How should states tax NFT sales?

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On July 1, 2022, the Washington State Department of Revenue released an interim statement on how sales tax applies to non-fungible tokens, or NFTs. Washington is one of the few states to tackle the imposition of NFTs, and it is starting to emerge as a leader in the field.

This is pretty much uncharted territory.

What is an NFT?

NFTs were born out of the blockchain, a “decentralized peer-to-peer network that sits on top of the internet.” Blockchain emerged in October 2008 during the Great Recession, when trust in traditional financial processes was wavering. Bitcoin, a virtual currency that represents “the first application of blockchain technology”, was introduced in 2009.

The first topic addressed by the Washington State Department of Revenue (DOR) in its interim statement is to provide what it calls “functional descriptions” for terms not fungible, tokenand non-fungible token. These terms and the technologies they represent are so new that they do not yet have state-codified definitions.

According to the DOR:

Not fungible means not capable of being exchanged, so that something which is not fungible cannot be copied, subdivided or replaced. In contrast, something “fungible” is a commodity, money, or anything else that is replaceable in equal shares in payment for the settlement of a debt or an account.

A token is a digital unit supported by a blockchain.

A non-fungible token is a unique numeric identifier that cannot be copied, subdivided or replaced; it is recorded in a blockchain and used to certify authenticity and ownership. An NFT is not a cryptocurrency, which is fungible; similarly, cryptocurrency is not an NFT.

An NFT can be bought and sold as a standalone item, for lack of a better term. Or, the sale of an NFT may allow the buyer to receive products or services such as:

  • Digital products (artwork, music, video games or video works)
  • Admissions to events (tickets for concerts, clubs or sporting events)
  • Food or drink prepared in a restaurant or club
  • Tangible personal property (clothing, collectibles)

For example, a company sells golf club and country club memberships through NFT to allow for more fractious usage and heritability. A private dining club in New York sells memberships through NFT. And in the world of fashion, NFTs are increasingly tied to physical objects.

It should be noted that the Interim Statement functionally describes NFTs as a digital code. Most states have yet to do so, casting doubt on the taxation of NFTs. David Lingerfelt, senior director of North America tax content at Avalara, wants states to clearly define NFTs the way Washington currently does. “Failure to do so invites tax controversy that is costly and time-consuming,” he says.

Is the sale of an NFT subject to sales tax?

There is no single answer to this question because taxation depends on several factors: what is included in the transaction, the taxation of each component and the identity of the buyer and seller.

The DOR identified four basic types of NFT transactions and provided guidance on sales tax:

  • 1. The object of the purchase is a stand-alone digital product (the NFT itself), such as a work of art, an autograph or video clips. Sales tax generally applies to retail sales of digital goods in Washington, so the sale of a standalone NFT would be taxable.
    • a. Retail and Occupation (B&O) tax also applies.
  • 2. The object of purchase is a stand-alone good or service, not the NFT itself. Retail sales of goods or services are generally subject to Washington sales tax, so this transaction would generally be taxable.
    • a. Retail and Occupation (B&O) tax also applies.
  • 3. The object of purchase is a stand-alone good or service that is not classified as retail, not the NFT itself. Washington sales tax generally does not apply to sales of goods or services not defined as retail sales, so the transaction would not be taxable.
    • a. B&O tax, use tax or other excise tax may apply.
  • 4. The sale of an NFT includes the payment of a royalty to the creator of the NFT or to another party who resells the right to the royalties for the future sale or distribution of the NFT. Royalty payments are not subject to Washington sales tax.
    • a. The B&O tax applies to gross royalty income.

How to tax bundled transactions that include an NFT

While some people are undoubtedly happy with buying a standalone NFT, the DOR expects that many NFT sales will be mixed or bundled transactions. And determining the taxation of any type of bundled transaction can be like untangling a knot: you have to follow different threads to get to the end.

First, the seller must determine whether the sale is, in fact, a bundled transaction (i.e., it is a retail sale of two or more products, the products are otherwise separate and identifiable, and that the products are sold at a non-detailed price).

Second, the seller must determine whether sales tax applies to each good or service included in the sale. Bulk transactions are generally subject to both Washington sales tax and B&O retail sales tax, but there may be exceptions to this rule.

How do you source the sale of an NFT?

In order to determine the rate of sales tax to apply to the sale of an NFT, you need to know where the sale originated. Supply-by-destination rules base sales tax on where the consumer takes possession of an item or receives a service. Origin sourcing rules base sales tax on where the sale is made (i.e., the location of the seller). Learn more about destination and origin provisioning.

Sourcing the sale of tangible personal property can be tricky, but there’s nothing about sourcing the sale of a digital product like an NFT. As a member of the Streamlined Sales Tax (SST), Washington State is obligated to follow the SST Procurement Hierarchy. But SST has yet to specify how to source NFTs, and until it does, SST member states like Washington are on their own. “It has happened in the past that the first state has to reconsider its position if another ESS member state develops a different policy, and the ESS, as arbiter, decides that the other state’s position is more accurate . once SST takes a stand,” says Scott Peterson, vice president of government relations at Avalara and first executive director of the SST board of directors.

For now, Washington applies SST’s sourcing rules for digital products to NFTs:

  1. Origin supply is used when the digital product is received by the buyer at the seller’s place of business.
  2. Destination procurement is used when receiving does not occur at the seller’s business location.
  3. If not 1 or 2, the sale is coming from the buyer’s address from the seller’s business records.
  4. If not 1-3, the sale takes place at the location indicated by an address for the buyer” obtained during the making of the sale, including the address of the primary payment instrument of the ‘Buyer”.
  5. If not 1-4, or if Seller does not have sufficient information to enforce any of these provisions, venue is determined by the address from which the digital code was originally available to transmission by the seller, or from which the digital machine service (or other service which is a retail sale) was provided. In other words, the original supply is used.

It is necessary to specify all options due to the intangible nature of digital products. A seller does not need a physical address to complete the sale and delivery, and therefore the address may not be obtained.

“To properly find a state sale, you need at least the five-digit ZIP code, which is often all the credit card needs,” says Peterson. “That then translates into credit card rules that decide how precisely retailers collect local sales tax. This is not an ideal situation.

Washington’s interim statement regarding taxation of non-fungible tokens is a good read. The department clearly identifies relevant issues and provides excellent examples to bring each scenario to life. Businesses are encouraged to contact the department for guidance in the event that the facts and circumstances of their business activities are not addressed in the statement.

Pennsylvania and Puerto Rico are also working to clarify how sales tax applies to NFTs. In February 2022, Puerto Rico’s Treasury Department proposed adding NFTs to the list of taxable digital products. A few months later, the Pennsylvania Department of Revenue updated Rev-717 to clarify that non-fungible tokens are taxable. The Multistate Tax Commission and the Simplified Sales Tax Board of Directors are also working to determine how best to classify NFTs for sales tax purposes.

To date, Washington’s guidance is the strongest. NFT sales described as taxable in the interim return should be deemed taxable as of July 1, 2022.

Learn more about the mysterious nature of NFTs and the metaverse:
Taxing the metaverse: the basics
Selling goods in a virtual world can have real tax implications
Will there be a sales tax holiday in the Metaverse?

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