Metaverse Expansion into Real World Activity
The evolution of the metaverse is leading towards a rapid and unprecedented integration of the real and digital worlds. The unfolding of this event will be singularly transformative across a broad range of human activity. It’s safe to say that the metaverse should enhance the ability of people from different parts of the world to come together for purposes of learning, working, trading and playing. It should also provide qualitative enhancements to such activities. Consider the following:
- Higher Education. Universities across the globe are launching virtual reality classrooms as part of a goal of establishing completely immersive metaverse campuses that will permit millions of students to attend classes irrespective of geographical boundaries.
- Workplace. The metaverse will enhance provide workers in far flung locations to convene in a shared space that permits for higher quality collaboration that increases productivity and reduces costs.
- Commerce. Bricks and mortar shopping and e-commerce shopping will effectively converge in the metaverse creating an enhanced e-commerce experience that permits shoppers to have a more sensory experience and appreciation of the products or services they are buying.
- Communication. The metaverse will give participants from different corners of the world the unprecedented ability to interact with each other in a shared virtual environment. In this regard, one of Meta’s projects is the establishment of a “universal speech translator” that will facilitate metaverse communications among global metaverse participants of differing language backgrounds.
- Cinema and the Arts. Viewers will be more deeply immersed to the point where they feel like they are in the actual movie. Participants should enjoy similarly immersive experiences at metaverse venues such as concerts, museums, theme parks, professional sports venues, virtual vacations, etc.
Technological Drivers of the Metaverse Economy
Although a metaverse can exist without blockchain, the blockchain is the key technological facilitator of economic transactions in the metaverse. A blockchain network represents a revolutionary accounting platform that operates via a dispersed digital network. Through the active participation of persons across the network, the blockchain digitally tracks the online creation and trade of digital assets and services and effectively maintains a secure decentralized public ledger of transaction and ownership data.
Non-fungible Tokens & Smart Contracts
A non-fungible token (“NFT”) is a unique strip of code on the blockchain that serves as a record and certification of the authenticity and ownership of a specific item. (The item can be tangible or digital, but for purposes of this article, we will focus on digital items in the metaverse such as an original 3-D image of a brand sneaker or other items of clothing worn by an avatar, furniture, artwork, a plot of virtual real property, etc.) Closely associated with each NFT is a blockchain program called a smart contract that brings the NFT into being on the blockchain (i.e., “mints the NFT”) and automatically executes the transfer of particular rights to a digital item when predetermined terms (including price) are met. Depending on each vendor, the smart contract can stand on its own as the sole binding agreement between transacting parties or it can be supportive of a separate written contract.
Tax Issues Related to NFT Transactions
Because NFT acquisitions must be made with cryptocurrency, the acquiror may have a taxable event to the extent the cryptocurrency (which the IRS views as property rather than currency) has appreciated between the date the acquiror obtained the cryptocurrency and the date the NFT acquisition occurred. Government backed stable coins would prove useful for facilitating and promoting a future metaverse economy by relieving purchasers from having to track, report and pay tax on every single purchase involving cryptocurrency. However, a government backed stable coin that is treated as currency is a topic for another day. The focus of this article is on the tax implications for parties that own and market NFTs in the global metaverse economy.
Presently, it is taken for granted that NFT transactions should receive sales treatment and that the related income should be taxed accordingly. For example, where the NFT is sold by artists, creators or enterprises that hold NFT inventories, the income is presumed to be ordinary. Where the NFT is sold by an investor after being held for one year, the related income is presumed to be either (i) capital gain subject to the 20% capital gains tax, or (ii) collectibles income subject to the 28% collectibles tax.
However, depending on the terms of the NFT smart contract (or the separate written contract if one exists), it is equally likely that the IRS would conclude that income related to a good portion of NFT transactions should be characterized a rents or licenses as opposed to sales. This difference in characterization could result in significantly different and unexpected tax and reporting consequences for metaverse participants.
