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How Do You Tax an NFT?


www.coindesk.com 19 May 2022 11:31, UTC
Reading time: ~10 m

New global tax reporting rules could soon extend into crypto, non-fungible tokens (NFT) and decentralized finance (DeFi), but some worry the Organisation for Economic Cooperation and Development’s (OECD) inflexible framework threatens to constrain a sector that’s still moving fast.

Proposals set out by the international organization in March require details of crypto holdings to be shared with foreign tax authorities. But blockchain and tax experts have told CoinDesk they’re concerned the rules are neither well adapted nor well coordinated with the other waves of regulations set to hit the sector.

The OECD, which sets international guidelines on major tax issues, wants new rules to prevent tax evasion by anyone trying to keep their bitcoin (BTC) hidden overseas, mirroring the procedures that already apply to foreign bank accounts.

In a March consultation document, OECD proposed that crypto providers would have to report to the authorities whenever crypto transactions are made, such as exchanging bitcoin for fiat. That information will then be sent back to the taxman in the owner’s country of residence. The OECD also proposes extending existing banking rules to cover new means of payment such as electronic money and central bank digital currencies.

It’s easy to see how even well-meaning changes designed to deal with conventional finance that involve regulated intermediaries might fail to deal with the reality of distributed ledger technology. Witness recent controversies over how to apply money-laundering rules, intended to curb dirty money by getting crypto users to prove their identity, to unhosted crypto wallets.

At a meeting due in Paris on May 23, some industry advocates may plead for a rethink of plans they say could strangle growth, while others are merely hoping the rules can be streamlined to avoid too much administrative heartache.

Read more: Crypto Providers Would Have to Swap Transaction Details Under OECD Tax-Dodging Proposal

The OECD proposal to extend the existing information-swapping system to virtual assets was expected and, in some cases, welcomed. Tax collectors want to ensure crypto currency gets treated the same as Swiss bank accounts – once famed for their absolute discretion, but no longer.

It’s clear why officials might be concerned. According to a May 11 research note from Barclays (BCS), in the U.S. only around half of crypto taxes due are correctly declared. The note estimates the country’s crypto tax shortfall to be about $50 billion, or 10% of the total the Internal Revenue Service is missing. In a May 17 speech, U.K. minister Lucy Frazer welcomed the OECD’s plans.

But some were surprised at how far the OECD wants to extend existing measures beyond currency holdings like bitcoin and ether (ETH) into the Web 3 space – in a way seen as unfair and potentially harmful.

“What they propose is very onerous regulation, much more so than for the traditional sector,” Luzius Meisser, founder of the Bitcoin Suisse association, told CoinDesk. “That's an unfair burden for the crypto sector.”

Applying the rules to non-fungible tokens is hard to do as – unlike gold or stocks – for a given token at a given time you don’t always know its value, he said. But it also means your Bored Apes get treated differently than their offline equivalents because a regular art collector wouldn’t, under current rules, see his paintings reported to the authorities.

Worse still is if the rules are made to apply to fast-developing, and hence less well-defined, sectors such as decentralized finance.

“Their DeFi rules are based on vague definitions, which, of course, hurts legal certainty,” Meisser said.

“There's a strong tendency to control everything,” he said, with a corresponding cost to economic growth. “The various barriers and friction introduced by this kind of regulation is particularly harmful for innovative sectors.”

‘Ill-conceived’

Regulators often get into trouble when they try to apply old rules to a new sector – and here’s no different. Tax reporting conventions are built on the assumption there’s an intermediary, namely a bank, that takes charge of identifying and reporting customer details to the authorities. But in crypto land that’s not always the case.

It’s a problem the OECD wants to come to grips with. “The ability of individuals to hold Crypto-Assets in wallets unaffiliated with any service provider, and transfer such Crypto-Assets across jurisdictions, poses a risk that Crypto-Assets will be used for illicit activities or to evade tax obligations,” the Paris-based organization said in its March 22 consultation document.

In jurisdictions like the European Union, lawmakers have already tied themselves in knots trying to figure out how to apply anti-money laundering rules to wallets where custody isn’t offered by any regulated crypto-asset service provider.

Read more: EU Parliament Passes Privacy-Busting Crypto Rules Despite Industry Criticism

It’s just as unclear what is supposed to be done with tax – for instance, in cases where a person uses an unhosted wallet to make a small payment in a store.

“The most ill-conceived requirement they have is to make service providers like BitPay responsible for identifying whoever buys something from one of their connected merchants,” Meisser said.

“You don't want to send in a copy of your passport and file identification forms just for buying a piece of bread,” he added. "It's completely unrealistic."

The OECD’s Common Reporting System (CRS), which in the U.S. takes the form of the Foreign Account Tax Compliance Act (FATCA), was introduced almost a decade ago, intended to make it harder to conceal foreign interest and dividends from the taxman.

Though the OECD comprises major developed countries, it persuaded jurisdictions such as the Cayman Islands and Liechtenstein – small, but significant for tax dodging – to join in, too.

At least part of the motivation for the OECD’s work is to ensure crypto doesn’t end up a loophole that makes those rules pointless – and that’s welcomed by banks, who bear the brunt of administering the current system.

“It fully makes sense that there is a level playing field and that the CRS is extended,” Roger Kaiser, a senior policy adviser at the European Banking Federation, told CoinDesk.

