Bankless DAO - Non-Fungible Tokens | Decentralized Law
A Monthly Journal Covering the Crypto-Legal Space
Dear Crypto-Legal Observers,
To a large degree, modern economies rely on fungibility, which Black’s defines as the “ability to exchange or substitute one asset with another”. Cash, commodities, and digital currencies are all examples of fungible assets; each BTC is “indistinguishable from another and equivalent in value”.
Unlike its fungible cousins such as BTC, SOL, ETH, or DAI, a non-fungible token signifies ownership of a unique digital asset. NFT holders have blockchain-based proof of “ownership and authenticity of a certain item”; even if each NFT is represented by the same image or sound file (for example), the token itself is one-of-a-kind.
NFTs gained popular attention at the beginning of 2021, when Beeple’s “Everydays: The First 5,000 Days” sold for over 69 million USD. Not surprisingly, when most people think about NFTs, they go straight to the art. Profile picture projects have become ubiquitous, and some, like Bored Ape Yacht Club, are an economic ecosystem within themselves.
While we most often associate NFTs with digital art, NFTs can represent virtually anything digital or physical, and can serve as both a record of ownership and an access card to a particular community or asset. NFTs can get you access to various community Discords, or they can serve as the key to unlock digital content. For example, the Global Tax Guide’s NFT unlocks access to 100 pages of crypto taxation information, whereas a Good Morning News NFT acts as a subscription to the first ever on-chain newspaper.
From a crypto-legal perspective, NFTs are complex. NFT projects must be mindful of not only regulations that may impact their issuance and functionality, but they also must consider how to set up their intellectual property regime. Without question, a crypto lawyer with actual and significant experience helping NFT projects launch is an essential member of any NFT project’s team.
Raul Calvo-Sanchez is that lawyer. Based in Spain, Raul works with NFT projects to set them up for long-term success by focusing on broad issues such as regulatory arbitrage and corporate structure and more narrow issues like founder tax liability.
Raul believes the blockchain and NFTs mark a turning point for how humans interact, and that “the best thing about NFTs is that it is an excellent tool/base layer to shape … human interactions … People tend to associate NFTs to PFPs forgetting that (just to set an example) Uni V3 positions are NFTs or .eth names are NFTs as well … I honestly believe we are just scratching the surface of what can be achieved through the usage of NFTs”.
Also in this issue we highlight key considerations when launching an NFT project, analyze NFT use cases, dissect the issues with LimeWire’s NFT platform, review the UK’s recent ruling that NFTs are property, discuss the NFT regulatory landscape, provide an overview of tax considerations for art NFT investors, learn how NFTs are treated under Australian tax law, and summarize NFT news and articles from throughout the cryptoverse.
Although this newsletter may help to familiarize readers with the legal implications arising out of blockchain technology, the contents of Decentralized Law are not legal advice. This newsletter is intended only as general information. Writers’ opinions are their own; therefore, nothing in this newsletter constitutes or should be considered legal advice. Contact a legal expert in your jurisdiction for legal advice.
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Raul’s Advice for NFT Projects Is on the Money
I used to be the managing partner of a corporate-law-focused firm in the Middle East. At a certain point I decided to sell the firm and try to move back to Europe, but one of my former clients ended up hiring me to manage the crypto-investment arm of its family office. It was a little crazy at the beginning (it all started at the end of 2017) but definitely worth it.
I firmly believe it is a turning point on human interaction. DeFi is proving there’s a way to financially engage without intermediaries. It obviously has its drawbacks but ultimately is providing levels of sovereignty unseen in the last decades to every single actor.
NFTs are an amazing tool to shape those interactions. On the (most extended) artistic side, things like on-chain generative art would simply have made no sense without NFTs. But, in my opinion, the best thing about NFTs is that it is an excellent tool/base layer to shape the human interactions I was speaking about before. People tend to associate NFTs to PFPs forgetting that (just to set an example) Uni V3 positions are NFTs or .eth names are NFTs as well … I honestly believe we are just scratching the surface of what can be achieved through the usage of NFTs.
I’m mostly focusing on community-building structures through the usage of NFTs and further ways to transfer IP through them.
Regulatory uncertainty is an obvious one, but contrary to what most people think I am of the opinion that it is not more regulation that is missing, it is actually more use cases and experience in dealing with NFTs; most of today’s use cases are addressable with current regulations.
Also, one of the things that is less spoken about when referring to NFT challenges are those “unsexy” small things you should take into account when approaching any project…. tax and accounting regulations; THAT can be a real challenge.