Tax Issues for U.S. NFT Vendors
Let’s consider an NFT transaction between a US seller (individual or business entity) and an acquiror in Country B. Let’s assume that U.S. tax authorities and Country B tax authorities will be able to claim normal taxing jurisdiction over transactions notwithstanding that they occur in the metaverse. Assuming the US seller has no business activity in Country B, an NFT transaction that is characterized as a sale would typically trigger only U.S. tax with no need to consider additional tax consequences in Country B.
However, if the transaction is characterized as a license or rental, a couple of tax issues arise. First, the NFT vendor’s income may be taxed at ordinary tax rates rather than lower rates applicable to sales. Second, Country B would generally have the right to apply withholding tax on the payment. In some cases, this withholding tax burden can be reduced if there’s a tax treaty. In other cases, the withholding tax could be mitigated by taking a U.S. foreign tax credit for foreign withholding tax paid. But a foreign tax credit is only available if the income is considered foreign sourced for U.S. tax purposes. In order to qualify as foreign sourced income, the rented or licensed NFT would need to be located/used outside the U.S. Establishing that a transferred NFT will be located/used outside the U.S. may be tricky where transactions take place in the metaverse. If the U.S. vendor cannot establish that the income is foreign source, such vendor will be unable to take a U.S. foreign tax credit for Country B withholding paid, thereby resulting in an unexpected increase in the cost of doing business.
If a U.S. corporation’s sale or license of an NFT to an acquiror in Country B qualifies for a reduced U.S. tax rate under the Foreign Derived Intangible Income (FDII) export incentive, a foreign tax credit will not be available at all with respect to foreign withholding tax paid. Further, if U.S. parties decide to market NFTs from a company set up in a tax haven, the Country B withholding tax will not be creditable by the tax haven entity or by U.S. shareholders.
Tax Issues of Foreign NFT Acquiror
Let’s now consider the tax considerations relevant to an NFT acquiror in Country B who believes she is acquiring total and complete ownership rights in an authenticated copy of a digital asset, including the right to makes copies, display to the public, etc. A closer review of the terms and conditions of the smart contract may reveal that the purchaser is acquiring an authenticated digital copy with very limited rights. Specifically, the smart contract provides that the purchaser does not receive the right to exploit the digital asset copy and is granted use of the copy for only one year. Under the circumstances, the transfer is likely not a sale but rather a lease or something else. However, because many parties to an NFT transaction are likely overlook the tax implications of the particular rights that are transferred (or not transferred), it is likely that there will be a failure to consider country B withholding tax, which could lead to penalty and interest exposure for both the buyer and seller since it is not uncommon for them to be held jointly liable for unpaid withholding tax.
As demonstrated in the above examples, U.S. NFT vendors and purchasers could potentially have unwelcome tax surprises if they discover that their NFT transaction are not treated as sales, but rather as leases subject to foreign withholding tax. But how are U.S. NFT vendors to navigate the tax uncertainty of NFT transactions?
Relevance of NFT Rights in Determining NFT Taxation
As of today, the IRS has not provided specific guidance on how NFT transactions should be taxed in the real world, much less in the metaverse. However, it’s fair to assume it will require the usual type of tax analysis, including (i) determination of the location of the real-world person or entity involved in the NFT transaction; (ii) determination of the type of property or service involved; (iii) determination of the character of the transaction (e.g., sale, rent, lease, etc.); and (iv) source of the income. A key element of uncertainty in applying the above analysis to NFT transactions is the question of income characterization (e.g., sale, license, rental, etc.). What are the relevant factors for determining the appropriate characterization of an NFT transaction?
When NFTs are minted, the NFT creator or vendor has the ability to program the smart contract to specify (1) the terms and conditions of transfer and (2) the rights in the digital asset that will be transferred to the buyer. Among the rights that an NFT owner can pass to an acquiring party are the right to copy and distribute, the right to display, the right to create derivative works or the right to own or use for various amounts of time, etc. It should be possible for a smart contract (or a separate written contract) to include any of a vast combination of rights. However, the failure to include information about rights conveyed can lead to substantial uncertainty about the character of income generated and may expose the transaction to surprising and unfavorable tax consequences.
