Digital assets and the blockchain will force the sales tax to evolve

by Arthur · September 18, 2022

The sales tax challenge facing state legislators and regulators in applying sales tax to digital assets traded on the blockchain is new, but it is by no means unique. There have been many occasions where VAT regulators have been asked to rise to the challenge of understanding emerging technologies. It’s fair to say that sales tax rules have recently been a step behind technology.

With the growing 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 with a reasonable path toward compliance.

Table of Contents

Getting the terminology right

In common parlance, the term NFT is often used to describe the digital asset that is potentially taxed, but that is not entirely correct. A token is simply a representation of a thing that lives on blockchain technology, and there are all kinds of tokens that represent all kinds of things beyond NFTs. Cryptocurrencies like 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 can be exchanged for another.

NFTs, on the other hand, represent a unique item, more accurately referred to as a digital asset. It is the digital asset 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 imprinted on the blockchain; the form and function of these assets are limited 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 images, videos, audio clips, GIFs, memes, experiences, and even interests in actual tangible personal possessions.

The role of marketplaces

Although there is no single, all-inclusive 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 offers advertising services for the creator. When the item is sold, the marketplace facilitates payment between buyer and creator, possibly including subsequent royalty payments for subsequent 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’s wallet address. Most marketplaces offer NFTs through an auction system.

Today, each sales tax state has accompanying rules that place collection and remittance obligations on e-commerce marketplace facilitators, which perform a payment processing and marketing function for marketplace sellers. These rules can be extended to cover at least some NFT marketplaces.

The sourcing challenge

Transactions over the blockchain mean that the identity of the buyer or their location is not necessarily known. When the NFT is minted, the smart contract addresses point to the location of the NFT on the 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 VAT perspective, this creates a unique procurement challenge. Which jurisdiction has the right to impose tax on 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 buyer as reflected in the books and records of the seller maintained in the ordinary course of their business or obtained during the confirmation of the sale.

Today, some digital real estate sellers collect street address information from their customers to verify that the buyer is using a valid payment method. However, many only collect the customers’ five-digit postcode. While by no means perfect, knowing a buyer’s zip code at least provides some clarity on applicable sales tax. A nine-digit postcode, on the other hand, provides even more relevant information, and a full street address essentially gives you everything you need to know.

However, it is far from clear whether NFT marketplaces that facilitate payments from anonymous customers using cryptocurrency will be able or inclined to collect location data from the customer, because it is not necessary to complete the sale. The buyer may not want to give it either. After all, people are becoming increasingly protective of their personally identifiable information.

When is tax due?

Common requirements for sales tax suggest that tax is due and payable upon transfer of ownership or possession – whichever occurs first. But there are nuances in determining when someone has a digital asset. For certain assets, the answer will be simple: Tax must be paid when the asset is acquired for the buyer. For others, the answer may be far more complex.

How will states assess digital assets that can be exchanged for tangible property or services? Take, for example, a digital asset that can be redeemed for a night’s stay at a major global hotel chain. At the time the asset is purchased, no one knows at which hotel the stay will take place or the prevailing room rates at that location. If so, 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 is usually paid in cryptocurrency, which means that states should clearly articulate where to find current exchange rates 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 probably have no interest in the wild swings that can be experienced in the cryptocurrency market.

In addition, it is possible for creators to earn additional income if the digital asset is resold by the first buyer or the subsequent buyer. Since most of these sales occur over a marketplace, the obligations of the marketplace facilitator, if any, must be complied with in detail.

What comes next?

States will inevitably begin issuing guidance on sales tax treatment of digital assets and blockchain transactions. The industry – and the money involved – is simply too big to ignore. Hopefully, they will first take the necessary time and effort to understand the industry and its practices, and provide thoughtful and comprehensive guidance that will allow sellers and marketplaces to comply efficiently and affordably.

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.