Taxing Tokens

The last few weeks have seen a number of cryptoasset milestones reach the mainstream press - in that context it is perhaps a tad disappointing that HMRC's cryptoassets manual, which it updated recently, still seems in places to use the terms "cryptoasset", "cryptocurrency", "asset" and "token" interchangeably.

One subset of cryptoasset that has recently made the headlines is NFTs or "Non-Fungible Tokens".  Christie's recently sold their first purely-digital artwork in NFT form, bidding opened for the first digital NFT home, and Damien Hirst announced a new project with more environmentally-focussed platform Palm.

NFTs and Cryptocurrencies - what's the difference?

Like a cryptocurrency "coin", an NFT is a unique token that exists on a blockchain, such as Etherium, and is governed by a smart contract that records its origins and transaction history.

The key thing is that, unlike cryptocurrencies - or normal currencies, for that matter - NFTs are non-fungible, hence the name.  This means two NFTs can use the same smart contract but have different values, depending on their particular characteristics.  That uniqueness is recorded in the NFT's metadata.

This makes NFTs attractive as a secure way of tracking the provenance of physical luxury goods such as paintings, sculpture or diamonds, essentially replacing paper certificates of authenticity.  However, they are also increasingly used to reflect digital assets that have no physical existence at all.  This is achieved by including a "token ID" within the NFT metadata that points to a specific digital resource - such as, in true internet form, virtual kittens.

What's the problem?

I have written before

about how cryptocurrencies are both difficult to define and challenging to shoehorn into pre-existing legislative regimes designed to deal with fundamentally different assets.

NFTs present some of the same difficulties as cryptocurrencies: it is possible for holders to remain anonymous, the assets themselves are prone to hybridity and mutability and, more fundamentally, there is so far no consensus on whether these are intangible assets, commodities, financial instruments - or something else entirely.

There is, though, yet another layer of complexity.  Unlike cryptocurrencies, which are indistinguishable from the value they represent, NFTs represent the holder's right to claim a separate, distinguishable asset.  Put another way, a cryptocurrency holder might lose access to their cryptocurrency wallet, in which case HMRC may allow them to crystallise a loss, but an NFT holder may find themselves holding a token that points to nothing at all.  The underlying asset could be moved, duplicated, swapped, or even destroyed.  Whether the NFT holder has any enforceable rights in that situation - and therefore whether they can crystallise a loss in the same way - depends on the specific terms of the smart contract.

What's this got to do with tax?

Simply put, when it becomes difficult to determine what an asset is, where it is, and how much it is worth, it also becomes pretty difficult to tax that asset - and while the NFT boom seems to be subsiding for the time being, digital assets are not going away any time soon.

In fact, these questions are starting to appear before the commercial courts.  Recent cases have determined that cryptocurrencies are indeed property, that speculating on cryptocurrencies is not inherently a business activity, and (albeit only at first instance and placing significant reliance on academic texts) that the lex situs of cryptocurrencies is the place of domicile of the holder.  It's also clear from the cryptoassets manual that the tax treatment will depend heavily on the characteristics of the particular cryptoasset in question - potentially even the specific token.  As cryptoassets become more widespread and more varied (and if, as seems likely, guidance struggles to keep up) it surely won't be too long until they begin to crop up before the Tribunal.

Of course, the other element that may be relevant to how we tax NFTs is the impact on the environment.  With a number of governments and international organisations discussing how best to use tax - whether as a stick or a carrot - to incentivise progress towards carbon neutrality, the higher carbon footprint of an NFT over a physical asset is likely to have a real tax impact on the nascent NFT economy.