Assess before executing. Projects tend to solve the issues ‘on the go’ without having set a proper assessment plan before starting production. Also, please try to be original and not to fall in the “let’s do this cuz someone has done it this way” trap … maybe that someone has done it wrong and maybe you are just copy-pasting shitty work; please try to approach everything from a fresh look.
Unsurprisingly, crypto startups (I have a policy to work with one project at a time).
The level of knowledge and understanding shown by the regulators I’ve dealt with … whoever thinks they are not aware of what is happening is utterly wrong. We tend to generalize and apply the level of understanding shown by a minority to all the regulators, but that is not the case. The other surprising thing is that we agree on the regulatory approach or the best course of action.
Pre-launch: On the top I would set a mix of corporate structuring, regulatory arbitrage, and most suitable fundraising structure, together with tax implications (to founders mainly) and AML requisites.
Post: Generally everything which has not been properly addressed pre-launch — mainly the impact regarding consumer law (if the launch has not gone as planned), AML implications when offramping, and tax impact to founders.
After several years working in the industry I can confidently say that crypto is — for better or worse — becoming mainstream; today almost nobody doubts it is here to stay and the debate is focusing on which form it will take.
Personally, I can see two separate crypto worlds coexisting, a more regulated crypto which ultimately will become no more than the next step of what today is called “fintech”, and a more libertarian, unregulated, and open one which will remain as the last resort of economic freedom to a big chunk of the world’s population.
Six Key Considerations When Launching an NFT Project
Author: Teresa Carballo
When launching an NFT project, the legal aspects may not be top of mind, but they should be on your to-do list. We have seen different legal issues arising from NFTs, such as the famous MetaBirkins vs Hermès case. This article examines various legal considerations that should be kept in mind, remembering that each project has different characteristics and that’s where your lawyer comes in. This article is not legal advice but may help with brainstorming.
Since most Web3 applications aren’t clearly regulated, complying as much as possible with the rules and keeping good records can help prevent future legal issues.
Teresa has a background in litigation but now focuses on corporate preventive law. She is fascinated by lawyering in Web3 and is licensed to practice law in Panama and Mexico.
Expanding NFT Use Cases
In May 2021, the University of California, Berkeley tokenized the early research and correspondence of James Allison’s groundbreaking research into cancer immunotherapy, which was filed with the University’s patent office. Subsequently, the University auctioned the non-fungible token for more than 50,000 USD, the majority of which is earmarked to fund early-stage research. This highlights the untapped potential of NFT auctions/sales as a source of funding for research projects.
Researchers or institutions could choose to tokenize documents of significant scientific value over which they hold ownership, as was done by the University of California, Berkeley. The University of Pennsylvania recently announced that it tokenized the mRNA patent documents which were crucial in developing Covid-19 vaccines, and will subsequently auction the NFT and direct the proceeds towards funding for ongoing research at the University.
Last year, Sir Tim Berners-Lee, who is often credited with creating the world wide web, tokenized the source code files to the original web browser and a 30-minute video depicting the code being written. Even without any kind of rights over the code itself, which is in the public domain, the NFT sold for 5.4 million USD, which will support causes chosen by Sir Tim and his wife.
Clearly there are opportunities galore for institutions and individuals across disciplines, be it science, technology, law, business or any other field, to similarly tokenize documents and contributions of significant value and sell the NFTs to fund research or public goods. Some researchers, inspired not by profit but by knowledge sharing, are starting to mint NFTs for research papers, thus bypassing the traditional and often lengthy peer review and scholarly publishing process. The NFT creates an open access and immutable record of the research outcomes, without the need to sign rights away to a publishing giant.
Another significant development has been the formation of decentralized autonomous organizations which specifically aim to fund research projects aimed at the public good. For instance, The Science DAO accepts pitches from its community members for technology and life sciences projects. Members who hold the native token (THRY) can vote on the projects they wish to support. If a project is approved for funding, NFTs are created as fundraising vehicles. The NFTs offer holders utility in the form of early purchasing rights for products or access to privileged venture capital rounds for additional fundraising. The Science DAO’s goal is to foster cutting-edge technology and science projects and provide access to like-minded people within the DAO.
Similarly, VitaDAO targets research projects in ‘longevity science’, and collectively funds such projects in the form of an IP-NFT sale. In one such instance, VitaDAO has funded the longevity research undertaken by Scheibye-Knudsen Labs and Copenhagen University, taking full ownership of the IP resulting from the project in the form of IP-NFTs. Such crowdfunding through DAOs is a game changer for researchers who want to get on with research instead of spending hours trying unsuccessfully to access traditional grant money.
