Step Into the Brave New SALT World of Blockchain

“Not a day goes by, not a single day”¹ without The New York Times or The Wall Street Journal discussing an issue regarding blockchain technology — whether bitcoins or non-fungible tokens (NFTs). The original material girl herself said it: “We are living in a [non-fungible] world,”² staring at an industry brought to life by developments in digital technologies worth trillions of dollars. But what is so far missing is any analysis of the state and local sales tax consequences of selling or trading of blockchain technologies. We tackle that subject in this article.

To put this article in context, it helps to get a lay of this new digital landscape. In the first section, we explain what blockchain technologies are and how they are used. In the sections that follow, we dive into what makes the state tax implications of blockchain technologies so novel yet familiar.

Background — What Is Blockchain?

Blockchain technologies, also known as distributed ledger technologies, are based on a network of databases that store and make data available. Blockchain networks are entirely decentralized. Each computer within a blockchain network (such as Bitcoin and Ethereum) is a node. The use of the term blockchain is deliberate: Each fresh bit of data — each block — is added to the previous block of data, forming a chain. Each node updates each blockchain with any changes. The majority of nodes connected to the network must verify the authenticity of the new data before any node updates the blockchain.³ Most blockchain networks are public, so data is publicly accessible, much like an on-call super librarian. Once data is recorded inside a blockchain, it becomes very difficult to change — increasing the transaction’s inherent transparency, integrity, and value.

Blockchain technology forms the backbone for multiple uses, the tax implications of each we will discuss throughout this article. The most common use is cryptocurrency, such as bitcoin and ether, the currency used on the ethereum platform. Each transaction — whether the mining-creation of the currency or the sale of already created currency — is recorded on the blockchain, creating a verified history of ownership and use. Blockchain technologies also facilitate NFTs. Transactions involving NFTs center on the exchange of assets, both digital and tangible, for cryptocurrency.⁴

Sales and Use Tax Implications

Basic Principles

In determining the sales tax implications of blockchain transactions, the initial questions are obvious: What is the service or product that is purchased — is it tangible or intangible property? Is payment made in a recognized form of consideration? Who is the seller? And where does the purchaser make use of the services or products purchased?

In a sense, we embark on a similar exercise that the courts, tax agencies, and tax professionals undertook when wrestling with the taxability of software and other digital products and services. In the early stages, before legislation characterized pre-written software as tangible personal property (TPP) regardless of delivery medium, courts applied the true object test to determine whether software conveyed on tangible tapes was taxable as the sale of TPP or not taxable as the sale of intangible personal property.⁵

Courts have also used the primary object or principal purpose test to characterize an IT service and determine its taxability.⁶ For example, based on this test, a Connecticut court concluded that a consulting firm provided taxable computer and data processing services instead of nontaxable professional services.⁷ In contrast, a Tennessee court determined that an online service was not a taxable service, but a nontaxable information service, because the primary object of the purchaser was to obtain access to the provider’s website and not to obtain the transmission of its messages.⁸ Finally, in an opinion frequently cited by New York tax authorities when addressing services involving data processing, software, and cloud computing, the New York Tax Appeals Tribunal stated that the primary function of a taxpayer’s matching service at issue was to “allow members to meet others” and thus not an information service, even though members received information about future matches.⁹

In entering the new world of blockchain, we use the tried-and-true primary object test as a starting point in our analysis.

Taxation of Services Provided in Connection With Blockchain Transactions: Blockchain as a Service

Is BaaS Taxable?

Companies providing blockchain as a service (BaaS) facilitate and maintain a platform network of blockchain technologies for companies that wish to use blockchain technology — by transacting in cryptocurrency, minting NFTs, or using smart contract features.¹⁰ In layman’s terms, BaaS providers enable users to “develop and host blockchain apps and smart contracts in a blockchain ecosystem that’s managed and administered by cloud-based service providers” by use of the provider’s infrastructure (hardware and software) and technology.¹¹ Major tech companies such as IBM, Oracle, Amazon Web Services, and Microsoft offer BaaS to their enterprise subscribers for a fee.

