ABCs of NFTs: Key Tax Considerations

I. Introduction

Web 3, the metaverse, digital assets — these rapidly developing technology applications are increasingly discussed in media reports and everyday conversations. Web 3 will enable widespread adoption of the metaverse,¹ and digital assets are the means of trade in those environments. Indeed, digital assets have applications far beyond the metaverse. As the growing volume of cryptocurrencies in the market denotes their mainstream adoption, use of a new class of digital assets is also growing rapidly: nonfungible tokens (NFTs).²

NFTs have recently exploded into the mainstream — most prominently with a digital art piece sold at auction for $69 million³ and the first-ever tweet selling for $2.8 million⁴ — creating a new and substantial market for this type of digital asset.⁵ At their most basic, NFTs are unique digital assets that prove ownership (that is, functioning as a digital certificate of ownership or authenticity) of a copy of digital content (for example, digital art or music) or tangible property (for example, limited edition shoes). More broadly, NFTs are the next wave of digital assets that simplify the buy-sell process (including by reducing participants’ transaction costs) and elevate an online user’s digital experience in the gaming, music, entertainment, real estate, and collectible industries. Moreover, NFTs can enhance creators’ ability to benefit from the use of their creations, including by offering the possibility of receiving perpetual returns. NFTs have the potential for commercial application beyond just sales of digital art. As a broader group of taxpayers begins to incorporate NFTs into their commercial activities, it is important to understand the myriad tax consequences arising from those activities. Some of the federal income tax consequences are addressed below.

Guidance on the taxation of “digital assets” — a term only recently defined in the code as part of statutory changes to rules applicable to returns of brokers⁶ — is primarily limited to cryptocurrency (generally fungible in nature) and does not directly address the tax treatment of NFTs.⁷ As a result, the taxation of NFT transactions, including determining the character and source of income generated from a transaction involving an NFT, must be evaluated through analogies and comparisons with existing tax rules.

This article explains what NFTs are, how various parties engage in NFT transactions, and how NFTs are commonly exploited commercially. We then address some of the common federal income tax questions that arise in NFT transactions.

II. Background

A. What Are NFTs?

NFTs are unique crypto tokens, or digital assets, that are marked with codes to differentiate one from another and are written into so-called smart contracts. They are stored on a decentralized ledger (like the blockchain) that allows the NFT to be securely transferred between parties and for its transfer history to be easily traced.

As the name indicates, NFTs are not fungible, which means they are unique and not interchangeable for identical property. In contrast, cryptocurrencies and fiat currencies⁸ are generally interchangeable and have a one-to-one value.⁹ An NFT is more akin to a misprinted dollar bill because the misprint creates uniqueness and scarcity that drives value.

NFTs also provide a way to establish the ownership of or right to use referenced property. The referenced property is generally in the form of a copy (but not the underlying copyright rights) of digital content (for example, a JPEG or audio file), but it can also be a physical asset (for example, real estate or tangible artwork) or represent the right to access services. Acting as a unique identifier, the token often stores metadata regarding the asset and enables smart-contract functionality. These features permit ownership of an NFT to be easily proven.

1. Who are the participants in NFT transactions?

Generally, up to three parties are initially involved in an NFT transaction — a creator-seller (or reseller), a buyer, and an NFT marketplace:

• A creator is a person (an individual or entity) who holds property rights (for example, the copyright in digital content) to a referenced asset and “mints” the NFT (typically accomplished through a third-party platform), publishing a token onto a blockchain to make it purchasable.

• A buyer is any person who purchases an NFT from a creator-seller or a buyer-reseller and enjoys all the rights acquired with the purchase.

• An NFT marketplace is a digital platform that facilitates NFT transactions and allows users to track an NFT’s ownership and transaction history.

