How the metaverse and Web3 are creating novel tax issues

The metaverse promises to be a hive of economic activity. But how will this virtual world be taxed in the real world? 

In brief

• Multinationals are already building their presence in the metaverse, aware it will be a key transactional space.
• But while the metaverse is expected to nurture a blossoming layer of commerce, significant questions remain over taxation.
• Corporations and governments face a broad range of metaverse challenges and the need to navigate an increasingly complex global tax landscape.

The metaverse — in the form of seamlessly linked virtual worlds where individuals can live, work, play and do business — may seem like science fiction to the uninitiated. However, key enabler technologies are already in use and major tech corporations such as Meta and Microsoft are realigning their strategies in response; a new technology epoch already triggering myriad taxable events.

The metaverse is not a new concept — embryonic versions have been in existence for several decades. These have included early virtual worlds such as Second Life, launched in 2003, to the advent of digital twins, used in engineering and manufacturing to explore real-world scenarios virtually.

Now a powerful mix of blockchain-based and other innovative technologies are converging to give birth to a new iteration of the internet, known as Web3, which promises to decentralize and disintermediate the current Web2 internet, making it easier to create a shared, persistent, three-dimensional virtual world.

“The metaverse is here to stay,” says Dennis Post, EY Global Leader Blockchain Tax Services. “Within five years everyone is likely to be using it in some shape or form.” This could involve going to a doctor’s appointment in the metaverse, using it in an educational or work setting, attending a concert or taking part in a commercial transaction.

“This kind of activity is going to be commonplace, so organizations, individuals and tax authorities need to embrace it, understand the fundamental switch to Web3 and make sense of the tax implications of living and transacting in this new and exciting space,” Post says.

Web3 and blockchain – the foundation of the metaverse

Web3, with AI capabilities, has already given rise to digital assets such as cryptocurrencies and non-fungible tokens (NFTs), as well as blockchain-powered smart contracts, which execute tasks automatically once certain conditions are met. Add virtual and/or augmented reality to this potent tech mix and the stage is set for the creation of the metaverse. Governments and businesses are already working to apply or adapt tax concepts to these new concepts. 

But what exactly is a metaverse? And how is it distinct from immersive gaming experiences such as Fortnite and other existing virtual communities? 

Metaverse venture capitalist and commentator Matthew Ball1 has attempted to answer this question, identifying the following five defining concepts of the metaverse:

• A robust economy: the metaverse will likely incorporate future iterations of crypto, NFTs and other blockchain-based digital assets – all of which raise new tax challenges.
• Interoperability: rather than the walled gardens of Web2, the metaverse promises to offer a seamless and integrated experience, allowing individuals to move between platforms, retaining ownership of their identity, data and assets.
• Persistence: the metaverse will never be reset and, in theory, never end.
• Synchronous and live: metaverse “life” will continue whether a user is logged in or not.
• Uncapped users: there will be no limit to the number of people in the metaverse, and each person will have their own persistent identity.

Companies leading the development of metaverse platforms include Decentraland, which launched its virtual world in 2017, enabling customers to buy parcels of virtual real estate using a crypto token known as MANA, which is linked to the Ethereum cryptocurrency. Once a customer has bought a virtual plot of land, they can build a settlement and purchase NFT versions of physical objects needed to construct their world – from buildings and avatars to digital representations of anything that exists in the real world. 

People and businesses are already inhabiting this virtual space, with Decentraland attracting around 300,000 monthly users. Meanwhile, Microsoft plans to roll out Mesh, its metaverse collaboration tool, to hundreds of millions of customers as a Teams extension during 2022.

The explosion of Web3 and metaverse initiatives has also created an opportunity for people around the world to work together on new business ventures, establishing their own rules and making decisions autonomously.

Known as decentralized autonomous organizations (DAOs), these member-owned and controlled organizations are governed by computer software in the form of blockchain-powered smart contracts. 

DAOs can be organized around any type of initiative or endeavor, with governance relying upon tokens and voting rights aligned to the controlling membership of the organization. 

The legal and tax status of DAOs remains unclear in many jurisdictions. In July of 2021, Wyoming became the first US state to afford legal entity status to a DAO. 

Elsewhere, some organizations have received third-party advice to apply an existing legal framework, such as an entity, cooperative or an association, around a DAO in order to afford a level of comfort amid high levels of uncertainty.

One thing is certain, however, DAOs are becoming an increasingly popular type of organization for Web3 and metaverse-related initiatives. As DAO adoption increases, their legal and tax treatment across the globe will need to be clarified.