It could be argued that BaaS is a type of platform as a service (PaaS) because BaaS involves the use of cloud tools and services to build, develop, and host blockchain applications in much the same way that PaaS providers maintain and facilitate access to a platform on which software developers can develop, test, and provide applications through the cloud. PaaS is often treated as software as a service (SaaS) because the object of the service is to provide an infrastructure for software applications.¹² Thus, if BaaS is treated as PaaS, it may be taxable in those states that tax SaaS.

On the other hand, depending on the description of the services the BaaS provider offers to its users, BaaS could be characterized as infrastructure as a service or data processing. Providers, for example, note that they facilitate the compiling or processing of information, manipulation of data, or maintenance and secure storage of customer information, which by definition is infrastructure as a service or data processing.¹³ Based on that offering, BaaS may be deemed data processing, which would result in a lighter tax burden compared with PaaS or SaaS, since data processing is not taxable in as many states as is SaaS.¹⁴

In short, understanding the nature of the service that the BaaS provider furnishes and the user is purchasing is critical to determining whether it is a taxable service in the first place.

How Are BaaS Transactions Sourced?

There is no universal rule for sourcing sales of services, which ultimately is the umbrella under which BaaS falls. Unlike TPP sourced to the delivery address, services are more ethereal. To quote a certain Reverend Mother, “How do you catch a cloud and pin it down?”¹⁵

Streamlined Sales and Use Tax Agreement states use a waterfall approach to source the sales of services, in which one cascades to the next level down if the location for an upper tier is not known: first, to the vendor’s place of business;¹⁶ second, to the location where the customer receives the service, if known to the vendor; third, to the customer’s address, if known from the vendor’s business records (for example, the address on the vendor’s invoice); fourth, to the address given in the transaction (for example, the address provided in a credit card transaction); and fifth, to the location from where the service was provided.¹⁷

Other states’ approaches vary but generally are based on where the benefit of the service is realized.¹⁸ In many cases, these rules converge to source the service by the location of the users.

This is all fine and good, but in an entirely digital landscape like the metaverse, how does the seller know where its customers are located in any sense? And as we discuss in the last section of this article, there are questions under the Complete Auto Transit¹⁹ test regarding sourcing to a state of the purchaser where the provider of the service may not have any connection.

Taxation of the Sale of Cryptocurrencies

Is Cryptocurrency Tax Exempt as Currency?

Many states offer a limited exemption for the sale of currency. As with all things regarding state and local taxation, the definition of currency varies widely among the states. Many, however, incorporate a requirement that currency be recognized as current or former legal tender.²⁰ Currency is defined for federal tax purposes as “the coin and paper money of the United States or of any other country that is designated as legal tender and that circulates and is customarily used and accepted as a medium of exchange in the country of issuance.”²¹

This raises the question: Are the current cryptocurrency offerings “currency” in a way that renders them exempt? Arguably, no. As of the date of publication of this article, the United States does not recognize cryptocurrency as an official form of tender.²² Because they are not official currency recognized to be used as tender in transactions, cryptocurrencies likely do not qualify for the exemption in most states.²³

There are exceptions to the rule, however. Several states have recognized digital currencies as the equivalent of cash, subject to the same exemptions from sales tax as cash. Those states are California, Kentucky, Michigan, Minnesota, Missouri, New York, New Jersey, and Wisconsin.²⁴ Four states have taken the express position that the sale or exchange of cryptocurrency is not taxable: Arkansas, Kansas, New Jersey,²⁵ and Washington.²⁶

Sale of Cryptocurrency: Is There a Taxable Sale?

Of course, evaluating whether cryptocurrencies qualify for a sales tax exemption is rather like putting the cart before the horse. What is more important is whether a taxable sale has occurred. Arguably, one has not.

