The Tax Treatment of the Metaverse Economy and the Potential for a New Offshore Tax Haven

What if you could climb a mountain, fight a dragon, meet new people, and then come home to gather with your friends from all over the world, all in one morning? And what if this were available to you at your fingertips, with no need to physically move, and all you needed was a computer or smartphone and internet access? That is one of the promises of the metaverse, a virtual world set up in a decentralized platform where anyone can create a digital representation of themselves (an avatar) and socialize, buy and sell goods, play games, attend events, visit art galleries, buy property, conduct business, and much more. Although it seems like a concept borrowed from science fiction,¹ this technology is already becoming a reality,² and companies are creating 3D environments that are accessible and interactive in real time.³ But while the available platforms are still mostly focused on online gaming (play-to-earn games with in-game purchasing as the backbone of their business models⁴), have colorful and cartoonish graphics, and are more widely used by younger generations, big tech companies and financial institutions are heavily investing in the technology and hoping to monetize its full potential — going beyond online games and into business and all aspects of life.⁵

The Metaverse

Before we understand how the metaverse may be taxed in the future, we need to understand what the concept entails, who the enablers of this technology are, and how companies and users can potentially monetize it.

Enthusiasts believe the novel Web3,⁶ which includes the metaverse, is the next major computer evolution — the next phase of the internet. The main differences that set Web 3.0 and the metaverse apart from the internet today are: (i) their blockchain technology,⁷ which creates a decentralized environment; (ii) the blurred distinction between online and offline reality in the metaverse because of its immersive, or extended, reality (a combination of augmented, virtual, and mixed reality⁸); and (iii) the ownership by individuals of their personal data.⁹

The metaverse is a framework for human interaction and should be seen as more of an experience than a product.¹⁰ A user is not just someone who shares their personal data, agrees to receive advertisements in exchange for information access, and occasionally acts as a creator, but is instead a person inside the platform, communicating and interacting in a much more immersive way. The key aspects behind the metaverse concept are presence (being in a virtual space and feeling the presence of others), interoperability (being able to transport your virtual avatar and virtual assets between different virtual spaces¹¹), and standardization (that will enable interoperability of platforms and services across the metaverse).¹² Although interoperability of different platforms is still quite limited, international organizations are already attempting to define the standards to bridge different virtual worlds.¹³

Unlike the internet, which nobody owns and users pay to access,¹⁴ the infrastructure behind the metaverse is being developed by private enterprises (which defies the concept of decentralization, at least currently).¹⁵ Each organization has its own perspective on what the metaverse could become, and the possibilities are endless. While some companies are creating platforms that would be mainstream for all and would involve several aspects of our lives (such as Meta Platforms Inc., formerly Facebook), others are targeting limited environments in some business areas, such as Microsoft integrating Teams into the metaverse and Nvidia Corp. creating a graphically realistic environment with virtual representations of real-world devices and systems to create a digital simulation of a factory.¹⁶

The tech community is betting, however, that the metaverse has the potential to act as a new (and possibly the main) environment in which people will conduct business in the future. It is no surprise that the future of the economy is online. The enormous growth of the gaming industry (the world’s largest media category with an astounding value of $336 billion in 2021¹⁷) already points toward the potential of monetizing online activities. Players in play-to-earn games are able to make money by having a digital identity, owning their personal data, earning or creating digital assets (also known as non-fungible tokens, or NFTs), and selling or trading them¹⁸ — similar to how someone would make money in the metaverse.¹⁹ Instead of creating armor for an avatar to win a battle in a game, think of an artist creating and selling their work (paintings, songs, or concerts) as an NFT. Instead of a landscape for a virtual game competition, think of a virtual conference table, inside a virtual office, where coworkers can meet daily to carry on their business.

Stakeholders are already buying into the idea, calling it a multitrillion-dollar²⁰ opportunity. We are seeing governments purchasing plots of digital land in the metaverse and building virtual embassies;²¹ multinational enterprises signing legally binding business agreements through their metaverse avatars;²² auction houses selling artists’ digital work for millions;²³ magazines commercializing NFTs containing their cover images, news articles, or columns;²⁴ individuals purchasing real-world homes and their identical metaverse versions;²⁵ traditional entertainment MNEs that own physical theme parks appointing executives to oversee metaverse strategies;²⁶ luxury brands offering virtual versions of their famous products as NFTs; and sports brands selling actual pairs of shoes that come with a cryptographic²⁷ token with the digital version of the same good.²⁸

The metaverse will reshape virtual ownership in a way we have never seen before (although it is questionable and quite challenging to define how virtual ownership relates to legal ownership).²⁹ NFTs can boost development of the metaverse and digital marketplaces. The creators of the metaverse could charge commission fees on transactions occurring on their platforms, similar to how app stores function today (which can be controversial³⁰). It is debatable how decentralized³¹ or sustainable³² this new technology will be in the future. However, the monetization potential is real (even if it is not unanimous how big and how soon it will materialize).