Research-Focused NFT Marketplaces
Currently, NFTs traded on major marketplaces revolve predominantly around digital art, and the IP rights vary from project to project. However, RMDS Lab has created the first-ever NFT marketplace dedicated to science and technology IP. It allows the listing of data science projects, source codes, reports, patents, and art which can then be tokenized and sold as NFTs. RMDS Lab currently has several projects listed, including research projects on space exploration, Covid risk mapping, and investment predictions.
Even companies and brands have begun selling NFTs and donating the proceeds to social causes that align with the business objectives of the brand. For instance, VidaCap launched a collection of mushroom NFTs to raise money for Alzheimer's research and increase awareness of the wellness and cognitive benefits of functional mushrooms.
The practical application of NFTs and the tokenization of any form of data has great use in the maintenance of identity, health, and legal records. All the identity data pertaining to an individual, be it a passport, driver’s license, or any other identity-related document, can be tokenized and made accessible through a single NFT. The scope of such records can even be increased to include medical records, education credentials, and legal records — all accessible in one place. This data can be compartmentalized into individual ‘security deposit boxes’, with access restricted to only the data necessary for verification. This presents significant privacy and data security benefits to individuals who are the owners of such data.
For instance, South Korea has already started to offer drivers’ licenses on chain, which has been adopted by more than 3% of the driving population there. Similarly, several pilot projects and initiatives in India have used the blockchain network to digitize physical assets such as real estate, tribal caste certificates, or diploma certificates. The Indian Government think tank, NITI Aayog, in its 2020 report titled Blockchain: The India Strategy, has further showcased the desirability of tokenizing ownership records, such as land records, on chain.
Although there are currently only a few science, technology, or medical projects exploring the tokenization and sale of NFTs, it is only a matter of time until research projects across fields look to NFTs as a source of funding. Similarly, the use case of tokenization is being realized by governments and regulatory authorities that are expressing interest in digitizing assets and certain documentary records. You can’t spell ‘heart’ without ‘art’, and perhaps NFTs that fund heart research may soon be as well known as the now-familiar forms of digitized ape art.
lion917 is a legal-tech consultant based of India. He specializes in legal project management for large Web3 communities and projects. He is currently the BanklessDAO Legal Guild project manager and also a Grants Committee member at BanklessDAO.
Legal Quagmires With LimeWire's New NFT Platform
Digital music sharing services are returning to the spotlight as these companies race to create services that run on Web3 platforms. LimeWire has recently been at the head of this race, after its announcement of a partnership with the Algorand blockchain in March 2022 to relaunch its digital collectibles marketplace. The once-discontinued software has re-entered the spotlight through this partnership, which stands to make a huge impact across both the music and DeFi industries. While Ethereum has historically controlled the majority of the NFT market, Algorand, as a forkless blockchain with exceptionally low transaction costs and a minimal carbon footprint, is poised to lead the NFT market in the coming years.
LimeWire x UMG Seeks to Bridge Web2 and Web3
In May 2022, LimeWire announced that it had signed Universal Music Group — a major label which hosts successful artists like Taylor Swift, Drake, and Billie Eilish. The global deal will allow artists signed to this label to release NFTs on the marketplace, creating a one-stop-shop for curators, fans, and artists to create and trade digital collectible items while bypassing current barriers in the NFT ecosystem. By partnering with popular musicians, LimeWire aims to bring one million users into the program within the first year.
Barriers to entry into the NFT ecosystem, especially knowledge of the tools needed, have long been a concern in terms of mainstream adoption. This joint venture aims to “combine the user experience of Web2 with the benefits of Web3”. By removing the requirement for a crypto wallet and instead allowing purchases to be made directly via a credit card and other fiat methods, the onboarding process will be easier for NFT newbies. Later this year, LimeWire also plans to launch its own token on the blockchain that will grant users access to exclusive artist content.
This partnership also potentially benefits the artists. NFTs offer a multitude of benefits for creators through return of full control and independence to artist hands. NFT technology creates a world of opportunity for smaller artists who have previously been limited to platforms like TikTok and SoundCloud to release content independently of a label deal. Beyond profits, NFTs give artists a direct line to their own audience — enabling them to cultivate a fan base and form closer relationships by providing exclusive access to unique pieces. The world of digitized content circumvents the need for a third-party intermediary, opening up the world of music to a larger group of people, and overcoming the highly centralized nature of the industry.
NFTs, Copyright, and Me
However, this deal and the recent explosive growth of music NFTs bring up a myriad of legal implications for both artists and music labels. NFTs occupy a unique space under copyright law; lawmakers have yet to fully regulate the Web3 space, and current regulations and enforcement of NFT copyright laws are murky. NFTs are subject to basic copyright laws; NFTs that are derivatives of other works are only allowed if the creator is a copyright owner of the original. For example, Taylor Swift could mint an NFT of her latest recording of the song “Love Story”, which would be considered a derivative work even if it were the exact same as the song that is available on Apple Music because it would now be a digitized version tokenized on the blockchain. If anyone but Taylor Swift were to mint an NFT of “Love Story”, the token would need to be significantly different in order to meet fair use doctrine. For other NFTs that are closely derived from other works, the minter would have to follow general copyright laws and receive permission from the copyright holder or otherwise license the original piece.
