Collectors: NFT buyers beware

Article 21 February 2022 Experience: Art

So much has been written about NFTs and crypto art that it is fairly safe to assume that most art collectors have an awareness of these unique tokens built on blockchain technology which express ownership over a digital art asset. However, along with rapid innovation and frothy values come legal and practical issues. This article raises some of the key issues that collectors seeking to buy NFTs would be wise to take into account.

When an artist mints a crypto art NFT, he or she does so by uploading the digital artwork to a URL which is, along with the details of the artwork, included within the unique token on the relevant marketplace platform. The other details included in the token metadata depend upon the coding of the smart contract that the platform has used, and it is the smart contract that determines the bundle of rights that the buyer of the NFT acquires. Subsequent sales of the NFT may take place through the same or a different marketplace, or indeed off-market. A number of implications follow:

  • Some creators of NFTs have dishonestly posed as well-known artists and have minted fake or misappropriated artworks. Disappointed buyers are unlikely to obtain redress by unwinding the purchase or obtaining a refund. Some marketplaces do claim to vet creators, so choose marketplaces carefully;
  • Some creators of NFTs may mint artworks without the authority of the copyright owner. This can easily happen where works or copies of works are already available online. It remains to be seen how the courts will deal with infringement matters in this context;
  • NFT works can become overexposed and – although the digital token confers a unique status to an NFT – there is no limit to the copies of the work that the artist could create. Not only do collectors have to consider what to buy, but they may need to consider how best to protect the integrity of their NFT once purchased;
  • URLs hosting the digital art need to be maintained in order for the art to be accessed and viewed by the NFT owner. Certain NFTs use a system that ensures the content is accessible so long as it is hosted by at least one node on the network, others do not. ;
  • Buyers of the NFT should try to understand the terms that govern their purchase and the bundle of rights they are actually acquiring. Indeed, many platforms have a term of use stating that the buyer is responsible for reviewing and understanding the smart contract;
  • Moreover, as each marketplace has its own terms of use, buyers of secondary market NFTs must appreciate that the bundle of rights they possess over the NFT may also include the terms of any intervening sales and the current sale, as well as the original terms of sale. (For example, some marketplaces retain a percentage of sales proceeds to send back to the original creator’s wallet as a resale royalty regardless of the terms of the original smart contract); and
  • An “off-market” purchase of NFTs (such as a sale through a major auction house) does not fully take place via the blockchain. It remains to be seen whether this will have a detrimental impact upon provenance or values in the future.

Fraudulent activity, market manipulation and lack of transparency in the market, are of course all factors that will ultimately lead to the increased regulation of the crypto-sphere. Reports suggest that “wash trading” (artificially increasing the value of an NFT by being on both sides of the transaction) and money laundering are not uncommon. “Rug pulls” (when initial NFT collections sell out for huge gains on the basis that buyers will receive free NFTs in subsequent drops, but then the (anonymous) individuals behind the collections “cut and run” leaving the original NFT purchasers with worthless NFTs) are also increasingly common.

However, assuming an NFT has been successfully purchased, what are the other factors that collectors should be aware of to safeguard their assets? Although it will not be a surprise to hear that NFT collectors would be unwise to forget their private keys to their crypto wallets, collectors should also ensure that their digital assets are known about and can be accessed by their beneficiaries in the event of their death.

Usual fine art insurance policies are unlikely to cover NFTs, and, in any event, the valuation of a cryptoasset is a complex question currently being dealt with in a deficit of market data and understanding, and in the throes of great market volatility. Such uncertainty raises big questions for trustees considering the purchase of NFTs to form part of an underlying collection.

That brings us to tax, and the taxable events that collectors might trigger by buying and selling NFTs. Although HMRC has not issued specific guidance about NFTs, in principle the same tax rules that apply to other cryptoassets will apply to NFTs. In most cases, if the NFTs’ ultimate owner is tax resident in the UK, they will be within the scope of UK inheritance tax (IHT) (up to 40%), income tax (up to 45%) and capital gains tax (CGT) (up to 20%) depending on the activities undertaken. However, HMRC reserves the right to treat different tokens differently depending on their characteristics – a broad statement which may leave some investors unsure of their position. Any tokens received in connection with an NFT may, depending on the facts, be taxable as income. For example, an NFT that is used in an online game may give rise to rewards that are likely to be taxable as miscellaneous income.

Increasingly NFTs are being used as collateral against borrowing on DeFi platforms, to provide owners an income while the NFT appreciates in capital value. In February 2022, HMRC published guidance on DeFi, stating its view that transferring the collateral may sometimes trigger a taxable disposal. The subsequent return of the collateral would be treated as a repurchase of the NFT at the then market value. This is a highly complex area on which specific advice should be sought.

Like any new market, additional diligence is advisable. Buyers be aware.

First published by Arts and Collections in February 2022.

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