Non-Fungible and Non-Classifiable? What Lawyers and Accountants Should Know about NFTs

By Małgorzata Kociszewska, Penteris

The world of new tech and computing has gone mad for nonfungible tokens (NFT). But is it just another technological innovation, albeit created in 2015, or a natural consequence of the development and spread of the virtual world? Unlike virtual currencies, non-fungible tokens are, as the name suggests, non-fungible, i.e., non-exchangeable, meaning that they represent a unique record of a string of code in the digital ledger, within blockchain technology.

NFT has taken a particular liking to the intellectual property industry, with these tokens making it possible to trade in virtual works of art. For example, in March 2021, the NFT containing the “Everydays” art collage series of 5,000 images by Mike Winkelmann, aka Beeple, was sold by Christies for over USD 69 million making it the fourth most expensive piece of art by a living artist and the most expensive NFT ever. Payment was made in Ether as part of the Ethereum cryptocurrency, the most actively used blockchain.

NFT can not only secure virtual works, but also invisible ones. Italian artist Salvatore Garau created an invisible sculpture called “I Am” which sold for USD 18,300. The creator refers to a “space full of energy” and the use of zero-emission technology. Although the sculpture is not visible (“immaterial” as the artist states), Garau sent the buyer its specifications, indicating that the sculpture requires 150 cm by 150 cm of free space, which will be filled with energy.

NFT auctions are also used for charitable purposes. Twitter founder Jack Dorsey’s first-ever tweet (“just setting up my twttr”) was sold for the equivalent of USD 2.9 million and donated to African charity GiveDirectly.

NFT: What Are the Risks?

First, NFT has not yet been legally regulated. There are no EU regulations or guidelines introduced so far. NFT does not qualify as a virtual currency due to its unique nature (nonconvertibility). In most jurisdictions, virtual currencies are more or less regulated. In Poland, for example, the Anti-Money Laundering (AML) and Countering the Financing of Terrorism Act qualifies virtual currencies as property values and also includes a definition of virtual currency itself. According to this definition, a virtual currency is primarily characterised by its exchangeability in economic transactions. Similarly, in Germany, as of January 2020, the majority of transferable tokens can be qualified as cryptoassets and therefore as financial instruments pursuant to the German Banking Act, as long as they serve as an alternative means of payment or as an investment vehicle. NFTs are not units of account pursuant to the German Banking Act, but might be considered a cryptoasset in specific cases (mostly when the NFT bearer pays for the asset, but never uses the tokenised object or takes possession of it).

There are no EU regulations or guidelines introduced so far. However, on 24 September 2020, the European Commission adopted a digital finance package that includes a legislative proposal for the regulation of cryptoassets: the Markets in Cryptoassets Regulation. The proposal includes regulations that would apply to NFTs in certain cases and, for the first time in the EU, defines a cryptoasset as a “digital representation of value or rights which may be transferred and stored electronically, using distributed ledger technology or similar technology”. The proposal is expected to be implemented within the next four years as an EU Regulation, which applies directly in all EU member states.

In India, the legal situation is unclear. While Indian lawyers consider NFTs as derivatives, the current regulations relate only to financial instruments such as stocks or commodities. Therefore, it is legal only to trade derivatives on authorised exchanges and there is no legal framework for a derivative value for a non-financial asset.

It is also diffcult to talk about the transfer of an author’s economic rights in the case of NFT. In some jurisdictions (including Poland), the transfer of an author’s rights requires a written form in order to be valid. Using a certified electronic signature might be possible but not all certificates are recognised in all jurisdictions, so things begin to get complicated when, for example, signing a simple smart contract. Most commonly in NFT transactions, copyright is not mentioned at all, so in those cases there is no possibility that copyrights transfer upon the acquisition of an NFT. Owning an NFT by itself does not grant the right to print or distribute the work without the copyright holder’s permission.

What happens if the NFT is made without the authorisation of the copyright holder? This constitutes an infringement of copyright, and the author/s may apply for the NFT to be removed from the market. If such piece of a work is taken down for copyright infringement or if the relevant copy is deleted for any reason, the link to the NFT can be broken, and the NFT may represent proof of ownership of a copy that no longer exists.

NFT: How Can it Be Classified?

If the trend for non-fungible tokens continues – and it looks very likely that it will – regulations will eventually emerge in this area. In the meantime, lawyers and accountants must adopt interpretations of existing legal constructs to protect their clients. It would be useful to begin a discussion as to the legal classification of NFT: is it a property right on an intangible good? Or is it some kind of stamp of legalisation? Or perhaps a receivable? Derivative? Most of all, NFTs are just tokens that represent an asset, completely separate from the assets themselves. Therefore, I would opt for a specific kind of property right on an intangible good, but EU regulations shall dispel doubts while classifying NFTs as cryptoassets.

NFT trading should also be taxable. The consequence of recognising NFTs as property rights is to include the revenue from trading as a source of revenue from property rights. If the nature of NFTs as property rights is questioned, in principle, the revenue (income) from trading in them would qualify as other sources of income. NFTs might also be traded as part of a non-agricultural business activity (and then, for example, might benefit from a flat tax rate), provided that the activity of trading in NFTs has certain features inherent to a business activity (organisation, continuity, profit-making character).

Trading in cryptocurrencies is exempt from VAT, with the consequence that the taxpayer is not entitled to deduct VAT on goods and services purchased in connection with this activity. Would the analogous exemption apply to NFT trading? It is diffcult to say because in this case, on the one hand, the legal qualification of NFT is necessary and, on the other hand, there may be a variety of scenarios of transactions, including the sale of works with an NFT by artists themselves.

NFT: In Conclusion

Until specific regulations are introduced, for example, at the EU or national level, NFT transactions should be classified as highrisk transactions, both in terms of tax and AML regulations.

NFT market participants should consult with their advisers to understand the potential risk of the transaction and the impact of existing and upcoming regulations. In particular, we should consider whether current anti-money laundering policies require any updates. It is also worth paying attention to the fact that transactions should be concluded through recognised NFT auction platforms because the recognisable ones have introduced security measures in order to ensure the safety of transactions.


Małgorzata Kociszewska

Małgorzata Kociszewska

GGI member firm
Penteris
Law Firm Services
Warsaw, Poland
T: +48 22 257 83 00
E: This email address is being protected from spambots. You need JavaScript enabled to view it.
W: penteris.com

Penteris is a European law firm combining in-depth expertise, robust advice, and a pan-regional reach. We are committed to keeping clients ahead of the market with hard skills, legal acumen, and service-minded know-how.

Małgorzata focuses on the legal aspects of new tech and digital solutions, advising everything from start-ups to well-recognized organizations. Her interests also include the regulated market, cryptocurrencies, gaming and gambling.


Published: GGI Insider, No. 114,July 2021 l Photo: denisismagilov - stock.adobe.com

GGI member firm
Penteris
Law Firm Services
Warsaw, Poland
W: penteris.com
Małgorzata Kociszewska
E: malgorzata.kociszewska
@penteris.com

 

 

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