Taxing NFTs Is Tricky, but Puerto Rico, Washington Are Trying

At least 31 states apply sales taxes to digital products and services, but few if any tax dollars are flowing to them from the hottest commodity in the digital economy: nonfungible tokens, or NFTs.

The revenue gap, however, could be closed soon in two jurisdictions. Both Washington state and Puerto Rico are drafting regulations that would stretch their sales tax on digital products to include NFTs, unique digital assets that act as certificates of authenticity for digital products—including works of art, music, tickets, and collectibles. No other U.S. state revenue agency has yet introduced an NFT sales tax strategy.

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Despite their hands-off postures, other states will be watching Washington and Puerto Rico closely. Washington, home to tech giants like Microsoft Corp. and Amazon Inc., has been a leader on tax policy regarding digital goods at the Multistate Tax Commission, and Puerto Rico has actively structured its tax code to accommodate cryptocurrency investments.

“This could set the tone for other jurisdictions to establish NFT taxation,” said Javier Oyola, a director with the tax consulting firm Kevane Grant Thornton in San Juan, Puerto Rico. “Since many states already have taxation of digital products, a definition with examples by Puerto Rico could serve to guide the states.”

For some tax practitioners and NFT investors, the regulations can’t come fast enough, because the U.S. sales tax infrastructure wasn’t designed with this class of assets in mind.

“Puerto Rico’s regulation gives me hope that even states with a really broad definition of digital goods will acknowledge that NFTs may not fit squarely into the existing rules,” said Grace Kyne, a senior tax manager in the Boston office of EY LLP.

The states’ regulatory reluctance is a symptom of the tax uncertainty seen across the globe. The Internal Revenue Service has thus far declined to issue any NFT-specific guidance and very little has been said in other nations. Recently a senior tax policy adviser at the Organization for Economic Cooperation and Development asked global revenue agencies to consider strategies for regulating and taxing NFTs.

NFTs, like cryptocurrencies, reside on shared, decentralized digital databases know as blockchains. The tokens occupied a relatively quiet place in the digital universe until 2021, when—lifted by a mania centered on collections like CryptoPunks and Bored Ape Yacht Club — total sales volume surged to $25.5 billion from $95 million in 2020 according to Dapp Radar, a platform offering NFT research and trading opportunities. The investment bank Jefferies Group LLC recently predicted the market would exceed $80 billion annually by 2025.

‘Not a Priority’

Sales of NFTs arguably trigger tax duties in the jurisdictions that tax digital products, but little if any revenue is being remitted to the states, several tax consultants told Bloomberg Tax.

“I don’t think any of these NFT companies and marketplaces are even thinking about sales taxes,” said Shehan Chandrasekera, chief of tax strategy for CoinTracker, the exclusive provider of income tax services to customers of OpenSea, the largest global NFT marketplace.

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As tax agencies have said virtually nothing about NFTs, tax consultancies such as CoinTracker are relying on a handful of guidance statements from the IRS that regard virtual currencies as property and require taxpayers to pay taxes on any gains when these assets are transacted.

Layering dozens of complicated state sales tax frameworks on top of the evolving income tax requirements, “is a great conversation to have, but it’s not a priority,” Chandrasekera said.

A Case of Blindness

Applying sales taxes to NFT transactions still isn’t on state revenue agencies’ radars, said Edvin Givargis, a state and local tax partner in the Irvine, Calif. office of Sax LLP.

“The states are blind to it because their hands are on the shoulders of the IRS,” Givargis said. “And if the IRS is blind to it, then we are going to be fumbling around for a while.”

Even the Multistate Tax Commission, an intergovernmental agency fostering uniformity across state tax codes, has no plans to tackle cryptocurrency and NFTs as part of its nascent project addressing sales tax on digital products.

“NFTs are something that the states need to pay attention to and perhaps adjust their tax rules to address,” said MTC general counsel Nancy Prosser. “We are trying to educate ourselves as best we can.”

Some NFT promoters have simply washed their hands of any tax obligations. Last December, soft drink icon Pepsi launched its collection of NFTs, but warned that participants were “responsible for paying any taxes owed,” and said they “should consult their tax advisers to determine the tax consequences to them.”

Puerto Rico, Washington Jump In

Puerto Rico’s Treasury Department issued a regulation in January that folds NFTs into its definitions of “specific digital products” subject to sales tax. The regulation is currently on hold so the department can draft technical amendments, which will be released “possibly by May,” Oyola said.

Oyola described the initial regulation as simplistic, raising questions about the department’s ability to administer the program.

In response to a request for comments, Oyola of Kevane Grant Thornton asked the department for clarity on several fronts, including: What kinds of transactions will trigger a tax duty? Will subsequent sales of NFTs be taxed, or just initial sales? To what extent will the department rely on NFT marketplaces to collect taxes? And, given the anonymity embedded in many NFT transactions, how will the department source transactions and trace the identities of buyers and sellers?

“Clear rules must be established, with good examples in the regulations that do not leave gray areas,” Oyola said.

The Washington Department of Revenue, meanwhile, plans to issue an “excise tax advisory” addressing the taxability of NFTs. While Washington’s tax code is silent regarding NFTs, a department spokeswoman said the state had previously adopted a broad definition of digital products that is “intended to apply to a wide variety of products, regardless of the specific form or function of the product.”

While the tax advisory is being drafted, the department said taxpayers should treat NFT transactions as taxable under Washington’s existing sales and use tax code, and its Business and Occupation tax, a gross receipts tax on the gross sales of a business.

Too Much Innovation

Kirk Phillips, managing director of the accounting firm Global Crypto Advisors, said Puerto Rico’s proposed regulation would create a reasonable tax framework for tokens authenticating static works of art, but not the dozens of innovations that have emerged since the first NFTs arrived on the internet nearly a decade ago.

In many cases NFTs are bundled with other tangible and intangible features, resulting in instruments that defy classification within state sales tax codes, Phillips said.

Already NFT marketplaces are being populated with digital certificates bundled with a handbag or a pair of shoes, access to an event, membership rights to a club, or ownership of a financial instrument. Sales tax rules vary greatly in each of those examples, raising questions about any state’s ability to craft a single regulation accounting for the breadth and complexity of products depicted as NFTs.

Phillips, who serves on the American Institute of Certified Public Accountants’ virtual currency task force, applauded the current guidance efforts, but said he worries about tax code obsolescence, because NFTs and the markets they inhabit are innovating so quickly.

“If a state was to develop something today, they would have to revisit it in six months because we haven’t even seen the beginning of this,” he said.

https://news.bloombergtax.com/daily-tax-report/taxing-nfts-is-tricky-but-puerto-rico-washington-are-trying

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