The process begins when a creator establishes an account on an NFT marketplace to which it connects its blockchain wallet and follows the necessary steps to mint,¹⁰ thus making the NFT available for sale. A buyer that connects its digital wallet to the same marketplace account may then purchase the newly minted NFT (using cryptocurrency also stored in its digital wallet) by following the steps in the marketplace’s interface.¹¹ Once a buyer purchases the NFT, a smart contract created during minting will execute the sale by transferring NFT ownership to the purchaser’s digital wallet, distributing the sales proceeds to the creator-seller’s digital wallet, and transferring applicable transaction fees (for example, 2 percent or 3 percent) to the NFT marketplace. The buyer’s subsequent resale of the NFT involves similar transfers between digital wallets, and, depending on the terms of the underlying smart contract, may also involve a fee transfer (typically between 5 and 10 percent of all final sales) to the creator or other holder of ownership rights in the underlying digital content.

2. How do NFTs work?

As noted, NFTs are governed by smart contracts. These are pieces of computer code that facilitate NFT transactions by securely storing, verifying, and self-executing rules or protocols that use “if-then” logic¹² to verify NFT ownership, transfers, and, potentially, automated revenue collection upon future specified events. For example, smart contracts are often written to automatically allocate a portion of the amount paid for any later sale of the NFT back to the original creator, thus enabling the creator to realize the benefits of the secondary marketplace in perpetuity.

3. What do you own when you purchase an NFT?

The terms of the smart contract govern the rights that are transferred in the transaction. The types of transactions deployed using NFTs are continuously evolving, with the transactions taking various forms. Some of the most commonly used transactions are described in this article. In many cases involving art or collectibles, the digital content creator will retain all the copyright rights to the underlying digital art and associated intangible property, and the NFT buyer will typically acquire a token on the blockchain comprising an implied, nonexclusive limited-use license to use a unique copy of the digital art (but not legal ownership of the underlying art or embedded media).¹³

4. How are NFTs being used in the commercial marketplace, and how is money made?

An NFT can represent a collectible, a gaming piece, physical or digital art, the right to attend sporting and other events, cultural artifacts, digital real estate, or music recordings. These categories attract a wide range of buyers, sellers, and collectors, not to mention a growing number of NFT marketplaces. When an NFT is minted and originally sold, the buyer-owner can resell it at the going market price. This allows some NFT buyers to invest in an NFT with the hope that the market value will appreciate. Typically, the marketplace and other participants in the digital supply chain (for example, a third-party minting service) will also establish a right to a portion of the proceeds of any subsequent sales.

III. Tax Considerations in NFT Transactions

A. Overview

NFT transactions implicate many tax considerations that may change depending on the particular facts of any one NFT transaction. To understand the tax implications, one must first ascertain the character of the transaction. It will typically be either a sale, a lease, a license, or the performance of a service. The character of the transaction determines which rules apply to establish the following:

• the source of income or gain generated from the transaction, which can affect (1) a U.S. taxpayer’s foreign tax credit limitation under section 904(a) or (2) the United States’ ability to impose tax on the income of a non-U.S. person;

• whether a domestic corporation’s income is eligible for foreign-derived intangible income benefits;

• whether the income or gain, if generated by a controlled foreign corporation, is subpart F income or tested income;¹⁴ and

• whether a foreign tax imposed on NFT-related income is creditable under recently issued FTC regulations.¹⁵

Each of these determinations is discussed below.

B. Character of Income

As noted, Treasury and the IRS have not yet provided guidance directly addressing the character and source of NFT-related income. We therefore look to existing guidance and the framework provided in the following:

• reg. section 1.861-18 (the computer program regulations), which classifies transactions involving computer programs;

• prop. reg. section 1.861-18 (proposed digital content regulations), which proposes to extend application of the computer program regulations to include transactions involving other types of digital content (for example, books, movies, or music in digital format); and

• prop. reg. section 1.861-19 (proposed cloud regulations), which proposes rules for characterizing cloud transactions (defined below).¹⁶

1. Transactions involving digital content.

The computer program regulations were finalized in 1998 to address growth in cross-border e-commerce transactions corresponding to increasing internet use and capabilities.¹⁷ Treasury and the IRS limited the scope of the regulations to transactions involving computer programs,¹⁸ which they deemed a more pressing need than guidance for transactions involving other forms of digital content.¹⁹

In 2019 Treasury and the IRS issued the proposed digital content regulations and proposed cloud regulations to address rising consumption of digital content (for example, digital books, music, and video) largely because of growth in new forms of computer hardware, including laptops and smartphones, that “allows users to more easily obtain and use digital content.”²⁰ The proposed digital content regulations and proposed cloud regulations both define digital content to mean “a computer program or any other content in digital format that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time.”²¹ This definition likely includes digital content purchased through an NFT and may also include the NFT itself.