Let’s take Florida for example. A sale occurs in Florida only when there has been a transfer of title or possession of TPP for consideration.²⁷ The state narrowly defines TPP to mean “personal property which may be seen, weighed, measured, or touched or is in any manner perceptible to the senses.”²⁸ The true object of a sale of bitcoin or ether is the value of the special code for the currency. The true object is not TPP, so the exchange of these forms of currency does not constitute a sale (taxable or otherwise). In states that still limit TPP to physical items, cryptocurrency falls entirely outside the scope of their sales tax laws.²⁹

As a string of digital numbers in a specific pattern, cryptocurrency is much like software. That each set of digital numbers is unique to each transaction means that, at most, cryptocurrency is custom software, which is taxable in few states.

Taxation of the Sale of NFTs

Are Sales of NFTs Taxable?

Ethereum was the first decentralized, open-source blockchain platform to allow the creation of NFTs and remains the primary facilitator of NFT marketplace transactions.³⁰ NFTs are effectively an entry (or series of entries) in the blockchain that attest to specific attributes of specified underlying assets, which may be physical, though they are most often associated with digital products, such as digital art, music, and audio-visual works. The NFT certifies that the underlying asset is unique (or of limited editions, such as prints of a great painting), authentic, and original, and that the purchaser is either the owner (exclusively, or one of an identified, limited group) of the underlying asset or has specific rights to royalties regarding the underlying asset.³¹ Because NFTs authenticate both originality and ownership rights to the underlying asset, allowing the public at large to prove provenance, they are akin to deeds.³² Indeed, the ethereum protocol that launched NFTs uses this description: “a standard interface for non-fungible tokens, also known as deeds.”³³

A good example of the sale of NFTs is the 2021 sale by the digital artist Beeple at auction of his digital collage “Everyday,” for a record-breaking sales price of $69 million. In that case, NFTs acted like a bill of sale of the underlying asset — the digital artwork — and attested to the originality and authenticity of the digital art. The certificate of authenticity of the underlying asset gave great value to the asset, although the purchaser was entitled to use of the underlying asset — the digital art.³⁴

In some circumstances, the NFT does not transfer ownership of the underlying asset — that is the right to use the asset — but instead the purchaser acquires the intangible rights to a stream of royalties without ownership of the digital asset or TPP. In those circumstances, the sale is akin to the sale or license of a trademark or other intellectual property. In turn, this will make a difference for tax consequences. For example, Colorado treats art, books, or music as taxable regardless of the method of delivery (it makes no difference whether the good is physically or electronically transferred), so the NFT may be taxable as TPP if the ownership of the underlying asset is transferred.³⁵ However, Colorado holds that “intangible personal property constituting mere rights of action and having no intrinsic value, such as . . . deeds” are excluded from the scope of TPP.³⁶

Thus, as a starting point in the analysis of the taxability of the sale of NFTs, one should determine the rights obtained by the purchaser. Does the purchaser have the right to use, or allow others to use, the underlying asset? If the purchaser obtains those rights, the taxability of the NFTs will likely turn on whether the sale of the underlying asset is taxable, with the only difference with a comparable transaction being that the payment for the NFT is typically via cryptocurrency as opposed to credit card or check. Although the NFTs provide some additional intangible rights, such as the authenticity and the originality of the item purchased, which a typical sale of digital assets and physical assets does not, the purchaser receives a number of rights and benefits — the right to use the underlying asset and the intangible rights — for one price. As discussed in the section below, a taxpayer would argue that the true object of the bundled price is the intangible rights, while the tax agency would argue that the sale is taxable based on the taxability of the underlying asset.

Is the Sale of an NFT Tied to an Underlying Digital Product Taxable?