The metaverse is a new ecosystem that requires new protocols, new payment systems, new technologies, and new regulations. This innovative universe is powered by blockchain, cryptocurrencies, and NFTs, which transfer digital goods across virtual borders. But what does that mean?

NFTs, Crypto, and Web3

Digital goods are intangible goods that are available in a digital form. An exact definition is more complicated than it seems. There are no international standards to define digital goods. In a broad sense, any good that is sold, delivered, or transferred in a digital format and comes with a right to use that good could be classified as a digital good. Goods that do not hold this right of use are generally not considered digital assets. The Financial Action Task Force (FATF) uses the term “virtual assets,” which are defined as “a digital representation of value that can be digitally traded or transferred and can be used for payment or investment purposes.”³³ The OECD instead refers to the term “crypto-assets.” While the FATF definition aims at technology neutrality (defining virtual assets based on the asset’s basic characteristics, not the underlying technology), the OECD definition “focuses on the use of cryptographically secured distributed ledger technology, as this is a distinguishing factor underpinning the creation, holding and transferability of crypto-assets.”³⁴ Both definitions, however, cover cryptocurrencies and NFTs as long as they are used for payment or investment purposes.

An NFT is a digital file that is uniquely identifiable in the blockchain and cannot be replaced (as opposed to a cryptocurrency such as bitcoin, which can be replaced by another bitcoin and have the same effect). An NFT proves the ownership of a piece of digital content (such as a drawing, song, text, video, or GIF) and has an immutable record of when the item was created and how much was paid for it, including previous sales.³⁵

But how is that different from downloading a file from the internet and storing a copy in your computer, and why are people paying thousands (and even millions³⁶) of dollars for NFTs if anyone can have the digital copy? For starters, NFTs are backed up by blockchain technology, which ensures ownership (and potentially the underlying copyrights³⁷) and traceability of the asset, which is unlike downloading a digital file’s copy. Perhaps more importantly, when an individual purchases an NFT, the individual gains access not only to the digital asset but possibly also to the community linked to the asset (a private channel, often on Discord,³⁸ where individuals can exchange ideas, get to know each other, and create a community).

Another reason is a more philosophical one. If you compare NFTs to traditional artwork, the same question can be asked — why would anyone buy art if you can download the digital copy of a Monet or Picasso and see the same image the buyer sees? Usually, the reasons are linked to social prestige, cultural significance, or investment.³⁹ Some see NFTs as a new form of art, and collectors are rushing to get in the game.⁴⁰ Others may see NFTs as a Veblen good — a good whose demand increases as the price for it increases (which goes against the traditional rules of supply and demand). This is similar to what happens to some luxury articles that have limited utility beyond enabling owners to advertise their wealth.⁴¹

According to research,⁴² there are four main types of NFTs: (i) unique pieces of art (created by digital artists); (ii) generative art (created algorithmically on a platform, such as CryptoKittens or Bored Ape); (iii) play-to-earn platforms’ NFTs (high-volume trade for low-value items, for which sales continue to grow steadily⁴³); and (iv) collectibles tied to sport.

Creating an NFT is a simple action that anyone can do. Several NFT marketplaces offer users the ability to create and trade NFTs; the most popular marketplace is OpenSea. A user creates (or mints) an NFT with the files in the user’s computer (or the ones available on the platform) and then makes it available for sale. Typically, a marketplace does not charge a fee to mint an NFT, but it will charge a service fee for listing the NFT for sale on its marketplace.⁴⁴ Another option is for a creator to pay a gas fee (a transaction fee that miners on a blockchain receive for including that transaction in a block) directly to the administrator of the blockchain.⁴⁵

Most NFTs are part of the ethereum blockchain, which is a kind of cryptocurrency — that is, virtual currencies secured by cryptography and based on a blockchain (or decentralized) system. They are not issued or controlled by a centralizing authority.⁴⁶ In order to purchase an NFT in a marketplace, first one would need to purchase cryptocurrency that can be traded on that platform and then trade the cryptocurrency for the NFT.⁴⁷ Because you can earn and spend cryptocurrency in the metaverse, as well as create, buy, and sell NFTs, the metaverse, NFTs, and cryptocurrencies are closely linked.

