The sales tax challenge facing state legislators and regulators regarding the application of sales tax to digital assets transacted on the blockchain is new, but it’s by no means unprecedented. There have been many occasions where sales tax regulators have been asked to rise to the challenge of understanding evolving technologies. It’s fair to say that sales tax rules recently have been one step behind technology.
With the rising popularity of non-fungible tokens and more states considering implementing a sales tax on blockchain transactions, lawmakers should embrace the challenge of providing clear and comprehensive guidance that reflects reality and provides companies a reasonable path toward compliance.
Getting the Terminology Right
In common parlance, the term NFT is often used to describe the digital asset potentially being taxed, but that’s not quite correct. A token is simply a representation of a thing residing on blockchain technology, and there are all sorts of tokens that represent all sorts of things beyond NFTs. Cryptocurrencies such as bitcoin are a type of token. However, cryptocurrency tokens are intended to be used as a store of value and a medium of exchange, and are in fact fully fungible—one bitcoin is interchangeable with another.
By contrast, NFTs represent a unique item, more accurately referred to as a digital asset. It’s the digital asset standing behind the token, not the token itself, that has perceived value and is potentially subject to sales tax when bought and sold.
Digital assets are minted on the blockchain; the form and function of these assets are constrained only by the imagination of their creators. When most people think of NFTs, they think of digital art. However, almost anything can be represented by an NFT, including photos, videos, audio clips, GIFs, memes, experiences, and even interests in actual tangible personal property.
The Role of Marketplaces
While there is no single, all-encompassing sales approach, digital assets are often sold through online marketplaces. Much like their e-commerce cousins, NFT marketplaces are platforms where digital assets can be displayed and traded. The marketplace provides advertising services for the creator. When the item is sold, the marketplace facilitates payment between the buyer and creator, possibly including subsequent royalty payments on later transfers.
For example, say a buyer using a marketplace establishes a digital wallet and funds it with ethereum cryptocurrency. Ethereum can be purchased on most mainstream cryptocurrency exchanges and then transferred to the marketplace wallet address. Most marketplaces offer NFTs through an auction system.
Today, every state with a sales tax has accompanying rules placing collection and remittance obligations on e-commerce marketplace facilitators, which perform a payment processing and marketing function for marketplace sellers. These rules could be extended to cover at least some NFT marketplaces.
The Sourcing Challenge
Transacting over blockchain means that the identity of the buyer or their location is not necessarily known. Once the NFT is minted, the smart contract addresses points to the location of the NFT on blockchain, but the assets are stored on the internet through a file sharing system. Wallet addresses do not identify the physical owners of assets, which is what makes blockchain technology so secure.
From a sales tax perspective, this creates a unique sourcing challenge. What jurisdiction is entitled to apply tax to a particular transaction? Is it based on the location of the server where the digital asset is stored? Probably not. In many states, taxable digital property is taxed based on the address of the purchaser as reflected in the books and records of the seller that are maintained in their ordinary course of business or obtained during the confirmation of the sale.
Today, some sellers of digital property collect street address information from their customers to confirm the buyer is using a valid form of payment. However, many only collect their customers’ five-digit ZIP codes. While by no means perfect, knowing a buyer’s ZIP code provides at least some clarity on applicable sales tax. A nine-digit ZIP code, on the other hand, provides even more relevant information, and a full street address gives you essentially everything you need to know.
Even so, it remains far from clear whether NFT marketplaces facilitating payments from anonymous customers using cryptocurrency will be able or inclined to collect location data from their customer, because it’s not needed to complete the sale. The buyer also may not want to provide it. After all, people are becoming increasingly protective of their personally identifiable information.
When Is Tax Due?
Common sales tax requirements suggest that tax becomes due and payable upon the passage of title or possession—whichever happens first. But there are nuances to determining when someone possesses a digital asset. For some assets, the answer will be straightforward: Tax will be due when the asset is acquired for the buyer. For others, the answer could be far more complex.
How will states evaluate digital assets that can be exchanged for tangible property or services? Take a digital asset that can be redeemed for a night’s stay at a large global hotel chain, for example. At the time the asset is purchased, no one knows in which hotel the stay will occur or the prevailing room rates at that location. In that case, is tax better deferred until the asset is redeemed? When the time comes to publish guidance, states should address this complexity head on.
When digital assets are purchased, value generally is paid in cryptocurrency, meaning that states should clearly articulate where to find the applicable exchange rate for the most common forms of crypto. While Ohio briefly experimented with the idea of allowing tax payments directly in crypto, most states still expect payments in US dollars. States rely on tax revenue to fund their government and likely have no interest in the wild fluctuations that can be experienced in the cryptocurrency market.
Additionally, it’s possible for creators to earn additional revenue if the digital asset is resold by the initial buyer or subsequent buyer. Since most of these sales happen over a marketplace, the tax compliance obligations of the marketplace facilitator, if any, will need to be detailed.
What Comes Next?
States inevitably will begin issuing guidance on the sales tax treatment of digital assets and blockchain transactions. The industry—and the money involved—is simply too big to ignore. Hopefully, they’ll first take the necessary time and effort to understand the industry and its practices, providing thoughtful and comprehensive guidance that will allow sellers and marketplaces to effectively and affordably come into compliance.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Charles Maniace is vice president of regulatory analysis and design at Sovos.
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