Income tax in the different cases of use of NFTs

Source: Observatorioblockchain / Alfredo Collosa

In this post we are going to talk about income tax based on the different types of NFTs. The market for non-fungible tokens (NFTs), which are unique digital assets stored on the blockchain, has exploded. The result has translated into multi-million dollar sales and the launch of multiple NFT markets. As well as uses in the Metaverse and in play to earn games. The NFT industry grew from generating $100 million in 2020 to $23 billion in 2021, according to data from DappRadar. So far, the most expensive NFT in history has been Beeple’s «The First 5,000 Days» artwork, which sold for $69.3 million in spring 2021.

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NFT and Income Tax

NFTs are characterized by representing a unique and unrepeatable asset, which can be works of art, vinyl or other collector’s items. Their value is dictated by the market and they are non-fungible. That is, they cannot be exchanged for goods of another nature and of comparable economic value. In general, NFTs are used as a digital certificate to represent ownership or rights in relation to an indivisible asset, whether physical or intangible, especially digital intangible assets.

But the NFT is not the underlying asset itself, but rather an electronic record that proves ownership of the asset that is separate from other legal risks of ownership. Like the copyright of a digital work of art. In other words, owning an NFT is not necessarily equivalent to owning the asset underlying the NFT. Unless such NFT specifically includes a transfer of rights, such as copyright.

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Copyright

The most common scenario, using a work of art as an example, would be that the creator, who is the copyright owner, grants the owner of the NFT a license to use the work under certain circumstances. All this, as stated in the digital contract underlying the NFT. Typically, the digital contract also provides for the payment of a royalty to the copyright owner each time the NFT is resold, with an automatic payment function built into the NFT. Thus, we can say that there are different subjects and taxable events liable to pay income tax , an issue that will vary depending on the legislation of each country.

Creator of the NFT

It appears that the mere creation of an NFT is not a taxable event subject to income tax. However, the sale of an NFT is a taxable event that can be subject to general income tax when it is a habitual activity. Or sporadic activities with capital or equity gains, depending on the legislation of each country. Another income that is produced for the creator of the NFT comes from the collection of royalties for the resales of the NFT. Income that can also be considered subject to income tax.

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Buyers and investors of NFTs

Many jurisdictions regard cryptocurrencies as property, rather than a fiat equivalent. This means that any profit made from exchanging cryptocurrency for another asset (the NFT in this case) when the buyer first purchases the NFT is taxable. Therefore, it will depend on the legislation of each country if the general income tax or the income tax on capital gains is applied.

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Donation of an NFT

Increasingly, artists and investors donate NFTs to museums or auction them off for charity. In principle, the donation by itself would not be a taxable event in the income tax. Obviously, as in all cases, it will depend on the legislation of each country.

NFTs, Play to Earn (P2E) games

In these cases, the participants can obtain profits as a result of the specific actions that are carried out within the game. Although the mechanics of each game differ, if activities are performed in a game to earn rewards in the form of crypto assets, they would be subject to tax in countries that tax exchanges between crypto assets. Or when they are exchanged for legal tender. For example, in the US the IRS considers any crypto-to-crypto transaction to be a taxable event.

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The importance of guides with fiscal orientations

Currently, many jurisdictions are working to define the taxation of the most used payment tokens, such as cryptocurrencies, providing tax guidelines. However, on the issue of NFTs, not many countries have issued guidelines on tax matters. One of them has been Australia, where the ATO (tax office) published a specific guide to NFTs in income tax with concrete examples of taxation.

The first thing the ATO guide does is define the concept of NFT. Next, it specifies that the income tax of an NFT depends on various circumstances. Such as how it is used and the purpose for holding and transacting with said NFT. She indicates that income tax can be paid in the NFT, as an asset under the capital gains tax regime or in the income account as commercial shares, as part of a business or as a profit scheme. She also notes that as with other types of crypto assets, in rare circumstances an NFT could be held as an asset for personal use.

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Personal, business or capital use

The guide provides practical examples of when an NFT can be considered for personal use, part of a business or capital of a company. For example, in the NFT as a company’s capital, the following case arises: «Kim, a professional artist, paints a portrait of a famous Australian and decides to create ten NFTs. They each grant the right to a 4-hour private viewing of the portrait in her gallery every year for 20 people. Osman buys one of Kim’s NFTs. Running a touring business, she plans to use the private viewing of the portrait as part of an annual art tour of the region. She concludes that the NFT is a business capital gains tax asset.

In the case of NFT as part of a business, she explains: “Kim, a professional artist, paints a portrait of a famous Australian and decides to create ten NFTs. Each of these NFTs grants the right to a 4-hour private viewing of the portrait in her gallery each year for up to 20 people. On subsequent transfers of the NFTs to the new owners, the digital contract allocates part of the revenue to Kim as commission. Kim retains all other rights associated with the painting.» In this case, the proceeds from the initial sale of the NFTs can be assessed as business income for Kim. As long as she remains in business, any commission received would also be business income. If Kim ceased conducting the business, the commissions would still be assessable as ordinary income.

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multiple challenges

As we said at the beginning of the article, NFTs are in full growth and present multiple challenges for countries. Among them: civil, commercial, corporate, copyright protection, personal data protection, consumer protection, money laundering, regulatory issues and, of course, fiscal tax matters such as treaties. Therefore, it is essential that countries work with their regulatory framework and determine in each of the specific cases if there are taxable events subject to taxation.

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