U.S. Tax Regulations Related to Transfers of Computer Programs
By now it should be apparent that NFTs, smart programs and the digital assets they represent (whether it be metaverse real estate, digital sneakers, artwork, office space or digital services) are all strings of computer code, if not actual computer programs. In this respect, NFT transactions involving NFT digital assets are in many ways akin to transactions involving the transfer of computer programs. With respect to the latter, the U.S has well established tax rules regarding how transfers of computer programs should be characterized and taxed. These rules are found under regulation section 1.861-18 -Classification of Transactions Involving Computer Programs (hereinafter referred to as “the computer program regulations”). (T.D. 8785, 63 FR 52971 (October 2, 1998) The U.S. Treasury finalized these regulations in 1998 at the height of the dotcom era. Although the dotcom bubble burst in 2000, the computer program regulations have survived the test of time and have recently been updated with proposed amendments to accommodate cloud transactions and transfers of other copyrighted digital content including audio books, music, movies, etc. 84 Fed. Reg. 40317 (Aug. 14, 2019).
Per the U.S. computer program regulations, a computer program is defined as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” In addition, “a computer program includes any media, user manuals, documentation, data base or similar item if the media, user manuals, documentation, data base or similar item is incidental to the operation of a computer program.” Granted, this definition may not comport to how IT professionals would define a computer program. However, it suits the needs of the U.S. Treasury and the IRS in applying the tax law to transactions involving digital assets. The definition also conveys a sense of the breadth of items and transactions that the U.S. Treasury intended to fall within the framework of the regulations.
The Treasury’s preamble to the final regulations includes the following additional points worth noting: (i) the special features of computer programs should be recognized and that functionally equivalent transactions should be treated similarly; (ii) copyright law should be a factor in classifying transactions for tax purposes but should not be determinative; (iii) the regulations should be used for applying and interpreting U.S. tax treaties. (T.D. 8785, 63 FR 52971 (October 2, 1998).
Arguably, NFTs – including the smart contracts and the digital assets with which they are associated – would likely fit the definition of a computer program as set forth in the computer program regulations. Furthermore, given the similarities between transactions covered in the computer program regulations and transactions involving metaverse NFT items (including their common foundation in computer code and the importance of the rights that are transferred), the U.S. tax regulations related to computer programs and digital content should prove highly relevant (if not controlling) in determining the taxation of NFT transactions. However, even if a legal conclusion was reached that the existing regulations do not technically apply to NFTs, the analysis required to determine the character and taxation of NFT transactions should be similar, if not identical, to the analysis prescribed by the computer program regulations.
Framework of Computer Program Regulations & Application to NFT Transactions
The existing computer program regulations discuss the following two categories of computer program transactions that are relevant for purposes of determining the classification and tax treatment of NFT transactions:
(1) transfer of copyright rights in a computer program, and
(2) transfer of copies of a computer program (“copyright article”) Regulation Section 1.861-18(b).
The regulations specify that a copyright article includes a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated either directly or with the aid of a machine or device. The copy of the program may be in the main memory or hard drive of a computer or in any other medium (which arguably includes the internet, the cloud, a blockchain, the metaverse, etc.) Regulation Section 1.861-18(c)(3)
So how do we tell these two categories apart? Under the regulations, the determination of which of the two categories a computer program falls into depends on whether any of the following rights are included in the transfer:
- the right to make copies of the computer program for purposes of public distribution
- the right to prepare derivative computer programs based on the copyrighted computer program
- the right to make a public performance of the computer program
- the right to publicly display the computer program. Regulation Section 1.861-18(c)(2)
If any one or more of the above rights is included in the transfer, the transaction is treated as a transfer of a copyright right. Conversely, if none of the above rights are included in the transfer, the transaction is treated as the transfer of a copyright article. So how might these two categories be applied to an NFT transaction?