The NFT economy is growing swiftly: NFT sales hit almost $6 billion in the third quarter of 2021 alone, compared with just $22 million in the same quarter of the year before.⁴⁸ How the metaverse and NFTs will be regulated is still uncertain. Concerns revolving around human rights, legal ownership, and other legal regulations, including how to tax this new economy (which is the focus of the next section), are increasingly evident.⁴⁹ If the metaverse does not have basic regulations and does not prove itself to be a safe environment in which users respect basic rights, it is unlikely to succeed. Organizations are attempting to regulate the metaverse’s ethics and laws, but plans are still idealistic.⁵⁰ However, where there is money, there will eventually be taxes, and only governments can design the required governance framework.

Tax and the Metaverse

Tax administrations are lagging behind private organizations when it comes to technological development. Like many of us, tax offices do not fully understand how the metaverse or NFTs work, and they have not attempted to regulate or tax this economy. Although there is some guidance from tax authorities on how to tax cryptocurrencies,⁵¹ there is less guidance on how to tax NFTs or any other activity linked to the metaverse (such as the payment of gas fees).

Considering the close connection between NFTs and cryptocurrencies (with the important distinction that one is non-fungible and the other is fungible), some believe the same tax guidance may apply for both. In fact, this seems to be the approach that the Australian Tax Office is taking. It issued guidance on the income tax treatment of NFTs outlining that the income tax treatment of an NFT depends on the circumstances, the way someone uses the NFT, and their reasons for holding and transacting with the NFT.⁵² In Australia, one may be liable to pay income tax on an NFT: (i) as a capital gain tax asset under the capital gains tax regime⁵³ (for example, when the NFT is purchased as an investment and is later sold); (ii) held in a revenue account (NFT sales may be subject to the same tax regime as when one trades stock); or (iii) as part of a business or profit-making scheme (for example, an artist selling digital art as an NFT may see the proceeds of the sale taxed as business income). This is similar to the cryptocurrency treatment in the country.⁵⁴

With scarce guidance available, one must look to general tax principles to determine how NFTs may be taxed.

Metaverse Transactions

There are different transactions that can happen in the metaverse. First, a virtual good, or NFT, is created.⁵⁵ Then it can be sold by either the metaverse platform itself (for example, a sale of virtual land,⁵⁶ clothes, or an avatar name) or by another company transacting on that metaverse platform (such as Nike or Adidas selling shoes⁵⁷ or Balenciaga or Dolce & Gabbana selling clothes⁵⁸). NFT offerings can involve: (i) the sale of physical goods; (ii) the sale of virtual goods; or (iii) a sale combining both, in which an individual purchases the virtual good and receives a physical item as well. As a further complication, someone can purchase or sell an NFT for cryptocurrency or for fiat currency⁵⁹ or trade an NFT for another NFT. An NFT can remain static (that is, unchanged) or dynamic (which is an NFT programmed with a smart contract⁶⁰ to change over time⁶¹). Also, the virtual good might not be the product of a sale but handed out by the platform to the user as a prize or award (by completing quests or playing a play-to-earn game).

Other transactions that occur in the metaverse include renting digital land,⁶² purchasing a ticket for a virtual event, payment of income for a service provided in the metaverse under a contract, wages for compensation of work done in the metaverse,⁶³ and payment of gas fees. Someone may also buy an NFT as an investment and realize investment income, such as capital gains. Someone could keep cryptocurrencies in a digital wallet and receive interest income.⁶⁴ If you are a retailer selling a virtual good in the metaverse, you may attach a royalty agreement to that NFT and obtain continuous resale revenue on future transactions⁶⁵ (that is, every time there is a secondary sale⁶⁶ and the NFT trades hands, the original seller receives a royalty payment).⁶⁷ Or, as the owner of your personal data (the promise of Web3), you could sell it to a data broker⁶⁸ (or whoever is interested in insights from users’ behaviors) and receive income.

