How NFTs cause tax and legal issues for businesses

As organizations around the world seize the commercial opportunities of NFTs, understanding the tax and legal implications will be pivotal.

Three questions to ask

• How are organizations increasingly looking to drive revenue through NFTs?
• What are the objectives they are trying to meet?
• What are some of the steps they need to consider?

There are exciting and dramatic changes everywhere in the world, and tax and law are no exception. Multiple opportunities for tax and law functions to innovate and unlock long-term value are embedded at the heart of new developments like non-fungible tokens (NFTs). In a suite of articles, we will be considering the direct and indirect tax and legal implications of NFTs, looking at the way that business use of NFTs is starting to evolve.

In late 2018, a new internet game called CryptoKitties, which enabled players to collect and “breed” virtual cats, was launched. Within weeks, one of these virtual cats sold for the equivalent of more than US$117,000 and the game was later spun off to form its own company, raising US$12m of investment.

What made CryptoKitties so special was that it was the first successful attempt to monetize blockchain, with each unique collectable “card” in the form of a NFT. Just four years later, NFTs have evolved dramatically, featuring both tangible and intangible assets, and embedded with smart contracts that grant a wide range of rights. 

But what exactly are NFTs, how are they evolving, and how can organizations use them to drive revenue, extend their product lines, connect with new customers, and build corporate brand?

What are NFTs?

NFTs are unique digital identifiers recorded on a blockchain. They cannot be copied, substituted or subdivided and are used to certify authenticity and ownership of associated tangible or intangible assets.

NFTs’ ability to create unique assets in the digital world is unprecedented. In the physical world it has always been possible to own a one-of-a-kind piece of art. NFTs make it possible to create and own a digital original.

This uniqueness is helping artists combat plagiarism, prove authenticity and increase the collectability of their works, but NFT use cases are also increasingly extending beyond art and into the wider economy. For instance,  NFTs can help track donated blood within the healthcare industry, enable fractionalized ownership of tangible assets, such as real estate, and help brands generate revenue from secondary markets. NFTs can also play a big role in the creator economy, for example acting as a digital container used to store unique content.

What role will NFTs play in the growth of the metaverse?

The metaverse – in the form of seamlessly linked virtual worlds where individuals can live, work, play and do business – is being widely heralded as the next iteration of the internet. Without NFTs, or a later version of this blockchain technology, this vision of a new vibrant economic and social space may not be realizable.

That is because NFTs provide much needed authentication of ownership, without which it would be very difficult to buy and sell virtual goods and attribute value to virtual possessions. NFTs can also be used to identify individuals as they navigate from one metaverse platform to another.

In short, NFTs will provide the permanence or non-fungibility necessary in a virtual world to enable value to be created and transacted in a way that’s similar to the physical economy. Regardless of the current performance of the NFT market, which is highly volatile, the underlying technology is here to stay. That is because NFTs are expected to play a significant role in the transition from Web2 to Web3. They are perfectly placed to act as a way to facilitate ownership and interoperability as assets are transferred from one metaverse platform to another.

NFTs also give global brands an opportunity to tokenize literally trillions of dollars of intellectual property currently in their possession, as well as creating, cultivating and expanding additional cultural assets, so they can be exploited in new and exciting ways. Just imagine, for example, the value a multinational entertainment corporation could generate through the issuance of branded NFTs and the cross-branding and direct-to-consumer opportunities this could unlock.

How are companies leveraging NFTs?

NFTs have evolved dramatically since the birth of CryptoKitties in 2018. Digital art still accounts for a large proportion of the NFT market, but elsewhere use cases have diversified considerably.

NFTs are a natural extension of existing digital mediums in which artists can innovate, marketing teams can tell stories and develop their brand. For example, brands can leverage existing “sleeping assets” (such as iconic creative designs and images) to create NFTs.

They also represent the next frontier of e-commerce. That is because NFT use increases penetration among younger demographics who engage with eco-systems where social, play and shopping overlap seamlessly. Brand ambassadors – for example celebrity NFT buyers – can also amplify the awareness, credibility and virality of NFT creations. Due to the limited cost to create NFTs, they also present an opportunity to generate margin-enhancing revenues.