To further complicate the ownership rights, oftentimes artists sign away master rights to their label for set periods of time, meaning that they would not necessarily be the one minting and profiting from an NFT. Popular marketplaces for NFTs generally have policies against copyright infringement, but enforcement of these has historically been minimal, complicating the process for anyone trying to file complaints.
NFTs can be a viable way for artists to manage their rights as they sell their work online. Technology is still new and evolving, but it’s clear that it has potential in the music industry. Optimizing an NFT requires understanding how the technology works, what legal rights are in place, and how those rights interact with NFT marketplaces. It’s also important to understand the terms imposed by these marketplaces — including royalty rates and license agreements — and ensure adequate protections for both artists and fans.
Tayy graduated law school in 2016. Afterwards, he worked for Goldman Sachs in their Compliance Division driving AML/ Transaction Surveillance Initiatives before finding his way into Web3.
UK High Court Rules NFTs Are Property
2022 has been a good year for NFTs. As great as this seems for NFT collectors, investors, and artists, this emerging popularity has come hand-in-hand with a myriad of legal issues, as ambiguity regarding the nature of NFT ownership and the rights such ownership confers remains.
The absence of clear regulations and direction on the legal rights of an NFT have led to a growing number of disputes. One such dispute was recently decided by the High Court of England and Wales (the “Court”).
Where Are My Boss Beauties?
In February 2022 Lavinia D. Osbourne, founder of Women in Blockchain Talks, announced via Twitter that two NFTs had been stolen from her MetaMask wallet. The NFTs, a gift given to Ms Osbourne, were part of the Boss Beauties collection — an assortment of NFTs featuring diverse, empowered women — created by “Gen Z change-makers”. Following the loss of the NFTs, Ms Osbourne enlisted the help of Mitmark, a risk management and intelligence company, who traced the missing NFTs to two anonymous accounts on OpenSea, a peer-to-peer NFT Marketplace.
In seeking to reclaim her NFTs or get proprietary relief, Ms. Osbourne made a two-part application to the Court. The first part was an interim injunction against persons unknown to freeze the NFTs so they could not be transferred until the end of the legal proceeding. The second part was a ‘Bankers Trust’ disclosure order to compel Ozone Networks Inc. — Operators of OpenSea and the second defendant in the proceedings — to release information about the individuals in control of the wallets in which the NFTs were found.
The Court’s Findings
The Court subsequently granted the injunction. In reaching the decision to do so, the Court had to consider two crucial issues:
Key to deciding the two crucial issues was the primary question of whether an NFT is property. Without first deciding this point, the Court could not go ahead to grant the injunction. The reason for this is that to grant proprietary relief over an asset it is a prerequisite under English Law for that asset to be classed as property. The courts in relation to this case decided there was at least an arguable case that NFTs were 'property' under English law and in handing down his judgment, HHJ Pelling QC stated “[t]here is clearly going to be an issue at some stage as to whether non-fungible tokens constitute property for the purposes of the law of England and Wales, but I am satisfied… that there is a least a realistically arguable case that such tokens are to be treated as property as a matter of English law”.
So, What Happens Now?
As Racheal Muldoon, the counsel on the case, stated: “the utmost significance” of the ruling, is that it, “removes any uncertainty that NFTs are property in and of themselves, distinct from the factor they symbolize, underneath the legislation of England and Wales”.
What is nevertheless crucial and of utmost importance to note is that the ruling does not at any time extend to the NFT owner the private property rights of the underlying asset the NFT represents, only the digital representation to it and bragging rights. So, while the NFT shows possession of an item —or in simple terms a picture of an item represented by a unique string of numbers — stored somewhere, it is not an extension of proof of ownership of the item itself. Despite the ruling there still remains no recourse to the owner of the NFT for any benefit within a private property rights regime allowing the individual the ability to exclude others from the uses and benefits of their property.
I may be able to take an injunction against you to prevent you from reselling my stolen NFT — which in itself is a relief — but in reality, I cannot stop you from viewing it, right clicking to download it, or taking a screenshot of it as many times you wish and for whatever purpose you choose.
What Next for the UK?
