Introduction
While the majority of states have not provided indirect tax guidance specifically on non-fungible token (NFT) transactions, a lack of guidance should not be construed as a nontaxable position. The underlying representation of what the NFT represents will generally guide the taxability determination. With time, some states will publish NFT guidance, some states will expand the tax base, and others will remain silent. There are other various issues in the digital asset world that are not addressed in this document that also merit other discussions, such as the applicability of resale certificates, sales to nonprofits, and mining cryptocurrency. The various parties in cryptocurrency and NFT transactions should closely examine these transactions to understand any potential tax obligations. Companies may have to consider changing fundamental components of their business operations and strategy, such as data collection and the interaction with other parties in these types of transactions.
Background
Within the past decade, states have recognized the trend of the expanding technology industry, which allowed consumers to purchase goods online. Historically, sales tax was imposed on just the sale of tangible personal property. These sales tax statutes were crafted many decades ago when purchasing goods online was unfathomable. However, instead of purchasing an album at a record store, a consumer can now pay a subscription charge for access to music over the internet. Instead of purchasing or renting a DVD from a store, a consumer may now buy that same movie online and access it via an application.
While some states, such as Washington, were at the forefront of drafting legislation for taxing digital products, other states took notice and slowly attempted to expand the taxable base. The speed in which technology advanced led to many state legislatures falling behind in updating their now archaic statutory framework regarding digital products. State legislatures are often limited in having to compromise on law with different political parties, and that’s compounded by a relatively short legislative session to pass new laws. State legislatures are attentive to the public perception of new or increased taxes. These opposing factors have caused ambiguity in the application of archaic statutory/regulatory rules to new technological products and services. For states that were successful in expanding the tax base, most statutory language essentially focused on the method of delivery of the purchase, e.g., streaming music versus purchasing an album at a record store.
Over the last decade, a new technology emerged termed “blockchain technology,” which allowed a peer-to-peer decentralized network to record transactions and store certain assets. The creation of blockchain technology led to the creation of digital assets such as cryptocurrency and NFTs. Although various cryptocurrencies and NFTs (collectively known as digital assets) have emerged since the creation of the underlying blockchain technology, the mainstream adoption of these digital assets would not take place for several years.
Blockchain technology, in a broad stroke, involves several issues that are critical in the application of sales and use taxes:
- How the digital assets are used,
- How digital assets are sourced, and
- Whether cryptocurrencies are considered a collectible or currency.
Many things have yet to be determined with digital assets. The biggest question is the role digital assets will have within the economy, which may ultimately impact states’ taxation posture. One thing is clear—digital assets are here to stay, at least for now. Without applicable statutory or regulatory guidance, the indirect taxation of digital assets will be a challenging space for both taxpayers and states.
Sales & Use Tax Implications When Using Digital Assets
As society keeps finding more ways to use digital assets, the application of sales and use tax laws can vary by how digital assets are used and by state. Some retailers may allow a consumer to purchase a tangible good or service with certain eligible cryptocurrency. A consumer also can purchase an NFT using cryptocurrency. Although beyond this article’s scope, these are various types of cryptocurrencies that have stark differences in use. Some cryptocurrencies, e.g., Bitcoin, are intended to store or transfer value, just like money. Alternatively, other cryptocurrencies, e.g., Ethereum, have uses that far exceed just storing or transferring value. The resulting sales and use tax treatment varies with each of these examples, with unique issues arising that are discussed below.
Retail Purchase of Tangible Goods or Services
The retail purchase of tangible goods or services using cryptocurrency, once a phenomenon, is now facilitated by one of the largest payment processors in the world. Prominent payment processor Visa stated in a quarterly earnings report that retail customers made $2.5 billion in payments using their crypto-linked cards during Q1 2022 alone. The use of cryptocurrency as payment, instead of cash or cash equivalents, would generally be subject to sales tax so long as the underlying purchase would have been taxable in the first place. Most states’ statutory framework provide that the measure of tax is based on the consideration provided to effectuate the purchase.
Some states, such as Michigan1, New Jersey2, and New York3 impose additional record-keeping requirements on retailers accepting cryptocurrency. In addition to complying with the other various registration and record-keeping requirements under the traditional sales and use tax model, requirements for retailers accepting cryptocurrency can include recording the value of the convertible digital currency accepted at the time of each transaction, converted to U.S. dollars.
Purchasing an NFT
Since the creation of the first NFT in 2014, NFTs have hit the mainstream market and soared in popularity. That popularity reached new heights in 2021 when Vignesh Sundaresan set a record by purchasing an NFT titled “Everydays: The First 5000 Days” for more than $69 million.4 One may ask, what exactly did Vignesh purchase for $69 million? It was an image of the “Everydays” NFT available to view at OpenSea.io.