Potential Taxable Events

The first relevant question would be whether transactions give rise to taxable events. Although one might be quicker to answer “yes” for the sale of goods, the answer is not so straightforward when a user picks up a digital weapon from the ground in a game (and is now the owner of that digital asset) or earns a prize from the platform in a play-to-earn game.

Assuming a taxable event occurred, the next step is to determine which tax to apply (for example, VAT, income tax, capital gains tax, or interest tax). Whether it is an artist selling digital art as an NFT, an investor buying and selling NFTs for profit, or a curious person exploring the metaverse, the characterization of both the activity (as a sale of goods or service or as investment income) and the item is indispensable. This gets complicated very quickly.

Given all the different types of transactions that may occur in the metaverse, should the digital dealings be handled as if they were physical ones? Should the rental of digital property be treated as the rental of physical property? Should the sale of virtual event tickets be treated the same as tickets purchased for physical events?

Direct Taxes

First, what seems like one transaction may be two. When a person purchases an NFT in exchange for cryptocurrency, there are two transactions occurring: the disposal of the cryptocurrency and the sale of the NFT. Both the NFT’s seller and buyer may be liable for capital gains tax.

Capital gains are generally taxed only at the time of disposition of the relevant capital property. The key question is: When is a gain realized in a situation in which someone sells an NFT for cryptocurrency or when a user is awarded cryptocurrency or an NFT in a game? Countries have dealt with this by concluding that the gain is realized when that individual or company exchanges cryptocurrency for a fiat currency.⁶⁹ But what if this exchange never happens and the cryptocurrency’s holder spends it on the purchase of another virtual asset (something that is expected to happen more frequently)? And on a more operational side, how should this intangible asset be valued?

Moreover, if the seller is actively involved in creating and trading NFTs, the profits also could be taxed as self-employment income in some countries.⁷⁰

When it comes to the sale or lease of land or a house in the metaverse, should it be treated similarly to the purchase and lease of immovable property in the physical world? If so, that means that the state where the property is located should have the right to tax.⁷¹ But what is the source state if the property is located in the metaverse? Would it be the location where the seller connects online to the metaverse? What if the sale is concluded by the platform itself? Could a company ever constitute a permanent establishment⁷² in the metaverse (although there has been much debate about servers not constituting a PE⁷³)? What would be the consequences?

The government may apply income taxes to wages and investment income, such as royalties or interests, earned in the metaverse. In which jurisdiction would the transaction occur, and who would have the taxation rights? In the case of interest income, both the country where the income arises and the residence country of whoever receives the interest income could tax the income.⁷⁴ If the interest arises from an investment made in the metaverse, where is the source? In the case of royalties,⁷⁵ where is the beneficial owner of that income?

The characterization of digital assets — a key aspect in determining the type of tax that should apply — is also subject to debate. Although the majority of jurisdictions treat cryptocurrencies as property⁷⁶ (which includes intangible assets, commodities, and financial instruments), others take a different approach and consider virtual currencies to be foreign fiat currencies⁷⁷ or “digital representation of value.”⁷⁸

Indirect Taxes

When it comes to the sale of goods or the provision of services in the metaverse, should VAT apply (either for physical or virtual goods and services)? And how about the sale of tickets for a digital event? In the case of payments for gas fees, should they be treated as a service? Assuming that they should, where is the place of supply and place of consumption of a service rendered by an avatar? Answering these questions is crucial to understanding where the VAT obligations lie in a cross-border transaction.⁷⁹

Potential answers come from the European Commission cross-border VAT e-commerce package, which has been in place since July 1, 2021, and is designed to tackle some of the challenges of the digital economy. One of the key simplifications is that for digital transactions, VAT should be paid where the consumption of goods takes place.⁸⁰

But uncertainty remains: When there is a combined sale of a physical and a virtual good, would the physical good that is connected to the unique virtual good be treated the same, or should two different regimes apply?⁸¹ Perhaps the Court of Justice of the European Union’s decision on the VAT treatment of bundled supplies could provide some principles that may be applied in the metaverse economy as well.⁸²

Implementation Issues

On a more operational level, how does an authority efficiently tax income connected to the metaverse when cryptocurrencies’ valuations are so volatile?⁸³ And how do tax authorities track and tax such transactions when metaverse identities are pseudonymous?⁸⁴

For the last century, the same concepts, such as residence, source, and PE, have been used in the international tax law systems as the basis to determine taxable events and the nexus for taxation. Clearly the current tax rules are not suited to effectively deal with the economy that Web3 creates. Since 2015, the OECD base erosion and profit-shifting project⁸⁵ has attempted to deal with the challenges brought on by the rapid and intense digital transformation of the economy. The OECD recently issued a statement on a two-pillar solution for these challenges.⁸⁶ How this solution will affect the metaverse economy is uncertain.