In many instances, transactions involving NFTs simply involve the transfer of an authenticated copy of an original work. The NFT is written in code and resides on the blockchain. The associated digital item typically resides elsewhere – typically on the internet given the expense of storing on the blockchain. The acquiror of the NFT often has no rights to exploit the digital item other than by reselling it. In these cases, the NFT transfer would likely be treated as a transfer of a copyright article since it does not include the transfer of copyright rights listed above.
On the other hand, the purchaser of the NFT of the digital work of art titled Everydays: the First 5000 Days (which was sold for $63.9 million) received the right to display the artwork, but apparently not a right to copy and distribute. Under the computer program regulations, the purchaser of this work of art would be treated as receiving a copyright right since he acquired at least one of the copyright rights listed above – the right to publicly display.
Once the above analysis of rights has been applied to an NFT transaction to determine if it involves a transfer of a copyright right or a copyright article, what then? After categorizing an NFT transaction as either a transfer of a copyright right or a copyright article, the next step would involve determining whether the transaction should be treated as a sale or a lease. It’s worth noting at this point that the computer program regulations stipulate that neither the form adopted by parties to a transaction, nor the principles of copyright law will be determinative in establishing the U.S. the tax characterization of the transaction. Regulation section 1.861-18(g)
Under the computer program regulations, the determination of whether a transfer of a copyright right should be treated as a sale for tax purposes is based on whether there has been a transfer of all substantial rights in the copyright. In considering this question, the focus should be on the four rights listed above (including any rights similar to those). If all substantial rights are transferred, then the transaction is taxed as a sale. Conversely, if a transaction does not involve the transfer of all substantial rights in the copyright, the transfer is treated as a license generating royalty income. This analysis of whether all substantial rights have been transferred requires relevant parties to consider all the facts and circumstances of a transaction. The regulations provide examples to assist in determining when all substantial rights have been transferred.
With respect to an NFT transaction that is categorized as the transfer of a copyright article, the determination of whether it should be treated as a sale under the computer program regulations depends on whether the benefits and burdens of ownership of the copyright article have been transferred. The benefits and burdens of ownership might include one or a combination of the key NFT rights, for example, the right to use the NFT in perpetuity, the right to sell or having the risk of loss, etc. If an NFT transaction that is categorized as a transfer of a copyright article does not include the transfer to the buyer of sufficient benefits and burdens of ownership, it will be treated as a lease generating rental income.
Where a transaction involving a copyright right or a copyright article is treated as a lease rather than a sale, the NFT vendor would have to consider the resulting tax consequences of being taxed at ordinary rates rather than capital gains or collectibles tax rates. Conversely, where the lease is to a customer outside the U.S., there will be a need to consider potential withholding tax implications. In some cases, vendors will have flexibility to structure the transfer of rights so that they can achieve the most favorable tax consequences. In other cases, there may not be much flexibility, but it will still be important to fully understand what the actual tax consequences are likely to be and whether foreign withholding tax will be an item that needs to be appropriately accounted for and managed.
The emerging metaverse economy will leverage the blockchain’s distributed ledger accounting infrastructure, as well as billions of NFTs and smart contracts to drive the coming explosion of trade in metaverse goods and services. Although some of this trade will involve assets and services that heretofore were exclusively traded in the real world, a massive amount of metaverse transactions will involve trade in newly created digital assets and services. This expansion of metaverse trade will broaden the base of the metaverse economy (the economy of avatars and fiction) and will inexorably drive its integration with the real economy (the economy of humans and fact). As this integration progresses, they will evolve into a prosperous and powerful Faction Economy.
The issue of how a particular NFT transaction should be taxed is one of the basic issues that NFT vendors will have to manage as the metaverse economy progresses into the faction economy. Until the U.S. Treasury issues specific guidance, the analysis of rights that is at the core of the existing computer program regulations should prove instructive (if not controlling) in determining the character and applicable tax consequences of NFT transactions.