The “Everydays” NFT creates a record on the blockchain that verifies its authenticity and validates who currently owns it. The purchase of an NFT essentially proves that you’re the owner of the original copy of a digital file.
As NFTs usually digitally represent art, movies, music, and more, there are approximately 30 states that have enacted sales and use tax laws that expressly tax “digital products.” The definition of digital products varies state by state, as well as the taxability treatment of particular digital products within particular states.
One of the fundamental issues with taxing NFTs as digital assets is determining what set of jurisdictional rules apply in the transaction, which is commonly referred to as “sourcing” a transaction. The sourcing of a transaction is one of the paramount components in the determination of sales and use tax. Traditional sales and use tax rules base the calculation of sales and use tax upon the purchaser’s ship-to location. As the purchaser’s identity and ship-to location aren’t always known in an NFT transaction, sourcing these transactions can lead to more questions than answers. Although each state has different ways to approach sourcing issues, a common theme is generally present:
- Use the ship-to address of the purchaser if known; if not,
- Use the billing address of the purchaser if known; if not,
- Use the address of the seller.
In July 2022, Washington became the first state that issued NFT-specific guidance for sourcing and paying sales and use tax.5 The interim statement issued by the Washington Department of Revenue clarified that NFTs are already subject to the retail sales tax and business and occupation tax. To solve the sourcing issue that relates to digital products, e.g., NFTs, Washington provided a five-part hierarchy test to follow, summarized below:
- At the place of business if the sale happens there.6
- Where the purchaser takes delivery.7
- Any purchaser address.8
- Any address obtained by the purchaser during the transaction, including the address of a purchaser’s payment instrument.9
- The address from which the digital code was first available for transmission by the seller, or from which the digital automated service or other service was provided.10
For those familiar with sales tax sourcing rules, the tests above are similar to other sourcing tests for physical assets. The only major change is the addition of the last step in the hierarchy.
While the sourcing above can hold true for peer-to-peer sales, it can become more complicated when an online marketplace or platform is involved. The online marketplaces can connect NFT purchasers and sellers to transact on their platform, similar to the way eBay connects purchasers and sellers of tangible property. Depending on the site, the online marketplace may perform various activities such as facilitating the transaction or processing the cryptocurrency payment between the purchaser and seller for a commission. Marketplaces performing these types of activities could be viewed as “marketplace facilitators.” The specific definition of a marketplace facilitator can vary from state to state, but the term was originally created to require large online marketplaces such as Amazon, Etsy, and eBay to charge, collect, and remit sales tax on behalf of millions of marketplace sellers.
In relation to NFTs, crypto marketplace facilitators have historically not collected the required information to determine the location of purchasers and sellers or to determine the tax classification of the NFT. The IRS has recently begun to crack down on certain marketplaces and exchanges to enforce certain identification requirements for individuals who receive more than $10,000 of digital assets. However, even if the marketplace does not charge, collect, and remit the tax to the appropriate taxing jurisdiction, the tax liability owed to the state is not extinguished. In general, the purchaser and the seller are jointly and severally liable for the tax owed to the state. The parties transacting NFTs through marketplace facilitators should closely examine their sales and use tax obligations. Much like the IRS crackdown on income received from cryptocurrency trading, states will find new ways to generate additional revenue in an increasingly digital age.
Conclusion
Many states were already taxing digital assets or specifically identified them in their code or regulations. With the rise in popularity of NFTs, states, led by Washington, have added NFTs to the definition of digital assets and have come up with ways to source the transaction for sales tax purposes. We expect many states to look at taxing NFT transactions to increase their tax base over the next couple of years. With the ever-changing landscape of digital asset taxation, FORVIS can assist. The State & Local Tax Practice at FORVIS has a team of professionals specializing in indirect taxation issues that face the digital asset industry. If you have any questions or need assistance, please reach out to a professional at FORVIS or submit the Contact Us form below.
- 1Michigan: Treasury Update Volume 1, Issue 1, November 1, 2015
- 2New Jersey: Technical Advisory Memorandum 2015-1(R), March 18, 2022
- 3New York: TSB-M-14(5)C, (7)I, (17)S, December 5, 2014
- 4Scott Reyburn, “JPG File Sells for $69 Million, as ‘NFT Mania’ Gathers Pace,” The New York Times, March 11, 2021.
- 5Washington: Interim statement regarding the taxability of non-fungible tokens (NFTs), July 1, 2022
- 6RCW 82.32.730(1)(a)
- 7RCW 82.32.730(1)(b)
- 8RCW 82.32.730(1)(c)
- 9 RCW 82.32.730(1)(d)
- 10 RCW 82.32.730(1)(e)