“To a certain extent you can see a loophole in the reporting framework as unfair competition,” he said. “The loopholes must be closed; otherwise, it doesn't make sense to impose such requirements.”

But exactly how you do that is still up for grabs. Kaiser hopes it doesn’t mean creating new overlaps or inconsistencies – not least as banks no longer see crypto as a rival financial system, but as something they’ll need to get on board with.

“I already see the difference from the positioning we had one year ago,” Kaiser said. “We were talking in terms of potential competitors and now we are thinking of whether this new framework can impact us if we are providers.”

The worst outcome of all would be to create a new parallel system that repeats without precisely replicating – meaning banks must follow slightly different procedures, for example, to certify their clients’ identities depending on whether they hold crypto or fiat.

Welcome?

Tax experts appear to agree the new rules are needed, and see it as part of crypto’s integration into the mainstream economy.

“In my world, there is a strong desire to bring this [crypto] into the fold, to make sure it's ethical, it works, people are trusted, there's consumer protection, there's not money laundering associated with it,” KPMG’s Grant Wardell-Johnson told CoinDesk.

But doing that could mean a slew of regulations about to hit the crypto sector – and, with the Financial Action Task Force already setting laundering norms and other international bodies potentially looking at areas like financial stability and consumer protection, Wardell-Johnson hopes to see a more joined-up approach.

“If you end up with multiples of rules in relation to each of those domains, multiplied by many regions and countries, it will become a nightmare,” said Wardell-Johnson, who is global tax policy lead at the accounting firm.

Different regulators “are at different stages, and they've got different mindsets,” Wardell-Johnson said. “You need to try and have consistent definitions, and if one reporting obligation occurs then that information should be able to be used for other reporting obligations, to the extent possible, rather than duplication.”

In some areas, he notes, fiscal norms openly conflict with innovations like DeFi. Where you’re taxed often depends on where you’re resident or registered, but that’s hard to determine for a nebulous software protocol. Wardell-Johnson suggested simply tweaking the rules to focus on where the customers of a decentralized autonomous organization (DAO) are located.

But that’s just another illustration of how crypto tech doesn’t always map onto conventional regulations – and how the blockchain can mess with public policy procedures.

That can represent a risk – crypto data sharing is more likely to be hacked, and so needs greater security, Wardell-Johnson said – but canny regulators can also use the opportunities of public ledgers; for instance, letting tax collectors inspect crypto-wallet addresses directly.

The OECD plans say that “if a country demands it, the addresses of users should be reported, allowing them to follow the flow of your funds on the blockchain,” Meisser of Bitcoin Suisse said. “This is the only idea of the proposal that leverages the openness of blockchain technology.”

“This sounds like a privacy nightmare,” he said. “But I think it would be more desirable than shoehorning decentralized protocols into traditional structures and thereby destroying the value of disintermediation.”

Meisser moves beyond mere technical quibbles to ask if the OECD’s whole approach isn’t an overreaction, equivalent to introducing special rules for monitoring Apple (AAPL) stock – which, he notes, has a bigger market capitalization than the whole crypto universe.

“Crypto is still very far from taking over the financial system,” he said. “So the fear that crypto could be used to hide wealth at a globally relevant scale is not well-founded."

Detax

Meisser argues that, rather than intrusive new rules, it would be better to simply remove taxes from crypto entirely, as the U.S. did for e-commerce sales tax in the 1990s. Yet, global consensus on a zero tax rate seems far off: even agreeing on a framework for how to treat crypto would be a stretch.

“Can we get an agreement for all countries on how to tax crypto? … Certainly not for a very long period of time,” Wardell-Johnson said, citing the vast divergence in approaches reported by the OECD in a 2020 report.

Some have argued that, before hauling taxpayers over the coals for getting their sums wrong, the OECD needs to wait until there's greater clarity on the substantive tax rules in each jurisdiction.

That’s already happening in some cases – such as the German guidance issued Wednesday that sets out the tax rules that apply when you mine currencies, lend bitcoin or redeem a utility token – but not yet everywhere.

“The tax treatment of Crypto-Assets may be either unclear, or poorly understood, by users depending on the maturity of their domestic tax authority,” lobby group Global Digital Finance (GDF), whose members include Coinbase (COIN) and the London Stock Exchange, said in a written submission to the OECD.

“Collecting information about users without establishing a clear tax treatment for assets is likely to be inherently unfair for taxpayers,” it added.

That plea follows unexpected surprises in jurisdictions like the U.K., where a recent guide on how the tax authority wants to treat DeFi lending led to an industry outcry.

Meisser agrees the OECD shouldn’t rush, saying it would be better to postpone the rules until they’re less likely to disproportionately harm the sector.

So far, the work has moved relatively slowly – perhaps because tax officials have been preoccupied with a much more wide-ranging reform of international corporation tax rules. Even once agreed, banks would need a couple of years to put new crypto rules in effect, Kaiser said.

But the issue of crypto taxation isn’t going to go away, and once rules are in place, we might be stuck with them for a very long time.

“Once you’ve got the definitions in place, from the OECD ... it's very hard to change those at the edges,” KPMG’s Wardell-Johnson said, adding that any attempt to make the rules more flexible now could also make them less legally certain.

“Future proofing this is going to be difficult,” he said.

In the fast-moving world of Web 3, that could be a big problem.


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