The first step in characterizing a digital content transaction is determining which set of regulations to apply — the proposed digital content regulations or the proposed cloud regulations. That determination appears to initially turn on whether the payer is downloading a copy of the digital content onto a computer (or other device) for offline use or accessing and using the digital content solely while online. If the former, the proposed digital content regulations would likely apply. If the latter, the proposed cloud regulations would likely apply. A third alternative might involve the purchase of a unique copy of digital content that the purchaser decides to store online on the seller’s platform rather than downloading it to a personal device.²² In that case, the digital asset seller might be treated as engaging in two bifurcated transactions: (1) a sale of a copy of digital content (subject to the proposed digital content regulations) and (2) the provision of remote data storage services (subject to the proposed cloud regulations).²³

To determine the character of NFT-related income under the proposed digital content regulations, one must determine whether any of the following copyright rights is transferred along with the copy of the digital content:

• the right to make copies of the digital content for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending;

• the right to prepare derivative digital content based on the copyrighted digital content;

• the right to make a public performance of the digital content; or

• the right to publicly display the digital content.²⁴

When a purchaser buys an NFT, it is not necessarily buying the underlying asset. The link between the token and the asset itself does not automatically result in the transfer of any rights in the asset, unless the terms of the sale (that is, the smart contract) state otherwise. If the terms both transfer to the purchaser a copy of the digital content and grant the purchaser one or more copyright rights in the underlying digital content, the transfer may be treated as a license of a copyright right or a sale of the underlying property. The transfer of a copyright right is treated as a sale (rather than a license) if all substantial rights in the copyright are transferred.²⁵

For example, assume Artist, an individual, creates digital content to commercialize online. She logs on to an NFT marketplace and, through a digital wallet, mints an NFT token linked to a unique copy of the digital content. Artist then transfers the NFT to a purchaser under a smart contract that also grants the purchaser a time-limited, nonexclusive right to distribute for sale to the public an unlimited number of unique copies of the underlying digital content. This transaction may be treated as Artist granting a license of copyright rights to the purchaser because one or more copyright rights listed above are transferred in addition to the copy of digital content, but those rights likely did not comprise all substantial rights in the copyright.²⁶

Alternatively, if the terms of the sale of the NFT grant the purchaser only a file from which the digital content can be perceived, without also transferring one or more copyright rights in the underlying asset, the transfer could be viewed as a lease or sale of a copyrighted article.²⁷ In that case, the income derived from the transfer would be treated as proceeds from a sale (rather than a lease) of personal property if the transferee receives the burdens and benefits of ownership in the property in the transfer.²⁸

For example, assume NFT Games, a gaming company, creates unique digital skins for use as clothing or weapons in online gaming. NFT Games then mints NFTs (on an NFT marketplace) that gamers can purchase (while online) that allow them to download a unique copy of the underlying digital skin onto their NFT Games consoles to use while playing NFT Games video games both offline and online. The smart contract does not grant the purchaser-gamer any of the copyright rights listed above, and the downloaded digital skin deactivates exactly one year after download. Assuming offline use of the digital skin is non-de minimis,²⁹ NFT Games may be treated (at least in part) as leasing a copyrighted article to the purchaser-gamer because none of the copyright rights described in the proposed digital content regulations are transferred, and the purchaser is viewed as returning the downloaded digital skin after one year.³⁰

