcing digital NFTs because a blockchain is a decentralized network of computer systems. The blockchain preserves the anonymity of purchasers and sellers by identifying only their cryptographic keys. In other words, the identity and location of the buyer are unknown.
So how does the seller source the sale? If none of the other sourcing rules apply, the final NFT sourcing rule in Washington says to use the location where the NFT was first made available for transmission. Essentially, that means the location of the seller's server.
In VAT countries, the analogous sourcing concept is the place of supply. The VAT rate for electronically supplied services is the rate in the country where the business registers or has a fixed location. If the purchaser is a consumer (i.e., a B2C transaction), the place of supply for digital services is where the consumer is registered, has their permanent address, or usually lives. In countries that lack a specific B2C place of supply rule for digital services, the place of supply is where the seller is established.
When the location of the buyer is not readily available, a VAT seller may use the following factors to determine the place of supply:
- The billing address of the buyer as retained in the business records of the seller;
- The internet protocol of the device used by the customer or any other method of geolocating the seller;
- The location of the bank or other merchant used for payment;
- The billing address of the customer held by the payment merchant; or
- Other commercially relevant information (the catch-all).
As previously established, the identities of NFT buyers and sellers are opaque, cloaked in a veil of cryptography. As such, the VAT place of supply rules, like the US sourcing rules, are difficult to administer.
What is the bottom line?
How do sellers remain tax compliant in this emerging industry? First, keep in mind that most NFTs are subject to sales tax and VAT. Look at the economic substance of the NFT transaction to determine the product or service sold, the rights conveyed, and whether the product or service is on or off the blockchain. After characterizing the transaction, determine if an applicable sales tax or VAT exemption applies. The marketplace for NFTs is global, with myriad taxability regulations and rates applying. Tax automation software can help sellers to reduce the burden and costs of getting taxability correct.
Second, because sourcing the sale is critically important for determining the applicable tax, an NFT seller may want to take measures to document the location of its purchasers. While this is not a current industry practice, the tsunami of tax audits on the horizon for this industry may force change, partially lifting the shroud of anonymity that surrounds NFT sales. Determining the purchaser's location is critical for accurately using tax automation software to simplify the compliance burden.
Finally, cryptocurrency is a fungible currency medium used to purchase NFT products. The cryptocurrency paid in the exchange must be converted to the local fiat currency at the time of the transaction to determine the selling price of the NFT product. Cryptocurrency itself is not subject to sales tax or VAT, but capital gains generated on the cryptocurrency may be subject to income taxes. NFT buyers should consult a tax professional to understand the income tax provisions for cryptocurrency in their country of residence.
