Is this just another bubble waiting to burst or is it the sign of an important shift in attitude towards the digital world? Whatever it is, the NFT model offers a vast scope for innovation (including applications in the DeFi space) that is likely to attract entrepreneurs, technology enthusiasts and investors. Undoubtedly we have not heard the end of the story so it is going to be increasingly important to understand the legal characterisation of NFTs, including how they are taxed and regulated.
Ownership of an NFT, evidenced by an immutable, cryptographically-secured record on the blockchain, is meant to be taken as proof by others in the cryptosphere (and in the real world?) that you are the owner of that underlying asset, similar to a digital certificate of title or stamp of authenticity. This record of ownership can be found on the blockchain, while the digital asset itself is stored on a non-cryptographically secured, separate server owned by a host platform. In effect, the NFT points to the existence of the digital asset on this other server, and so there is a separation between the NFT and the asset itself. This leads to questions about the exact nature and value of an NFT. Is it the NFT or the asset itself that holds the value? While an individual holds the NFT which evidences their ownership of the original asset, images of that digital asset, be it an artwork, tweet or basketball dunk by LeBron James, can be copied infinitely and viewed by anyone on the internet.
If the value of an NFT as art, investment or something else entirely is up for debate, its legal status in the UK is also far from clear. Firstly, what is the legal basis for asserting that minting a digital token can grant legal ownership of some other asset, digital or physical, by reference to the immutability of the blockchain ledger? From a UK perspective, a distributed ledger is not a legally recognised registry like the UK Land Registry. In any case, the blockchain itself is not a perfect record of ownership as private keys can be transferred off chain, which is a problem for those who argue that NFTs will provide a solution to issues of evidencing provenance in the art market. Further, in order to function as a reliable record of an artwork’s provenance, the information being fed into the blockchain itself has to be guaranteed to be accurate. It is claimed that the failure of many online marketplaces to verify those consigning apparently authenticated artworks has already contributed to a huge rise in art theft and fraud. Similarly, the rise of anonymous buyers of digital artworks has contributed to concerns about a lack of transparency and money laundering at a time when new regulations to combat this issue have been introduced to the art market.
Secondly, how does one determine the precise rights which a given NFT grants the holder over its underlying asset without reading the token’s code? Some marketplaces or issuers may obfuscate the true nature of an NFT, with the result that a purchaser may assume they have more rights than, in fact, they do. If you have acquired an NFT, do you simply have the right to sell it, or perhaps you can use it as loan collateral? Does it include rights such as copyright? The smart contract capabilities of the Ethereum blockchain have also given rise to a novel and rapidly developing breed of digital rights that can be programmed into the token, for example, royalty payments that are automatically transferred to an artist every time an NFT of their work is resold, and governance rights in relation to the future development of a platform (eg the RARI token). NFTs also make fractionalised ownership possible, creating additional liquidity by allowing users to trade shares of artworks on secondary markets. From a UK regulatory perspective, the entitlement to certain rights (such as the right of ownership and the right to income or a share in future profits) may mean that a particular NFT is a security according to the UK’s Financial Conduct Authority, which would result in it needing to be regulated.
In the UK, NFTs also fall squarely into a tax black hole, with no published HMRC guidance considering their UK tax treatment, although it is a fairly safe bet to assume that they would be treated as a taxable asset for capital gains tax and inheritance tax purposes, as well as taxable in other ways. The existing HMRC guidance is only stated to apply to exchange tokens such as bitcoin and does not consider how the tax treatment of a tokenised asset would differ. In fact, no tax authority in any jurisdiction has yet published guidance on NFTs or the tokenisation of assets. A particularly thorny question arises on the issue of a token’s location for tax purposes, which is significant for UK residents with a foreign domicile who claim the remittance basis of taxation. HMRC’s view is that bitcoin and similar fungible tokens will be located where the beneficial owner of the token is resident. It seems reasonable to assume the same principle could apply to NFTs representing digital assets, though it remains to be seen whether this rule will apply to a token that represents a physical underlying asset, the location of which can in fact be identified (unlike a bitcoin or a meme).
We seem to be increasingly comfortable with trusting code to preserve our assets, that is, as a new model of recording ownership that is more secure and more reliable than what has come before in the digital world. Of course, no matter how secure the blockchain is, the loss of the private key paired to an NFT would mean that the NFT itself becomes irretrievable. In practice, the range of institutional crypto custody services on offer is now vastly more sophisticated than it was even a few years ago and professional investors may well utilise these to protect their acquisitions. Nonetheless, there is an interesting question as to what happens to the original asset if the token is lost and what remedies the token holder might have in a decentralised space. Similarly, while the technology which maintains the NFT may be relatively secure, if the server which stores the artwork itself is hacked or disappears, separating the NFT from the digital asset, does the NFT become functionally worthless to the holder?
It could be that NFTs are in part a phenomenon connected to the pandemic and the inability to visit galleries and exhibition spaces in person. On the other hand, it may be that, in the not too distant future, we will view owning digital art or other digital assets via NFTs as on a par with owning a physical collection of art or collectables, a claim made by some of the market’s key players. Nonetheless, a small number of eye-popping sale prices should not distract investors, and artists, from being mindful of the complex legal issues and risks that NFTs pose.