2. Cloud transactions.

The proposed cloud regulations outline the treatment of cloud transactions as a service involving the use of, or as a lease of, digital content, computer hardware, or similar resources.³¹ For this purpose, a cloud transaction is defined as a transaction through which a person obtains on-demand, non-de minimis network access to computer hardware, digital content as defined in prop. reg. section 1.861-18(a)(3), or other similar resources.³² Whether a cloud transaction is treated as a service or a lease (of computer hardware or digital content) is determined based on all relevant factors,³³ including the extent to which one or more of the following factors apply, each of which is indicative of a service rather than a lease:

• the customer is not in physical possession of the property;

• the customer does not control the property beyond the customer’s network access and use of the property;

• the provider has the right to determine the specific property used in the cloud transaction and replace it with comparable property;

• the property is a component of an integrated operation in which the provider has other responsibilities, including ensuring that the property is maintained and updated;

• the customer does not have a significant economic or possessory interest in the property;

• the provider bears any risk of substantially diminished receipts or substantially increased expenditure if there is nonperformance under the contract;

• the provider uses the property concurrently to provide significant services to entities unrelated to the customer;

• the provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than on the mere passage of time; or

• the total contract price substantially exceeds the rental value of the property for the contract period.³⁴

For example, assume NFT Place is a marketplace that provides on-demand (non-de minimis) online access to platform software capable of minting tokens. NFT Place charges NFT creators a fee to use its platform software to mint and sell NFTs. The fee may be treated as services income under the all-relevant-factors test.³⁵ Factors indicating a services transaction may include the following: (1) the NFT creator does not physically possess the platform software; (2) the NFT creator does not control the platform software other than the creator’s network access and use of the platform software; (3) the NFT marketplace has the right to determine the specific platform software available to the NFT creator and can unilaterally replace that software with comparable property; and (4) the NFT marketplace uses the platform software concurrently to provide significant services to persons unrelated to the NFT creator.³⁶

Application of the all-relevant-factors test to an NFT creator seems less clear. For example, assume NFT Games uses NFT Place’s online marketplace to mint NFT tokens that allow purchaser-gamers while online to use digital skins that are remotely stored on third-party servers (that is, not downloaded on to a gamer’s video game console). The transaction may be treated as a provision of cloud services by NFT Games to the online gamer if (1) the digital skin is not unique, (2) the digital skin can be updated by NFT Games without the purchaser-gamer’s permission, (3) the digital skin can be used simultaneously by other online gamers, and (4) the smart contract does not allow the purchaser-gamer to capture appreciation in the NFT’s value.

Alternatively, the transaction arguably may be treated as a lease of a copy of digital content by NFT Games to the online purchaser-gamer if (1) the copy of the underlying digital skin is unique, such that NFT Games cannot unilaterally replace it with comparable digital content or simultaneously provide the same unique copy of digital content to another online gamer, and (2) the online gamer pays only a set annual fee (based solely on the passage of time) that does not exceed the rental value of the unique copy of digital content.³⁷

Finally, assume the NFT transaction provides the online gamer the same unique digital skin in perpetuity, with the digital skin stored on a third-party server contracted for by NFT Games. Could NFT Games be treated in part as selling a copyrighted article (transferring benefits and burdens of ownership to the purchaser-gamer) under the proposed digital content regulations and in part as providing a cloud service (that is, infrastructure service under its third-party server contract) to the purchaser-gamer?

C. Source of Income

As noted, a transaction involving digital content is generally expected to be characterized as a sale, lease, license, or the provision of services. A different source-of-income rule applies for each of these respective characterizations, and, depending on the facts, the source of a transaction’s income may differ based on which set of sourcing rules applies.

Rental income (for example, from a short-term download of a unique copy of digital content with full offline functionality) is sourced to the location of use of the rental property.³⁸ Royalty income (for example, from a transfer of a copyright right comprising less than all substantial rights) is sourced to the location of use,³⁹ which may refer to the place of licensee activity,⁴⁰ the place of ultimate use or consumption,⁴¹ or the place granting legal protection for intangible property.⁴²

Under current law, income from the sale of a copyrighted article may be sourced to the location of production (if the seller creates the copyrighted article)⁴³ or the location of the copyrighted article when title and the risk of loss pass from the seller to the buyer (if selling purchased copyrighted articles).⁴⁴ Note, however, that the proposed digital content regulations would source the sale of purchased copyrighted articles transmitted electronically to the location of download or installation onto the end-user’s device (rather than under the title passage rule).⁴⁵