As NFTs are most commonly associated with digital products, we begin with a discussion of the taxability of the sale of digital products. Under the SSUTA, digital products are digital works that are sold to a purchaser who has the unconditional right of permanent use, or continued use conditioned on payment, and who is the end user.³⁷ Specified digital products generally comprise digital audio-visual works, digital audio works, and digital books.³⁸ In the SSUTA states, “specified digital products” are excluded from the definition of taxable TPP and instead are adopted as a separate, unique category of products. SSUTA section 332 allows states the option to tax all “digital products” transferred electronically or to exclude one or more of the subcategories from the scope of taxable products. Under the SSUTA’s broad definitions, NFTs may be considered digital products if they convey ownership or use of the underlying product. To the extent they transmit the right to use the underlying digital asset as the purchaser sees fit, whether they will be subject to tax in those states that adopt the SSUTA (or a substantially similar) definition will depend on the NFT’s underlying asset (art, audio, video, or text) and whether that type of specified digital product is taxable in the state.

Is the Sale of an NFT a Sale of TPP?

In states where sales tax statutes do not contemplate digital products, state tax agencies may interpret existing statutory language to cover NFTs by reinterpreting the scope of the term “tangible personal property.”³⁹ This is when a detailed examination of the exact rights being transferred is key.

Consider, for example, a transaction that consists of the sale of the Kings of Leon NFT album,⁴⁰ transferred electronically with a personal license to listen to the album. This transaction is likely to be treated as the taxable sale of TPP, except in Florida, which generally does not tax the electronic transfer of property. If, on the other hand, the transaction consists of not the sale of the album but the right to future royalties each time the album is played on a streaming service,⁴¹ the transaction likely is the nontaxable sale of intangible property.

What Happens When One Purchases an NFT Together With Redemption Rights for a Physical Asset?

NFT sales can incorporate the right to redeem the purchased NFT for physical assets later. Is a sale of such an NFT a taxable transaction?

Whether the sale of an NFT that carries with it redemption rights may be considered the sale of TPP will likely turn on whether the true object of the purchaser is to acquire the physical good for which the NFT can be redeemed or to acquire the token itself. For example, in the fall of 2021, athletic retailer Adidas sold nearly 30,000 NFTs that came with the right to redeem them for (real) apparel items in 2022 “at no additional cost.”⁴² Is the purchaser’s true object a digital Adidas token (arguably not taxable)? Or the right to acquire next season’s “it” sweatshirt (taxable in all states that tax clothing)?

Is There a Bundled Transaction?

NFTs that are sold in connection with a combination of physical and digital assets likely trigger the bundled transaction rules.

A bundled transaction occurs when an item or service that is taxable is sold in the same package, for a combined price, with an item or service that is not taxable. The taxable item taints the package, rendering the entire bundle taxable. As the saying goes, one bad apple spoils the bunch. There are exceptions to the rule, which if applicable would allow the transaction to preserve its nontaxable components as nontaxable. For example, a transaction that otherwise meets the definition of a bundled transaction in an SSUTA member state will not be treated as taxable if the taxable portion of the bundle is de minimis (meaning 10 percent or less of the cost or price of the bundle).⁴³ Texas adopted a similar test, applying a lower threshold of 5 percent.⁴⁴ On the other end of the spectrum sits Chicago, which takes the position that if 50 percent or more of the bundle consists of nontaxable items, the bundle is not taxable.⁴⁵

Let’s take major fashion house Dolce & Gabbana as an example. The couturier led the fashion NFT charge when it launched a hybrid couture collection — in September 2021 in connection with fall fashion week.⁴⁶ The collection consisted of NFTs for digital couture (four pieces) alongside some actual couture (five pieces, each of which also came with a digital version).⁴⁷ When we talk about NFTs entitling the purchaser to both digital and physical assets, the question becomes: Which component is more valuable? And when we talk about digital assets that do not have a ready physical corollary, how do you value each component?

Are Auction Houses Marketplace Facilitators?

With 2021 NFT sales exceeding $25 billion, traditional auction houses clamored to answer the call by establishing NFT-specialized platforms to facilitate these less-traditional transactions. By virtue of setting up these online auctions, should the auction houses be considered marketplace facilitators?