New Offshore Tax Haven?

Special economic zones (SEZs), used as an umbrella term for free trade or export zones,⁸⁷ are geographically limited areas in which governments create and implement a distinct special regime to provide fiscal and regulatory incentives to businesses to facilitate economic activity. These zones, existing in their modern format at least since the 1950s, are created by special economic regulations and are designed to attract investment and boost economic development.⁸⁸ The economic significance and policy development of an SEZ differ among jurisdictions.

Foreign partnership zones can be formed in cooperation with a foreign partner, which is either a private company (in a public-private partnership (PPP)) or another government. A bilateral agreement to develop an SEZ is put in place between the parties and sets up a cooperation framework, a division of responsibilities, and the development of the regulatory framework of the zone.⁸⁹ These zones bring development assistance, economic cooperation, and strategic considerations for both partners. In our physical world, these SEZs can be developed inside the borders of the country or in a cross-border context (for example, a joint ownership with a neighboring country), although the latter is a recent concept.⁹⁰

The metaverse is creating possibilities for new SEZs and innovative types of sovereignty and governance that go beyond physical territories.⁹¹ Public and private parties could agree to create a special zone in a digital environment where regulations apply differently. Governments can buy virtual land, build digital embassies,⁹² set up special trade zones, and define their own rules in the metaverse. Governments and companies can create PPPs in the metaverse and in the physical world. Looking into the not-so-distant future,⁹³ avatars representing companies could make business agreements, provide services, and sell digital goods to each other in a tax-free metaverse SEZ.

If avatars can perform in the metaverse most of the actions that are performed in the physical world, laws are needed to regulate this framework. Who will set these regulations and how the concept of sovereignty translates to the metaverse is yet to be seen.

Future Research

The metaverse, with its unimaginable potential, will continue to be the subject of a complex and wide-ranging discussion. Virtual worlds are still part of our physical world and, as such, they must be subject to laws, taxes, and rules. This article merely scratches the surface of some of the metaverse’s tax challenges, and there are more questions than answers.

Going forward, the first step governments should take to enhance compliance is to understand for themselves these new concepts and the metaverse’s new economy. Most importantly, governments need to engage in a principle-based dialogue with stakeholders to find common ground on tax principles and the Web3 mindset (including self-sovereign identity and the right to privacy in an open, transparent, inclusive, and verifiable environment with self-forming communities). Early movers are more likely to be able to set these rules, and that is why governments must act soon to build a governance framework in partnership with the private sector. The OECD recently released a public consultation document on these issues.⁹⁴

Authorities should make it easier for taxpayers to comply with tax law requirements by using blockchain to regulate blockchain — that is, embedding and automating tax compliance into the system (and following the principles of an invisible tax administration or tax by design⁹⁵) as an efficient manner to take advantage of the digital evolution. Artificial intelligence tools, such as machine learning, can be implemented to crunch big data and perform risk assessments to assist tax administrations to be more efficient, cut down on costs, and make better use of their limited human resources.

However, one cannot ignore the existence of intermediaries that create a peer-to-peer connection environment (such as eBay), in which users can connect to one another directly to exchange digital assets. It is possible to transact in the digital economy without an intermediary. Therefore, governments must understand the way the economy works and come up with solutions for different scenarios.

The metaverse and NFTs could fundamentally change established tax concepts and the way tax compliance functions. Although this presents an enormous challenge for tax authorities, if they embrace this change, they can automate the collection of tax with real-time compliance measures, minimize the need for audits, and reduce tax fraud.

If states do not dive deep into the issues of metaverse taxation and create global rules to regulate and tax this environment in a cooperative fashion, there is a risk that courts will feel obliged to make decisions on the matter, turning it into a confusing and litigious topic.⁹⁶ An unregulated digital universe means a free pass for businesses to take advantage of an unregulated economy. If that were to happen, the metaverse might become the next offshore tax haven.⁹⁷

Correction, August 18, 2022: An earlier version of this article incorrectly defined the term "Veblen good" as a good whose price increases as demand for it increases. The article has been updated. Tax Notes regrets the error.