If payments made to acquire all substantial rights in a copyright right are contingent on the productivity, use, or disposition of the right, the income from the transaction is sourced according to the royalty sourcing rules (location of use). Alternatively, if the sale is not based on a contingent payment, and the digital content is not inventory, the sale is generally sourced according to the residence of the transferor.⁴⁶ If the digital content is purchased inventory, a sale of purchased digital content is sourced according to the title passage rule (or the location of download to the end-user’s device under the proposed digital content regulations), and a sale of created or manufactured digital content (for example, an NFT sale by NFT Games) may be sourced according to the location of creation or manufacture.⁴⁷

Income from the provision of a service (for example, NFT Place’s platform services) is sourced to the location of performance of the services.⁴⁸ When applying this sourcing rule to automated cloud services, however, it is less clear where the services are “performed.” The proposed cloud regulations do not address this issue and instead request taxpayer comments on administrable sourcing rules consistent with sections 861 through 865.⁴⁹ Taxpayers have traditionally applied existing (albeit dated) case law and other guidance that sources income from specific types of services (for example, advertising services) to the location of the service provider’s employees and tangible assets.⁵⁰

D. FDII

Section 250 allows a domestic corporation to claim a deduction equal to 37.5 percent of its FDII, subject to a taxable income limitation.⁵¹ A domestic corporation is generally eligible to claim FDII benefits on income or gain from (1) the sale (or lease, license, exchange, or other disposition) of property to a foreign person (the foreign person requirement) for a foreign use (the foreign use requirement); or (2) services (including electronically supplied services)⁵² provided to a person, or for property, located outside the United States (the foreign location requirement).

The FDII regulations include different sets of rules for determining whether sales, royalty, rental, or services income is eligible for FDII benefits. Thus, the character of an NFT transaction is important for determining which set of FDII rules to apply and, depending on the underlying facts and circumstances, may dictate whether income or gain from the transaction is eligible for FDII benefits. For example, the sale of a copyrighted article (for example, a sale of an NFT by NFT Games) or a sale or license of copyright rights (for example, a license of digital content by Artist) to a U.S. person would fail the foreign person requirement and therefore be ineligible for FDII benefits.

Even if it were a sale to a foreign person under reg. section 1.250(b)-4(c), one must establish that the sale was for a foreign use under reg. section 1.250(b)-4(d), which determines foreign use of general (for example, a copyrighted article) and intangible property under separate sets of rules. Therefore, a taxpayer must first ascertain whether an NFT transaction is a general property or intangible property transaction before determining whether the foreign use requirement is met.⁵³ If an NFT transaction is instead characterized as providing a cloud service to a U.S. person (for example, NFT Games grants online users limited access to remotely stored digital skins that NFT Games controls), the income derived may be eligible for FDII benefits if the U.S. recipient benefits from the service, at least in part, in one or more locations outside the United States. That is, the foreign location requirement, rather than the foreign person and foreign use requirements, applies to services transactions.

E. Subpart F and GILTI

The character and source of income or gain that a CFC derives from an NFT transaction (under the rules discussed above) can factor into whether the CFC’s income is subpart F income or tested income.⁵⁴ If a CFC derives subpart F income or tested income, its U.S. shareholders (as defined in section 951(b)) (1) may have an income inclusion under section 951(a) or section 951A(a); and (2) could be allowed a deemed-paid FTC under section 960 for the CFC’s foreign taxes that are properly attributable to that income.

Income from the sale of property may be subpart F income — under section 954(c) (foreign personal holding company income from the sale or license of passive assets), 954(d) (foreign base company sales income (FBCSI)), or 954(e) (foreign base company services income (FBCSvI)) — if there is no applicable subpart F exception. The subpart F regulations provide different exceptions for different types of income.