While state definitions of marketplace facilitator vary, the SSUTA’s definition indicates that a marketplace facilitator is generally “a business or person who owns, operates or otherwise controls a physical or electronic marketplace and facilitates the sale of a third-party Seller’s products . . . either directly or indirectly through contracts, agreements, or other arrangements with third parties, collect[ing] the payment from the purchaser and transmit[ting] all or part of the payment to the Seller.”⁴⁸

Under this definition, NFT marketplaces will likely be classified as marketplace facilitators if they involve the transfer of ownership of the underlying asset. Auction houses operate and control electronic marketplaces that facilitate the sale of NFTs, which grant the purchaser varying intangible rights to original digital art, audio, text, or audio-visual assets. The auction houses also collect payment from their purchasers and transmit that payment (less, of course, their fees and commission) to the seller. Recently, several states have amended their statutes to define an NFT marketplace as a marketplace facilitator.⁴⁹ In contrast, Illinois, a state that is not a member of the SSUTA, amended its definition of marketplace facilitator to exclude internet auction houses.⁵⁰

But whether an auction house is a marketplace facilitator raises the question of which state law governs that determination. Certainly, the state where the auction house is located has jurisdiction to impose sales tax obligations on the marketplace facilitator. But just as the sellers of cryptocurrencies or NFTs have good arguments that they are not subject to the laws of another state, so too would auction houses be able to argue that the only state that can constitutionally assess collection obligations on them is their home state. For example, an auction house located in Delaware or Oregon could well argue that it has no sales tax collection obligations because those states do not impose sales taxes. Every auction house should review its state’s marketplace laws to determine its obligations to collect the sales tax of that state.

Underlying the discussion of whether an NFT marketplace is obligated to collect sales taxes is whether the NFT is subject to tax in the first place, a debatable proposition.

Limitations on States’ Rights to Tax Sales Involving Blockchain Technologies

In blockchain transactions, anonymity is king.⁵¹ Unlike a credit card transaction, in which the seller obtains the credit card holder’s billing address, the seller in blockchain transactions does not learn the purchaser’s address. Nor does the seller have the purchaser’s email address, from which the seller can determine an approximate location. Indeed, in most circumstances, the seller does not know the name of the purchaser.⁵² Instead, the seller transfers the NFT to the purchaser’s digital wallet address,⁵³ a feature designed within blockchain communities to make breaking anonymity as difficult as possible.⁵⁴

What then is the seller’s obligation to collect and remit sales tax based on the law of any jurisdiction other than its own home state? As a matter of constitutional law, the first prong of the Complete Auto Transit test — the activity has a substantial nexus with the taxing state — is not satisfied. The first prong requires that the “taxpayer avails itself of the substantial privilege of carrying on business in that jurisdiction.”⁵⁵ Similarly, as the Miller Brothers Court wrote, the due process clause requires that there be “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”⁵⁶ Just as in Miller Brothers, in an anonymous blockchain transaction any state other than the seller’s home state lacks the nexus to impose tax on the transaction.

Unlike in a standard online transaction, in blockchain transactions there are real limitations on the purchaser’s home state imposing any obligation to collect and remit sales tax on the seller. Of course, the state where the purchaser is located may be able to impose use tax on the purchaser, but just as it is difficult for states to enforce use tax obligations on purchasers under ordinary circumstances, it will be even more difficult for states to do so regarding blockchain transactions for which anonymity is rampant. There may also be real limitations on the state where the seller is located to impose sales tax obligations, including exemptions under the state law for sales made that are intended for use outside the state.

Conclusion

Blockchain technology is rapidly changing the technological landscape as companies look to take advantage of the verified, authentic, and unique characteristics of blockchain. States, for now, are playing catch-up. With an economic landscape worth trillions of dollars, one can only wonder how much longer it will be before states attempt to get in on the action.