The Court’s decision represents a pivotal point in the legal treatment of NFTs under English law. It gives claimants the assurance that under English law NFTs are property which can be subject to a trust, and which will 'exist' where their owner is resident. It also provides some clarity on the UK position on legal remedies for claimants in disputes regarding cryptoassets and brings the legal position on NFTs in line with existing authorities for cryptocurrencies.
In relation to cryptocurrency, in an earlier ruling in AA v Persons Unknown, Re Bitcoin  EWHC 3556 (see the comment), the Court adopted the UK Jurisdiction Task Force approach in its ‘Legal Statement on Cryptoassets and Smart Contracts’ and established that, "for the purpose of granting an interim injunction, cryptocurrency such as Bitcoin is a form of property capable of being the subject of a proprietary injunction".
Other Jurisdictions That Treat NFTs as Property
The UK is not the first jurisdiction to consider NFTs as property and it probably will not be the last. In recent times the U.S. has taken a similar approach although this was primarily for taxation purposes — allowing the Internal Revenue Service to treat all digital assets, including NFTs, as property. In Singapore, a court has also recently granted a proprietary injunction in favor of an NFT investor to freeze the sale and ownership transfer of a Bored Ape Yacht Club NFT.
G0xse is a UK based TradFI lawyer. BanklessDAO Legal Guild contributor. Freelance Legal Consultant and Researcher for Crypto Startups on all things DLT, Blockchain, Crypto Regulations, DeFI, Smart Contracts and DAOs related.
NFTs Are (Not) Already Regulated
Regulators around the world seem to be using crypto winter to come up with more and more drafts that aim to regulate the crypto industry. With the Markets in Crypto-Assets legislation in the EU and the Responsible Financial Innovation Act draft in the U.S., we might expect that when the bear market is over, we will wake up in a comprehensively regulated crypto world. Where does that leave NFTs? The hype might be partly gone but nevertheless NFTs are here to stay, and they will most probably be regulated, both in the EU and U.S. But to what extent are NFTs already regulated?
Without going into specific regulatory tax regimes of the U.S. or certain EU countries, many countries have some sort of tax regime that is applicable to NFTs. Usually, capital gains tax would be applicable to the sale of an NFT. Certain countries, such as the U.S., have established direct reporting lines from crypto exchanges to the tax authorities in relation to crypto activity, including NFT trading.
Regulation of Securities and Commodities
In the U.S., the Responsible Financial Innovation Act would classify the vast majority of digital assets as commodities. This would most probably cover NFTs. Currently, the supervisory authority responsible for the commodities markets in the U.S., the Commodity Futures Trading Commission (CFTC) has already indicated that a 'commodity' includes, among other assets, cryptocurrencies. Although NFTs are not currently considered a commodity, it seems that the path is clear. The consequence of formally treating NFTs as commodities would be that the U.S. Commodity Exchange Act would apply, including its provisions on the prohibition on manipulation.
NFTs are currently not considered securities in the U.S. or EU. However, this might not apply to NFTs that have certain characteristics of a security, that is, the way they were designed to resemble actual securities. For example, this might be possible with NFTs that are owned by more than one investor and provide interest to their holders, thus making them fractional and therefore fungible. To be considered a security, a fungible portion of NFT would nevertheless have to go through the so-called ‘Howey Test‘ — a U.S. court case that defined whether a transaction is an investment contract. In the case of the EU, a financial instrument under the Markets in Financial Instruments Directive includes 'transferable securities', which might be the closest in terms of applicability.
Anti-Money Laundering Rules
Currently, the supervisory authorities do not treat NFTs as cryptocurrencies for purposes of AML rules. Make no mistake, regulators are aware of the fact that NFTs could be used for the purpose of transferring and legitimizing illegally obtained financial resources (a.k.a money laundering). As a consequence, more laws are being adopted that might not directly address NFTs in particular but that apply to intermediaries such as exchanges dealing with digital assets. A regulator could certainly find that AML laws would apply to an NFT purchase or sale if the transaction was intended to obfuscate ill-gotten gains.
Although the general perception is that NFTs are still not regulated, there are numerous regulations that are directly applicable to NFTs, like taxes, or that might be used if a government chose to do so, for example, to protect victims of fraud or fight money laundering. Crypto winter might be here, but regulators around the world will inevitably be passing new laws to address criminals and fraudsters in the crypto ecosystem. NFTs, partly due to all the hype, will surely be on their hit list.
RedHatRoss is an EU-based attorney-at-law/compliance officer/MLRO with 10+ years background in the financial supervision and payment services industry. BanklessDAO Legal Guild and LeXpunK_Army contributor.