For section 954(d) purposes, a CFC’s income from selling property that is manufactured, produced, grown, or extracted by the CFC or in the CFC’s country of organization may be excepted from FBCSI treatment,⁵⁵ even if the sale is made outside the CFC’s country of organization. For example, if NFT Games were a CFC, its sales of copyrighted articles to a foreign person (related or unrelated) may qualify for the manufacturing exception to FBCSI. What constitutes the manufacture or production of an NFT is an open question, however. If a CFC were instead treated as providing a service (for example, if NFT Place were a CFC providing platform services) to a related person, the services income would likely be FBCSvI to the extent performed outside the CFC’s country of organization (the FBCSvI regulations include a same-country exception but do not include a manufacturing exception).

A CFC’s income that meets an applicable exception to subpart F income may instead be treated as tested income if it is not otherwise excluded from tested income under section 951A(c)(2)(A)(i). Treatment of a CFC’s income as either subpart F income or tested income may dictate the corresponding allocation of the CFC’s income and foreign taxes to general, passive, or GILTI FTC baskets. Whether subpart F or tested income treatment is preferred for FTC limitation purposes depends on the taxpayer’s FTC profile.⁵⁶

F. FTC Regulations

Recently issued final FTC regulations⁵⁷ contain rules affecting the creditability and basketing of a broad range of foreign taxes, including section 901 and section 960 taxes. The final FTC regulations apply an attribution requirement (formerly the jurisdictional nexus requirement) to the credibility of a corporate income tax or a withholding tax imposed on a nonresident.⁵⁸ The attribution requirement is met if the gross receipts and costs attributable to each item of income included in the foreign tax base can satisfy an activities-based test,⁵⁹ a source-based test,⁶⁰ or a property-based test.⁶¹

Proper application of the source-based requirement to an NFT transaction engaged in by a nonresident depends in part on the federal income tax characterization of the transaction. If the NFT transaction is characterized as something other than a sale of a copyrighted article (for example, a royalty, service, or rental of a copyrighted article), the foreign tax satisfies the source-based requirement if the foreign country’s sourcing rules — as applicable to the character of the NFT transaction under the laws of the foreign country — are “reasonably similar to the sourcing rules that apply” under the code.⁶² For example, if NFT Place provides a platform service that a foreign country characterizes as a license, the foreign country must source royalty income according to the place of use for, or right to use, intangible property for the foreign tax to meet the source-based requirement.⁶³ Similarly, if the foreign country characterizes NFT Place’s income as services income, the foreign country must source the services income according to the place of performance for the foreign tax to meet the source-based requirement.⁶⁴

In contrast, if an NFT transaction is characterized as a copyrighted article sale for federal income tax purposes (for example, NFT Games sales), the foreign tax imposed on a nonresident cannot meet the source-based requirement.⁶⁵ A foreign tax imposed on that transaction can meet the attribution requirement only if (1) the foreign country treats the transaction as a sale of tangible property and not as a license of intangible property and (2) either the activity-based requirement or the property-based requirement is met.⁶⁶

G. Other Tax Considerations

If NFTs are characterized as either royalties, services, or leases using the arguments above, reporting could be required on the income paid for these types of payments. The reporting depends on the tax residency of the income recipient and the source of the payment.

1. NFT income paid to a U.S. person.

Recently, with the enactment of the Infrastructure Investment and Jobs Act,⁶⁷ the tax reporting on cryptocurrency has significantly increased. This new law includes an information reporting requirement for cryptocurrency asset exchanges and custodians on a Form 1099.⁶⁸ It also requires that specified persons who accept large payments in cryptocurrency in their trade or business report that income on Form 8300, “Report of Cash Payments Over $10,000 Received in a Trade or Business.” Given that this is where the law is headed in terms of reporting digital currency, it is prudent to be aware that there could be requirements for Form 1099 reporting on payments made to U.S. persons in the coming years.

2. U.S.-source NFT income paid to a non-U.S. person.

Further, to the extent the income is considered U.S.-sourced and being paid to a non-U.S. recipient, the income could be subject to withholding at a statutory rate of 30 percent under chapter 3⁶⁹ and reporting on Form 1042-S.