NFTs (Non-Fungible Token, pronounced by some as ’nifties‘) are the latest fad to take hold on the internet, bringing attention to the art world and making millions of dollars in a short space of time.
The recent NFT phenomenon peaked with the Christie’s sale of digital artist Beeple’s work entitled ‚The First 5000 Days‘ for $69 million and has brought digital art into the limelight.
NFTs are non-fungible tokens, mostly executed on Ethereum’s blockchain and each token is proof of ownership of an asset, usually a digital asset, although they are marketed as being able to secure ownership of real-world assets as well. Digital assets include works of art, music, and collectibles, such as video clips of sports highlights, and even data, such as tweets. For example, Twitter founder Jack Dorsey recently sold his first tweet as an NFT for $2.9 million. Experts claim that NFTs could one day be used to record everything from the ownership of our homes to our birth certificates, and there are already countless examples of attempts to tokenise anything.
As with any innovation, the legal and fiscal aspects of NFTs need to be considered.
There are doubts about the exact nature and value of an NFT, i.e., whether the NFT is the asset itself that holds the value. While an individual holds the NFT that proves his or her ownership of the original asset, images of that digital asset, be it a work of art, a tweet, or a Lionel Messi goal, can be copied indefinitely and viewed by anyone on the internet.
The smart contract capabilities of Ethereum’s blockchain have also given rise to a new mode of digital rights that can be programmed with tokens, for example, royalty payments that are automatically transferred to an artist whenever an NFT of their work is resold, and governance rights in relation to the future development of a platform (e.g., the RARI token).
NFTs also make fractional ownership possible, so it is possible to trade shares in works of art on secondary markets. From a UK regulatory point of view, the benefit provided by certain rights (such as the right of ownership) may mean that a particular NFT is a security under the UK Financial Conduct Authority (FCA), which would mean that it would need to be regulated both legally and consequently for tax purposes.
From a purely tax perspective HMRC has not yet published any guidance regarding the tax treatment of NFTs in the UK, although, as with cryptocurrencies, they should be treated as a taxable asset for capital gains tax and inheritance tax purposes, as well as being taxable in other ways.
The current guidance from HMRC only applies to exchange tokens such as bitcoin and does not consider the tax treatment of a tokenized asset. Indeed, no tax authority in any jurisdiction has yet published guidance on NFT or the tokenization of assets.
This volatile market will bring out some unexpected results and, for many, unforeseen liabilities. It is relatively easy to crystallise a taxable ‚disposal‘ without ever actually seeing the money. For UK tax purposes, disposals must be calculated in GBP and so, with the currency used to buy NFTs fluctuating and the rules for the cost base of the currency not reflecting the cash flow position, this can mean that investors are not prepared for tax liabilities.
Minting or buying Ethereum often involves gas charges. This is also categorised as a disposal of Ether but, as no currency is obtained in return, it is categorised as a capital loss.
There are likely scenarios where gains are made in year 1 but losses in year 2 cannot be carried forward.
There is also an option to claim relief for assets that are now of ’negligible value‘, allowing the investor to realise the loss and offset it against their gains. So, it’s crucial to understand the timing, but it’s not yet clear how HMRC will deal with negligible value NFT claims in the future. For example, when the market is trending downwards, many NFTs may be worthless for a long period, but then rise in value. Since a claim of negligible value is made without selling the asset, since it has no value to buy, that NFT could still be owned at the time the value rises again, so it will be important to be able to prove when the claim was made and that the value was indeed negligible at that time.
Again, there are several considerations to be made, especially in the case of receiving an airdrop, i.e., when a user gives another user an NFT or token as a gift. For example, if the owner of X is given another NFT in an airdrop, the tax consequences may differ depending on the reason for receiving the airdrop. If the buyer has purchased the NFT without being aware of the future airdrop, then it can be argued that the capital and proceeds are the gain without cost. But if the purchase was made and it was necessary to do something to get that airdrop, then HMRC guidance currently states that it would be treated as miscellaneous income. So, as well as being taxed at higher rates, you won’t be able to offset losses against the value received for tax purposes. The other problem is that it’s complicated to value an airdrop on the day it was launched.
A particularly thorny issue arises over the question of the location of a token for tax purposes, which is significant for UK residents domiciled abroad who claim the remittance basis of taxation. HMRC’s view is that bitcoin and similar fungible tokens will be localised where the actual owner of the token is resident. It seems reasonable to assume that the same principle could be applied to NFTs representing digital assets, although it remains to be seen whether this rule will apply to a token representing an underlying physical asset, the location of which can be effectively identified, unlike a bitcoin.
An interesting future lies ahead for artists and those offering collectibles but being aware of the legal and tax consequences is crucial.
Photo by Tezos on Unsplash
Find more: Hmrc nfts uk nft – Krypto-NFTs