NFTs now also attribute various legal rights (including ownership) to tangible underlying assets. These include clothing, vehicles, physical artworks, and real-world experiences, such as admission to events and concerts, and club memberships.

To complicate the situation further, it is also now common for individual NFTs to feature a mix of assets (known as bifurcation), which are both tangible and intangible. Companies are also using NFTs to disintermediate transactions and simplify complex business relationships.

Here is a cross-section of five use cases showing how organizations and industries are leveraging the transformative power of NFTs.

Film

Danish film producer Niels Juul is among many in the film industry who believe NFTs can disrupt the antiquated film-funding system. Juul announced his intention to raise up to US$10 million through the sale of NFTs to fund his next feature film. Each NFT will be a membership pass of sorts, granting voting power in studio decisions as well as other benefits like free merchandise, film festival afterparty tickets, the investor’s name in film credits, and more NFTs. Similar to other NFT film startups, a portion of the profits for each film will be funneled back to the company and earmarked toward the next project.

Gaming

The online gaming industry has been quick to see the potential of NFTs. Motorsport games, for example, have been built around NFT technology.

Players use cryptocurrency to buy cars that exist virtually in NFT form. They can also buy NFT vehicle upgrades and decorate their vehicles with NFT imagery. In addition, they can purchase sections of NFT-generated racetracks and share “dividends” from all activity taking place on those circuits, including race entry fees.

Music

In 2021, rock band Kings of Leon released “golden ticket” versions of their new album, which entitled the purchaser to a digital download of the recording (with an animated digital album cover), a limited-edition vinyl record, guaranteed front-row seats to Kings of Leon concerts for life, and more. Only 18 golden ticket NFTs were created to increase collectability.

Fashion and luxury brands

Companies such as Ralph Lauren, Nike and Adidas are using NFTs to extend their physical product ranges and connect with tech-savvy demographics. For instance, Ralph Lauren introduced its digital apparel collection in August 2021, partnering with Zepeto – a popular metaverse platform among Generation Z – to create a detailed virtual world where users have personalized 3D avatars which can be dressed with exclusive products.

Hospitality

The Flyfish Club is destined to be the world’s first members-only dining club based on an NFT business model when it opens next year in Manhattan. An initial US$14m was generated from the first Flyfish Club NFT drop with additional sales taking that figure to US$21m. Demand for Flyfish NFTs is so high that members of the upscale club can sell them on the open market. NFT owners can dine in the restaurant as well as attend special Flyfish Club events, such as cocktail parties, cooking demonstrations and wine tastings.

How can companies make and issue NFTs?

Businesses must make a series of important decisions before they can launch an NFT – a process also known as an “NFT drop” Some of the most important decisions are whether to mint NFTs in-house or outsource the process, and whether to use an NFT marketplace or create your own e-commerce platform. Outsourcing can be faster, potentially more cost-effective and requires a lower level of in-house talent. Minting and selling in-house, however, ensures greater control in key areas such as risk, compliance and regulation. Here is a high-level overview of the process: 

Companies launching their own NFT must:

1. Identify an underlying asset. This can be any digital or physical asset the organization owns the intellectual property rights to.

2. Choose the underlying blockchain technology the NFT will run on. Ethereum is the most widely used.

3. Set up a digital wallet and deposit cryptocurrency to fund the initial activity.

4. Select an NFT marketplace, such as SuperRare or OpenSea (which are similar to the conventional eBay marketplace), or develop a bespoke e-commerce site.

5. Upload NFTs. Convert the digital file into a marketable NFT format.

6. Establish a sales process and embed the NFT issuance into the overall operating model.

7. Consider the tax and legal implications.

The evolution of the Web3 landscape may seem complex, but embedded at the heart of new developments such as NFTs, there are significant opportunities for companies – including tax and law functions – to innovate and unlock real long-term value.