The world of NFTs: a tax perspective – Zoe Wyatt
Partner and Head of Crypto, Zoe Wyatt, discusses the UK’s regulatory approach to NFTs, along with their tax implications, in Accountancy Daily.
Zoe’s article was published in Accountancy Daily, 14 July 2022.
The UK tax authorities’ approach to cryptoassets is principles based. On 30th March 2021, HMRC published its Cryptoassets Manual, which embodied its policy document (Brief 09/14 – Tax treatment of activities involving Bitcoin and other similar cryptocurrencies) that was originally published in March 2014. What and how to tax DeFi was not considered until release of the DeFi chapters earlier this year on 22nd February.
HMRC’s principles based approach in the guidance still, nonetheless, came as a surprise to many. For example, some (predominantly retail) crypto investors had not appreciated that an exchange of one cryptoasset for another would be considered a disposal of the first, thus realising any inherent gain, giving rise to a capital gains tax (CGT) charge. Equally, others did not appreciate that staking or providing their tokens as collateral through a DeFi platform may be deemed as relinquishing beneficial ownership and therefore also a disposal for tax purposes.
HMRC has not yet published the NFT chapters of the Manual, which are expected later this year. This article is designed to raise awareness and to reduce the surprise factor; creators and investors need to consider their own tax position, while advisers need to understand that crypto and NFTs are here to stay.
The NFT market & UK regulatory landscape
Since they first appeared in 2014, Non-Fungible Tokens (NFTs) have generated strong investor interest, particularly over the past two years. The non-fungible tag relates to their unique digital identification: they can’t be copied. Although the most active market is currently digital art, NFTs have numerous other use cases. For example, they can be used as digital receipts or vouchers that can be redeemed for real world goods or services, grant rights to access certain crypto communities or a digital representation of your identity.
Trading platform eToro is currently launching a $20 million fund which aims to purchase blue-chip NFTs and support emerging projects in the space. Last year, the market exploded, as collectors outbid each other to purchase attractive NFTs. Estimates suggest that overall NFT sales grew by a remarkable 21,000% in 2021, reaching $22 billion in value, which accounts for an increasing share of the $1.2 trillion cryptoasset market.
Inevitably, once a burgeoning market emerges, speculators seek to snap up assets and sell them at a profit. As with cryptocurrencies, some commentators question their inherent value, while others invest with abandon. But anything for which people are willing to pay a price has value, albeit volatile in the case of NFTs.
When Twitter founder Jack Dorsey converted an image of his very first tweet into an NFT, it sold for a cool US$2.9 million. The buyer, crypto entrepreneur Sina Estavi, said, “This is the Mona Lisa of the digital world”. But when he later put it up for sale at US$48 million on the NFT marketplace OpenSea, it failed to attract any substantial offers, which neatly illustrates either the market’s unpredictability or that investors saw through the hype.
In response to the volatility of NFTs and cryptoassets more generally, there have been increasing calls for tighter regulation. Regrettably, the UK’s current regulatory landscape makes it practically impossible for NFTs to be legally created and sold in the UK. Such activity requires AML certification; however, UK businesses are apparently unable to get a response from the FCA to their applications within a commercially acceptable timeframe (anecdotally, many have waited more than a year for a response), or their applications are rejected. This drives NFT activity offshore and only serves to weaken consumer protection in the UK.
Whilst businesses look elsewhere, some UK individuals are still creating their own NFTs and selling them through third party marketplaces, which also appears to be an illegal activity without AML certification.
As with any novel asset class, it can be very challenging to interpret correctly how trading or investing in them should be taxed, and how they should be valued. Our approach is to identify the:
- primary stakeholders to the transaction; and
- attributes of the NFT(s).
Examples of primary stakeholders include:
- The creator
- The buyer who may then become a reseller
- The NFT holder who lends or stakes their NFTs with a DeFi platform
- The DeFi platform itself
- The DeFi platform may then repurpose the NFT
- Gaming, virtual reality, music platforms.
Example attributes include:
- Restricted Digital: The NFT does not embody an original digital asset, but rather a copy thereof with restrictions or limited rights attached. Ownership in the original digital asset is not transferred. For example, artwork, music, sports clips, digital wearables.
- Unrestricted Digital: The NFT embodies the original digital asset. The NFT holder is the owner of the original digital asset and can exploit it in any way desired. For instance, artwork, other collectibles, digital wearables, gaming certificates, non-sovereign information / data.
- Real World Goods or Services: The NFT can be redeemed for physical goods (e.g. investment wine and spirits, merchandise etc.) or real-world services (e.g. spa day, airport lounge access, ticket for an event). The NFT may cease to exist post redemption.
- Hybrid: Combination of any of the above. For example, an NFT that is redeemed for a real world good could provide the holder access to future merchandise “drops” and would still have a utility and some value even after redemption of the valuable goods.
This approach allows us to assess:
- what rights the NFT carries;
- how money (or money’s worth) is made from the NFT; and
- who in the transaction is making the money (or money’s worth) from it,
through which we can form a view as to the character of the transactions for direct tax purposes; gains, revenue, commission, royalty etc. and apply a principles-based approach to determine the tax outcome for each stakeholder.
However, this approach does not always resolve every issue; there can be real difficulties in assessing the indirect tax consequences of NFT transactions. For instance, in a B2C context, the obligation is on the seller to register for VAT in the customer’s location. However, the seller tends not to know where the customer is located, and demanding such information is not considered commercially viable.
Much like the wider crypto community found on Twitter and Discord, the crypto tax community is collegiate and collaborative; sharing ideas and working together to resolve these problems to set an industry standard.