By Zoe Wyatt, Partner and Head of Crypto, and Laura Knight, International and Crypto Tax Director at Andersen in the UK.
The UK taxing authority, HM Revenue & Customs (HMRC) takes a principles-based approach to cryptoassets, as is evident in HMRC’s Cryptoassets Manual, published on 30th March 2021. The Manual updated a policy document that stretches back to March 2014: Brief 09/14 – Tax treatment of activities involving Bitcoin and other similar cryptocurrencies. Notably, the taxation of DeFi had not previously been considered until specific DeFi chapters were published on 22nd February 2022.
Nevertheless, HMRC’s principles-based approach still came as a surprise to some retail crypto investors and still does so for those who have not been through the Cryptoasset Manual. For example, they had not realised that exchanging one cryptoasset for another is treated as a disposal, creating a capital gains tax (CGT) charge on any inherent gain. Meanwhile, others did not appreciate that using their tokens as collateral via a DeFi platform can be considered as a disposal for tax purposes because beneficial ownership has been relinquished.
Following adverse feedback from the retailer / consumer sector on the DeFi chapters, earlier this month HMRC published a call for evidence as to three potential options to secure a tax neutral position for those moving in and out of lending and staking on DeFi protocols.
It is anticipated that the Manual’s NFT chapters will be published later this year. In the interim, creators and investors should consider their own tax position, while advisers need to understand that crypto and NFTs (non-fungible tokens) are now a permanent feature of the investment landscape.
The NFT market & UK regulatory landscape
Although they first appeared in 2014, strong investor interest in NFTs has really taken off over the past two years. As cryptographic assets on a blockchain, true NFTs have a unique digital identification and thus cannot be copied. Currently, the most active NFT market is digital art, but they have numerous other applications, such as digital receipts or vouchers that can be redeemed for goods or services, grant rights to access certain crypto communities, or digitally represent your identity. The recent UK legal case Fabrizio D’Aloia v. (1) Persons Unknown (2) Binance Holdings Limited & Others cements NFTs’ potential endless real world use after the UK courts allowed papers to be served to fraudsters via an NFT drop to their wallet.
Whilst an NFT cannot be copied, there are scams involving fake or imitation NFTs. As with physical art, copies can be made, or prints sold that do not have any right to the original asset.
Designed to purchase blue-chip NFTs and to support new digital art, crypto trading platform eToro launched a $20 million NFT fund in April. Last year’s market frenzy saw NFT sales grow by a remarkable 21,000% as collectors rushed to buy. The aggregate NFT market is valued at just over $12 billion, which accounts for an increasing share of the $900 billion crypto market. Despite the retraction in the NFT marketplace post the boom and a general crypto bear market, there is still significant value in NFTs with more projects coming forward for art, music, gaming, other utilities and governance.
Like any novel asset class, correct interpretation of how trading or investing in them should be taxed, and how they should be valued, can be very challenging. Our approach is to identify the transaction’s primary stakeholders and the NFT’s attributes.
Primary stakeholders of tradeable NFTs can include: the creator; the buyer who may become a reseller; the marketplace; the NFT holder who lends or stakes their NFTs with a DeFi platform; the DeFi platform itself which may repurpose the NFT; or gaming, virtual reality, and 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, subscription services). The NFT may cease to exist post redemption or have a self-burn date.
- 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 enables us to assess what rights the NFT carries; how value is created from it; and who in the transaction is receiving the value from it. We can then form a view about the transaction’s character for direct tax purposes; gains, revenue, commission, royalty etc. and apply a principles-based approach to determine the tax outcome for each stakeholder.
Such an approach does not always succeed in resolving every issue, particularly in assessing the indirect tax consequences of NFT transactions, where real difficulties can arise. For example, certain supplies of NFTs will be considered an Electronically Supplied Service and, in a B2C context, sellers are obliged to register for VAT in the customer’s location. In many cases, the seller will not know where the customer is located and will struggle to source two pieces of evidence required to make a reasonable assessment. For many low value NFT supplies (e.g. a digital wearable) sourcing such information is not commercially viable. This VAT treatment is relevant even where the seller is located in a jurisdiction that does not have a VAT system (e.g. BVI or Gibraltar), which is often misunderstood by start-ups.
NFT creators cannot continue to bury their heads in the sand; regulation and reporting is coming and it will be far easier for tax authorities to identify non-compliance. Based on the OECD’s draft Crypto Assets Reporting Framework (CARF) there is currently no exemption for low value NFTs and no phased approach for application to NFTs (which are still a particularly nascent and fast changing asset class), both of which we have advocated for.
It is highly likely that metaverse, gaming and other Web3 projects using NFTs will receive VAT enquiries from more than one administration. Without evidence to support where the customer is located and rebut a VAT (and GST / SALT) assessment, this may lead to double taxation.
All NFT stakeholders need to watch the development of the CARF and appreciate that, until ‘Soulbound’ tokens are practicable, traditional ‘know your customer’ requirements need to be built in.