Taxation of Non-Fungible Tokens – Musings observations and interrogations.

Non-Fungible Tokens (“NFTs”) have been hot, although the market seems to be cooling down as of late. According to a recent Bloomberg article though, there are still monthly NFT sales for an approximate value of 1bn USD. As trade value reduces, The Bored Ape seems to be boring its potential customers now. With the drop in the value of cryptocurrencies this may also affect the value of NFT’s.

Different countries have taken different tax positions on income derived from their supply, and on supply of NFTs (and some countries are yet to take a position).

When an NFT is sold, it is a digital representation on the blockchain of an artistic work or other object (e.g. trading cards, images, music, gold bars, diamonds etc.). The NFT grants the purchaser certain rights of use, although a precise legal framework is lacking in many jurisdictions. It is said that the blockchain ensures a digital title deed or proof of digital ownership.

When transferring an NFT, the underlying asset is not transferred. The NFT is a unique, non-interchangeable item. By way of an example, an NFT could be a digital representation of a painting featuring a monkey, but not the painting featuring a monkey itself.

In this article, we discuss the (possible) treatment of NFTs in different jurisdictions and the potential application of existing VAT and Corporate Income Tax (“CIT / CT”) laws on NFTs. Our article builds on an earlier analysis of the VAT treatment for cryptocurrencies, which you can find here).

VAT – between electronic services and regular taxable services.

As far as NFTs are concerned, the fact that these are usually paid with cryptocurrencies is not relevant. A sale of an NFT will raise the same questions on whether it is taxable, regardless of the mode of payment, whether the payment is made in regular (fiat) currency, crypto currency or in kind.

Currently, the most debated question is whether the sale of an NFT is subject to VAT or not? To answer this question, we examine the positions taken by some countries.

Firstly, it is important to note that NFTs are treated as services for VAT purposes under EU VAT law, as they do not constitute a supply of tangible assets.

In Spain, the Tax Authority (Dirección General de Tributos, the “STA”) issued an interesting ruling (V0482-22 of March 10, 2022). Fernando Matesanz discusses in his article the scenario of a natural person transforming photographs to produce unique pieces using photoshop-transformed illustrations. He then auctioned them on the internet through digital platforms that were not authorised to provide the real identity of the buyers (nicknames were adopted).

The STA held that the sale of an NFT is a supply of service, more specifically an Electronically Supplied Service (“ESS”), based on the fulfillment of the following tests: (i) automated and require minimal human intervention and (ii) are not feasible without information technology.

One major concern raised by many Spanish suppliers of NFT’s was that the identity of the acquirers was not disclosed to the supplier, given the nature of the transaction on the blockchain. Therefore, the difficulty was that the seller would not have been certain if Spanish VAT ought to be accounted for or not. If the buyer of the NFT would be abroad, no Spanish VAT would apply.

In our view, the qualification by the STA as an ESS is at least debatable. One school of thought can be that there is nothing automated about a digital representation of a(n artistic) work. It is a mere representation of an underlying asset. An NFT is a far cry from the traditional electronically supplied services, such as streamed music or movies. The ESS definition also does not refer to the requirement, or absence thereof, of a legal entitlement to an underlying asset.

At the same time, another school of thought can also exist, especially considering the facts of the Ruling, that while the act of using the photoshop software certainly requires human intervention and skills, the overarching representation (being the subject matter of the sale in question) which is generated via the blockchain itself does not require any human intervention. This latter view is supported by a Spanish tax expert, Rubén Bashandeh.

Fernando Martesanz’ article equally highlights the issues in determining the location of the supplier. Additionally, it flags the issues around the interpretation of the Use and Enjoyment rule which may localize the service in Spain, even if the regular place of supply rules determines these services outside the EU.

The UAE mandates the Use and Enjoyment rule (special place of supply rule), as a base rule for ESS and not as an exception to the normal rule to avoid double or non-taxation. It locates the service in the jurisdiction where services are used and enjoyed. The practical issues with this type of identification are well known.

Even if somehow, it can be established that the purchaser, say in the UAE, can be verified to have used and enjoyed the NFT in the UAE itself, or if a UAE supplier would adopt a conservative position on the matter, then the UAE would certainly be considered an attractive jurisdiction, given that the VAT rate is only 5% as compared to as high as 27% in some European countries or other jurisdictions.

A view similar to the Spanish Ruling was shared by the Belgian Minister of Finance, who recently stated in Parliament that he considers such a sale of an NFT akin to any other sale and therefore, in the view of the Finance Minister, an ESS.

In Switzerland too, as per the opinion of Cyrill Diefenbacher and Ollin Söllnerm in their article, the sale of NFTs would also qualify as ESS as Swiss VAT law is relatively aligned with the EU VAT laws. The authors also rightfully refer to the VAT exemption for creators of artwork which may apply, and which are common across multiple jurisdictions (but not the GCC).

The experiences that the UAE, or the broader Gulf Cooperation Council (“GCC”), can borrow from Europe are rather limited. NFT’s also do not seem to be as relevant in the other GCC countries.