U.S. Tax Considerations for Art NFT Investors
Author: Jason Schwartz
People sure have gotten cultured since blockchains introduced us to digital ownership. Every day, it seems countless new wallets with _vault.eth suffixes start accumulating PFPs, ArtBlocks Curateds, or other NFTs of digital images (collectively referred to as “art NFTs”). U.S. taxpayers sit behind many of those wallets, either as direct owners or through a DAO or investment fund. Before heeding punk6529’s invocation to 'seize the memes of production', here are some tax things you should know about investing in art NFTs.
A. Gain or Loss
Gain or loss from the sale of an art NFT held for investment is long-term capital gain or loss if you held the NFT for more than one year and, otherwise, is short-term capital gain or loss. Individuals are entitled to preferential long-term capital gains rates but can deduct net capital losses against only 3,000 USD of ordinary income each year, carrying the remainder forward indefinitely. Individuals are denied losses on sales of property held for personal use instead of investment. Don’t ever tell the IRS you’re only in it for the art.
ii. Collectibles or Not?
The long-term capital gains rate preference depends on whether the NFT is a 'collectible' for U.S. tax purposes. Collectibles gains are taxed at a maximum long-term capital gains rate of 28%, while other long-term capital gains are taxed at a maximum rate of 20%. Most long-term holders would prefer to avoid collectibles gain. There are two arguments for avoiding collectibles gain on your art NFT. The first is that collectibles must be tangible while art NFTs are intangible. The tax code defines a collectible to mean, in relevant part, 'any work of art…or any other tangible personal property specified by Treasury'. The definition seems to presuppose tangibility, which would mean that virtually all art NFTs are out. It’s unknown whether the IRS would agree with this argument.
The second argument is that your art NFT isn’t a 'work of art'. The tax code doesn’t define work of art, so a court would likely look to the term’s commonly understood meaning. With due respect to mfers, some judges probably could be convinced that a JPEG of a stick figure isn’t a work of art. It would be harder to disclaim photography or Fidenzas as works of art.
Some art NFTs might represent membership interests in a club or investment partnership. The tax law doesn’t deal well with hybrid classifications and usually forces the taxpayer to treat an asset in accordance with its primary purpose. An art NFT whose primary purpose is to function as a rewards club membership, like PROOF Collective or Moonbirds, is probably taxed as a regular capital asset. However, one whose primary purpose is to allow members to share or collectively govern a common treasury like Nouns could require further consideration (see II.A.ii., below).
The treatment of ERC-20 tokens that reference NFTs is unclear. The tax code treats gain on the sale of an interest in a partnership as collectibles gain to the extent attributable to collectibles. However, it’s unclear whether ERC-20 tokens that represent fractionalized or indirect interests in NFTs (like NFTX tokens) are interests in partnerships for U.S. tax purposes.
iii. Cost Basis and Amount Realized
When you buy an NFT with ETH, you are treated as if you sold that ETH (including gas incurred on the purchase) for U.S. dollars and then used those dollars to buy the NFT. If you have multiple lots of ETH and documented the date and time you acquired each lot, you are permitted to specifically identify which lot you used to buy the NFT; otherwise, you are deemed to adopt a first in, first out method. You recognize taxable gain or loss on the deemed ETH sale and take a cost basis in the NFT equal to its U.S. dollar value at the time of purchase.
You can’t add gas incurred outside of the purchase, like gas spent to transfer the NFT to your vault, to your NFT’s basis. And, as discussed below, you normally can’t deduct gas either. When you sell your NFT, you calculate your gain or loss by deducting your cost basis in the NFT from the U.S. dollar value of the ETH or other tokens received on the sale. You take a fair market value basis in the tokens received. It could be difficult to determine fair market value in an NFT-for-NFT exchange, and taxpayers often report an intraday OpenSea floor price.
iv. Netting Gains and Losses
Here are the steps to calculate your net capital gains each year:
v. Wash Sales
Because individuals can offset capital gains with capital losses, but can offset ordinary income with only 3,000 USD of net capital losses each year, it could make sense to try to recognize capital losses in years that you have capital gains to offset. One way to do that is to swap out of a losing investment for a short period before swapping back in. The tax code’s 'wash sale' rules limit taxpayers’ ability to take a loss on a sale of 'stock or securities' if they acquire substantially identical stock or securities within 30 days of the sale. ETH, BTC, and most art NFTs are not stock or securities under those rules. However, LP tokens, aTokens, cTokens, and other tokens that represent shares in, or governance over, a treasury could be stock or securities.
Even if the wash sale rules don’t apply, the IRS could try to disregard a token sale and repurchase within 30 days on the theory that the transactions lacked 'economic substance', unless the taxpayer stayed out of the position for a meaningful period of time. What’s meaningful is anyone’s guess, but it’s probably a lot less than 30 days in the current volatile environment.
