In a recent article, we observed that the Treasury Department and the Internal Revenue Service (IRS) could address the complex tax issues presented by new digital assets, either by developing a coherent framework for taxing these unique assets or by attempting to shoehorn them into existing legal constructions. The recent IRS announcement that it intends to classify some non-fungible tokens (“NFTs”) as “collectibles” for tax purposes indicates its continued inclination toward the latter approach. See Notice 2023-27 (the “Notice”).
NFTs are digital identifiers typically used to confirm ownership of distinct rights or assets (either physical or digital) where such ownership is recorded in a distributed ledger. Like units of a cryptocurrency, an NFT represents a distinct and transferable digital asset. However, unlike units of traditional cryptocurrency (whose value is fungible and usually unlinked to other assets), an NFT is non-fungible and its value is tied to the value of the underlying right or asset to which an NFT is attached. The close relationship between an NFT and its underlying right and/or asset raises the question of exactly how the NFT should be distinguished, if at all, from its underlying right or asset for tax purposes.
The notice announces the intent of the IRS and the Treasury Department to issue guidance treating certain NFTs as “collectibles” under section 408(m) of the Internal Revenue Code. Collectibles (e.gartwork, antiques, gems, etc.) are subject to specific federal income tax rules, namely increased long-term capital gains of 28% as well as restrictions on the acquisition of collectibles from individual retirement accounts (i.etreats the transaction as a deemed distribution of money to the taxpayer equal to the cost of the collectible and possibly subject to a 10% early withdrawal penalty).
While soliciting comments regarding the form and scope of the proposed guidance, the notice states in the meantime that the IRS will use a comprehensive approach to determine whether an NFT constitutes a collectible. Thus, if the underlying right and/or asset would constitute a collectible, the NFT itself would constitute a collectible. While it may seem intuitive that simply tokenizing a collectible using an NFT should not allow a taxpayer to escape the collectible for the underlying asset, it is unclear whether applying a traditional look-through rule to NFTs is the best approach. In particular, the announcement gives no indication of whether a transparency approach will be applied more broadly or limited to collectibles. A broadly applied transparency approach can have far-reaching implications for the nature and source of income generated by an NFT, as well as for tax rules that delineate the status of the owner of an underlying asset. For example, if a broad transparency approach is applied to an NFT with securities as the underlying asset, an NFT holder who is otherwise a dealer in securities may be subject to the mark-to-market rules on its NFT.
Applying transparency concepts can be particularly difficult where the NFT certifies ownership of multiple rights and/or assets or only transfers limited or proportionate rights to assets, for example when an NFT has been created for dual purposes. For example, a single NFT may facilitate a customer rewards program by both tracking participation in the program as well as digital or physical rewards selected to be received under the program. In this regard, Starbucks is currently testing this type of unique NFT use with its Odyssey Rewards program, which allows users to both collect points that can be redeemed for “immersive coffee experiences” as well as purchase “coffee-themed artwork,” which artwork can be bought or sold through a marketplace to other users. Arguably, the coffee-themed artwork may constitute a collectible for tax purposes, although the remaining rights associated with the coffee rewards do not appear to be collectible. It remains to be seen whether simply applying existing tax law concepts (as a pass-through rule) will be flexible enough to fit these unique NFT uses.
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