Given their continued importance, other jurisdictions are bound to take position on the matter. With the VAT systems in the UAE and GCC being relatively new, an opportunity presents itself to align the tax framework with technological developments.

Income Tax – speculative income or regular income?

In the GCC countries, the sale of NFTs by a private person would not be subject to any form of taxation, given the absence of personal income tax. If the sale is made by a corporate (or an establishment), this may be different.

NFTs are taxed and regarded as property in most countries. There exists a distinction between (i) a taxpayer who creates NFTs and (ii) merely purchases or sells NFTs. The creation does not usually trigger any income tax. However, once the NFT is sold or otherwise transferred, the gain from the sale or transfer may be subject to tax.

In Switzerland, the tax treatment of NFTs depends on whether NFTs are considered private assets (not subject to tax) or business assets (subject to income tax). According to the Swiss definition of business asset, any individual participating in a “self-employed activity” and making a profit would be subject to income tax on the purchase and sale of NFTs. The same above cited article states that the key criteria to consider in establishing such an activity would be the transaction volume and potential use of debt to finance the transaction.

In our view, the above criteria would hardly apply to the UAE because the trigger of CIT in the UAE will be based on whether the individual is (required to) have a license or a permit to conduct the trade in the UAE.

With the UAE bringing in business tax (perhaps a more appropriate word for a corporate tax that taxes individuals), that legislative framework needs to be considered too. There is no difference made between speculative income and regular income, although the UAE does distinguish between passive and active income, stating its intention to tax only active income of natural persons.

In the US, the Internal Revenue Service (“IRS”) guidance on taxation of digital assets is sparse. Yet some authors referred to below have opined on how the taxability of NFTs would be played out. Section 197 of the Internal Revenue Code potentially allows taxpayers to amortize their adjusted basis in their NFTs over 15 years, as NFTs are considered intangible assets. However, this section can only apply to taxpayers other than creators. In the opinion of these authors, ”Amortization deductions would be allowed, and any potential losses such deductions generate would also be allowed as long as the taxpayer meets all of the loss limitation rules.” It remains to be seen what tax payers will actually hold NFT’s for 15 years.

In the US, a dealer (one who buys and sells NFTs as a business) seems to be taxed on the sale of NFTs as ordinary income. Both dealers and creators could deduct business expenses relating to the sale of the NFTs (this includes the cost of the acquisition of the NFTs) and where the sale amounts to a loss, US regulations would allow for a deduction against other ordinary income for the dealers (see here). Lastly, regarding depreciation, it seems that NFTs would not be subject to depreciation due to the fact that their useful life is hardly determinable.

In India, the tax law was recently amended to introduce a charging section for income earned from Virtual Digital Assets (“VDA”) (which includes NFTs). It is a separate provision separate from provisions on business profits or capital gains. Given the intention of the Government of the UAE to have a relatively simple and business friendly tax system, it is unlikely that the UAE would follow the Indian route. The separate charge is heavily criticized as detrimental for the NFT trade in India.

In Denmark, the Tax Assessment Council in Denmark (Skatterådet – the highest administrative tax assessment authority), has taken the position that the gains derived from the sale of NFTs would be considered ‘business income’, at least in the particular case at hand.

In this case, a software engineer earned substantially higher income than his salary by selling NFTs (crypto art). The Tax Council in Denmark held that given his intention and professional abilities, the activity is more appropriately considered to be business income.

We can imagine that if a similar scenario would be considered in the UAE, a similar outcome would ensue, despite the fact that the revenue would be earned by an unlicensed person. A one-off gain on account of sale of an NFT may receive a different treatment though.

VARA – Virtual Asset Regulatory Authority.

Government entities and regulatory authorities have also jumped on the NFT bandwagon. In March 2022, the Emirate of Dubai enacted the first legislation relating to virtual assets (Law No. 4 of 2022 on the Regulation of Virtual Assets) creating a new regulatory authority, i.e., Virtual Asset Regulatory Authority (“VARA”) which would provide the legal framework for regulating the trading of virtual assets such as cryptocurrencies and NFTs.

The creation of VARA marks an important step in the Emirate’s journey in becoming the leading hub for Virtual Assets. However, this first step toward virtual asset regulation in the UAE has not yet addressed taxation issues. As for tax purposes, the recent law does not provide clear information on the taxation of such assets but simply states that a person engaging in “services related to offering, and trading in, Virtual Tokens” will require a permit from VARA (Art 16 (a) 7).

Uncertain Space – Uncertain Times!

In conclusion, we will have to wait and see the position that the Government of the UAE, and insofar as relevant, the other GCC governments will take on the VAT and CIT implications of NFTs.

As discussed above, each scenario would require a case-by-case analysis and there is no straitjacket formula available on the CIT issues. As for VAT, it seems considering NFT’s as services is a sensible approach.

We will need to keep a close eye on other countries’ positions and determine the position that fits most appropriately within the tax system of the UAE, and the GCC. Uncertain and equally exciting times are ahead of us.