Finally, swapping from one token to another that is not materially different from it, like ETH to wETH, shouldn’t be a taxable event, and so shouldn’t trigger a capital loss.
Normally, you’re taxed at ordinary rates on the fair market value of an airdropped token at the time you exercise dominion and control over it. Spam isn’t taxed if you don’t move it or have any intention to ever do so. If you do claim an airdrop, determining its fair market value is likely to be difficult. Again, taxpayers often report an intraday OpenSea floor price.
There are arguments why some airdrops shouldn’t be taxed. First, airdrops that you anticipated when you bought the NFT might have been 'part of the package'. There should be a concrete plan for the airdrop, not a vague suggestion on a roadmap. For example, if you bought in anticipation of an upcoming snapshot of eligible airdrop recipients, you might be able to allocate your basis between the NFT and the airdrop. One precedent for this would be a revenue ruling where the IRS let the purchaser of a pregnant cow allocate cost basis between the cow and calf, based on the premium paid for the cow’s pregnancy. Second, some (but not many) airdrops might be gifts. Gifts must be motivated by detached and disinterested generosity and made out of respect, admiration, charity or like impulses and not out of moral or legal duty or in anticipation of an economic benefit. Airdrops from artists to their most fervent collectors might fall within that definition.
A U.S. taxpayer’s ability to deduct expenses largely depends on whether they are a 'trader' or an 'investor'. It’s extremely difficult to be a trader unless it’s your full-time job and your portfolio undergoes significant turnover. Most art NFT collectors are likely to be investors, not traders. Investors who are individuals can’t deduct their investment expenses, which include gas and any fees paid to an asset manager. They can’t take a worthlessness or abandonment deduction when an NFT goes to zero (but can claim a capital loss if they sell it). And they can’t deduct fat finger trades to an unknown wallet. Traders can.
Both investors and traders can deduct losses from phishing scams if the scam is illegal under local law and the transaction is 'entered into for profit', even if not in connection with a trading business. Again, don’t ever tell the IRS you’re only in it for the art.
Tax law generally treats a joint venture for profit as a business entity, even in the absence of a legal entity. Thus, multisig wallets and LLCs that invest in art NFTs are all business entities by default. I’ll call them art NFT funds. Business entities can be treated as partnerships or corporations for U.S. tax purposes. In general, art NFT funds are partnerships by default unless they have more than 100 owners and their interests are readily tradable, in which case they are corporations. (A safe harbor from corporate treatment exists for readily tradable partnerships with at least 90% 'passive' income, but art NFT gains don’t satisfy the statutory definition of passive.)
i. U.S. Investors
U.S. partners in a partnership are taxed annually on their share of the partnership’s net income, gain, and loss, whether or not distributed. The partnership is required to provide this information on a Schedule K-1 to each U.S. partner. It seems likely that many small investment clubs investing through multisig wallets are not delivering K-1s. The failure to provide K-1s can subject the partnership to penalties, and doesn’t absolve U.S. partners of tax liability.
ii. Foreign Investors
Having foreign investors complicates matters when one or more decision-makers acts from within the United States. Foreigners generally are subject to U.S. tax on income from a 'U.S. trade or business' (a USTB). A partnership’s USTB taints its foreign investors. The tax is enforced through a withholding requirement at the partnership level so that, if a partnership is in a USTB and does not withhold on its foreign partners, the IRS can assess tax against the partnership.
U.S.-managed art NFT funds with foreign owners would be wise to significantly limit their NFT turnover to be able to take the position that they are investors, not traders. The threshold for trader in this context appears to be lower than the threshold for determining whether U.S. individuals can take business deductions. Art NFT funds with foreign owners also should think twice before investing in NFTs whose primary purpose is to allow members to share or collectively govern a common treasury. Those NFTs might, themselves, represent partnerships, whose USTB (if any) would taint the art NFT fund and, in turn, its foreign owners.
The tax code provides safe harbors whereby trading stocks, securities, or commodities generally is not a USTB. Although the safe harbors do not apply to NFTs, they might apply to ETH and other fungible tokens, enabling an art NFT fund to engage in some treasury management without being in a USTB.
Corporate treatment for an art NFT fund makes sense only if the fund (1) adopts a legal identity in a foreign jurisdiction that does not impose its own corporate income tax, like the Cayman Islands, and (2) avoids engaging in a USTB. Using a domestic corporation, or a foreign corporation that is engaged in a USTB, would be disastrous because it would result in an additional layer of U.S. corporate tax on earnings.
Foreigners tend to like corporate treatment where the above requirements are met because it further insulates them from USTB risk; if (contrary to expectations) the fund is engaged in a USTB, the fund owes tax, not the individual investors.