Multinational brands among the metaverse first-movers

As companies construct the metaverse, multinational brands are taking tentative steps to (virtually) set up shop. JP Morgan, for example, became the first major international bank to establish a presence in the metaverse in February 2022 with the launch of its Onyx client lounge.

Other first-movers include leading international luxury fashion and sportswear brands, which are producing NFT avatar clothing and accessories, and automotive firms, which are partnering with metaverse platforms to showcase their vehicle concepts. Meanwhile, the patent and trademark filings of some US retail and entertainment giants suggest they are preparing to launch their own metaverse offerings.

These brands may initially be taking modest steps, but their actions show they are alive to the metaverse’s potential and are eager to be in the vanguard for very good reasons. A recent report by Grayscale, for example, suggests that the metaverse promises global annual revenues of more than $1 trillion (pdf) with opportunities in almost every economic sphere.

Triggering significant tax complexity for governments and organizations

Jeffrey Saviano, EY Global Tax Innovation Leader, envisions “a blossoming layer of ecommerce” associated with the metaverse, which he says is already giving rise to taxable events.

“A prime example of the challenges tax teams face is the question of which jurisdictions are entitled to tax digital transactions, as well as the complex and evolving tax treatment of crypto currencies serving as consideration for digital asset purchases,” says Saviano. The complexity and speed of metaverse adoption is likely to exacerbate existing problems linked to the digital economy, increasing the complexity and uncertainty already experienced in the market.

A case in point is pop singer Ariana Grande’s October 2021 multi-day “tour”, which was broadcast on the Fortnite platform2. These shows were watched by approximately 78 million fee-paying customers worldwide, with Grande reportedly grossing more than $20 million from the performance, including merchandise sales. As yet, there is no global consensus on who has the right to tax such activity — whether it should be the jurisdiction where Grande performed, or the location of each member of the audience. 

There are other unresolved questions concerning indirect tax in the metaverse. For example, when a plot of NFT real estate is purchased in the metaverse using a cryptocurrency, should this transaction be subject to VAT or is it a bartering transaction triggering an income based (capital gains) tax? 

The Organization for Economic Cooperation and Development (OECD) is currently in the process of potentially creating a common crypto tax framework in an attempt to gain consensus among jurisdictions, but it remains to be seen how long this process will take and how many countries will eventually sign up. In the meantime, individual countries continue to take divergent tax positions, classifying assets in different ways and applying different tax treatments to transactions. This is adding a layer of complexity and risk for international businesses who must carefully navigate this fast-changing tax landscape.

Jeffrey Michalak, EY Global International Tax and Transaction Services Leader, says: “The tax function’s role is to comply with regulation and to offer the wider organization advice on how to structure its business in a way that achieves compliance. Of course, it is very difficult to create an effective plan and design an effective operating model when rules are unclear or non-existent. This means that tax functions risk living a world of uncertainty.”

Flexing existing tax frameworks to overcome metaverse challenges

Ultimately, the solutions to the metaverse tax challenges are likely to reflect the global response to the original 1990s dotcom boom and subsequent digitalization of the global economy. When faced with such challenges, jurisdictions have historically resisted the urge to draft new legislation. Instead, they have flexed existing tax frameworks and concepts to cover emerging digital activity, while plugging any remaining legislative gaps in a discrete manner.

There is already evidence of this approach being deployed by some jurisdictions to solve metaverse tax challenges.

Digital assets, such as cryptocurrencies, digital tokens and NFTs, not only bypass conventional intermediaries, they also bypass conventional operational tax reporting mechanisms. Rather than introducing brand new legislation, the OECD, US and UK are taking steps to extend existing legislative frameworks – such as the Common Reporting Standard (CRS), the eighth Directive on Administrative Cooperation (DAC-8) and the Foreign Account Tax Compliance Act (FATCA) – to include digital intermediaries such as crypto exchanges, custodians and crypto wallet providers.

Powerful solutions to the metaverse tax challenge may also lie in the metaverse itself, or at least its Web3 infrastructure. On one hand, the metaverse may be a decentralized, widely unregulated and pseudo-anonymous environment.  On the other hand, blockchain is transparent and it is possible to “see” transactions taking place in real-time on distributed ledger networks. This means that real-time tax reporting engines can be built on top of blockchain transactions, which automatically share transaction information with tax authorities as they happen, doing away with the conventional reporting process.

Meanwhile, governments such as the US are actively exploring programable central bank digital currencies, as well as ways to digitize gross-basis taxes, such as customs duties, through the use of crypto tokens.

Conclusion

The metaverse and its underlying Web3 technology may raise significant tax challenges. But they also hold the potential to place exciting new tools into the hands of tax practitioners, making it easier to collect the right tax at the right time and in a much more efficient and cost-effective manner for all parties involved.