Corporate treatment is more of a mixed bag for U.S. investors. In general, they would need to make a special 'QEF election' on IRS Form 8621 and attach the form to their tax returns for the first year in which they hold an interest in the fund. Failure to do so could subject them to onerous penalties. The election would subject them pass-through taxation on the corporation’s earnings, similar to their consequences if the fund were a partnership, with three important caveats:
In addition, setting up a foreign entity is more expensive and can impose additional tax filing obligations on U.S. investors.
Taxes Are Hard; Hire an Advisor
None of the above is a substitute for careful planning with your own tax advisor, but I hope this article can help educate prospective NFT collectors about issues they should consider with qualified professionals. Taxes are complicated, even when all you’re doing is trading JPEGs.
Jason is a tax partner and co-head of the Digital Assets and Blockchain Practice at Fried, Frank, Harris, Shriver & Jacobson LLP.
NFTs as Collectibles and Personal Use Assets Under Australian Tax Law
Australian tax rules allow taxpayers to disregard capital gains and losses on assets that fit within the definition of a ‘Collectible’ or a ‘Personal Use Asset’. This has generally extended to assets like physical works of art, collectible cards, or equipment used for hobbies. Could this potentially extend to Web3 with our digital gaming cards or PFPs that we use across our social media accounts? We lay out the case below.
A Collectible, as defined in the tax code, means artwork, jewelry, antique, coin, medallion, rare folio, manuscript, book, postage stamp, or first day cover that is used or kept mainly for personal use or enjoyment. A Personal Use Asset means any kind of property (such as land, buildings, company shares, contract rights, etc.), except a collectible, that is used or kept mainly for personal use or enjoyment. In each of these definitions, there are additional rules that cover any interests or options to acquire these types of assets. Capital gains or losses from Collectibles purchased for less than 500 AUD and Personal Use Assets purchased for less than 10,000 AUD are completely disregarded.
The Tax Man’s Interpretation
The above definitions are deliberately vague and ambiguous. In keeping with this theme, the Australian Taxation Office (ATO) has provided unofficial guidance that most cryptocurrency assets will not fall under these categories as they tend not to be held for personal use or enjoyment. They have, however, offered examples of when this may be the case, including tokens purchased and instantly used to buy tickets to a concert and NFTs purchased and used to gain access to an artwork viewing as part of celebrating a birthday. In Private Ruling 1051694175099, the ATO makes the argument that NFTs, by their nature as an intangible asset, are generally not personal use assets unless used to acquire an asset for personal use and enjoyment.
Interestingly enough, there is already a subset of NFTs in circulation where a physical asset can be redeemable in exchange for the burning of a token. One of the earliest examples of this is the UniSocks (SOCKS) token. Despite being an ERC-20 standard token, the features are comparable in that the burning of a whole SOCKS token would net you the physical delivery of a pair of UniSocks socks. There are also a number of projects that are collaborating with distillers to create NFT collections that are redeemable for physical delivery of limited edition batches of whiskey.
Under the ATO’s current interpretation of the rules, these types of NFTs would meet the definition of a Personal Use Asset and therefore disregarded for capital gains purposes upon their disposal.
The Case for an Extended Interpretation
The current interpretation of Collectibles and Personal Use Assets shows its age. The rules were established in 1997, when the internet was still in its infancy. Web3 natives know there are a myriad of possible classes of NFTs that fall under the categories of a Collectible or Personal Use Asset, such as PFPs used on social media accounts, artwork hung on digital screens and frames in private residences or displayed in AR/VR art galleries, or usernames, playable characters, and items that can be used in online games.
The ATO needs to change its views on Collectibles and Personal Use Assets to reflect what people of this age use and get enjoyment out of in their personal time. A lot of us are living our lives online more than we do in fiat space. A lot of us buy these assets for the same reasons our ancestors bought watches, jewelry, boats, and designer clothing. These are our modern day wealth flexes. These are the things that bring us personal enjoyment. The law needs to reflect that.
Keep Good Records
As with any tax scenario, records will be key. For example, if you use a PFP NFT in your social media accounts, start taking notes of which sites you have used it on and for how long. If you have a collection of digital trading cards, keep a log of how many hours you spend playing the game and any other relevant in-game stats to back up your pattern of usage. This kind of recordkeeping is similar to keeping an itinerary to claim deductions for travel expenses. If you make the decision — after seeking the right taxation advice from your trusted tax professional, of course — to disregard any gains from selling these assets, the records you keep will go a long way to proving your position if the tax man ever comes knocking.
merlo.eth is an accountant and tax agent who is currently growing specialist cryptocurrency tax services in a public practice based in Brisbane, Queensland.
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