In 2021, Collins Dictionary declared NFT its word of the year, recognizing it as the year that saw the viral photo behind the 2005 Disaster Girl meme sell for over £350,000. NFT is a term used to describe a non-fungible token, but what exactly are NFTs, and how well-equipped is the UK legal framework to deal with their complexity and growing popularity?
What exactly is an NFT?
A crypto asset is an NFT. Cryptocurrencies are digital representations of value or rights (just as a banknote is a paper representation of money).
A cryptocurrency is a token that conveys value, such as bitcoin, which can be sold for fiat currency or exchanged for goods or services. It’s also fungible, in the sense that it’s not unique – one bitcoin may be substituted with another.
A non-fungible token is a digital description of unique rights. When a collector purchases an NFT that is a digital work of art, they are buying the ownership rights to the artwork to which the NFT relates. Their rights are recorded on the blockchain using distributed ledger technology (see our guide for more information). This is made possible by the use of NFTs in tracking the origin of digital content, such as music or videos, although the technology may also be used to track real assets.
It might be tough to make sense of technical jargon and, as is the case with all things crypto, a more tangible example can be beneficial. The Land Register in the United Kingdom keeps track of land ownership and any rights connected with it. It’s conceivable to produce NFTs that represent real estate in theory. A smart contract would be created as a certificate of ownership for a given piece of property by minting an NFT representing ownership of the land. The owner of the NFT gives it to someone who will become the property’s owner and has their ownership recorded on the blockchain rather than the Land Register. It’s possible that in the future, smart contracts may be used to create land-related NFTs that mimic aspects of the existing real estate transaction process.
An NFT, as it is one-of-a-kind and stored on the blockchain, allows the owner to demonstrate ownership of their property in a secure and safe manner. It isn’t without risk, though. While the NFT will be permanently stored on the blockchain, the entity for which it provides proof of ownership might be deleted (if it is digital and exists elsewhere on the net), burn down (if it is property), In the event of a security breach, funds in their native currency may be lost. Purchasers of NFTs must also understand what they are purchasing. While the buyer of an NFT has rights to the piece of technology that supports it, this does not always include the copyright or intellectual property rights pertaining to the underlying asset (which can frequently stay with the creator). Owners of NFTs have the option to receive royalties every time an NFT is sold from person to person by adding the creator’s address as part of the NFT’s metadata.
Find out more about where NFTs go next
How are NFTs taxed?
Bitcoins and other cryptocurrencies can be bought and sold, as can NFTs. However, in the UK tax consequences of doing so, the UK is not alone in lacking specific legislation and, as yet, only limited practical advice to assist taxpayers.
NFTs are expected to be taxed in the same way as other cryptoassets such as digital currency, although HMRC has not ruled on this. If this assumption is correct, taxation would be determined by what is done with the NFTs. If a person receives an NFT in return for providing a service, this NFT would most likely be regarded as taxable income earned from the activity. A business that transacts in NFTs and trades them for cash is considered to be receiving taxable trading profits (and taxed accordingly). Income tax is also levied on the trade profit from selling an NFT produced by a professional artist.
When an NFT is sold from one person to another, it may be required to pay royalties to its creators. Although this is still an emerging area, it’s likely that such payments will be taxed in accordance with the usual rules for royalties (i.e., if they don’t qualify as trading income according to other rules).
Gains from the sale of NFTs will be subject to capital gains tax if income tax does not apply. HMRC’s recently updated crypto-assets manual is expressly dedicated to NFTs. “Non-Fungible Tokens…are separately identifiable and so are not pooled,” according to the IRS (meaning they should be valued as individual assets for capital gains tax purposes). The calculation of a capital gain or loss on the sale of an NFT is presumably straightforward: simply compare the proceeds received on disposal to the cost incurred in obtaining it.
Where are NFTs situated?
One of the most difficult challenges surrounding all cryptocurrency assets, including NFTs, is their position or “situs.”
In the United Kingdom, it is a safe bet to assume that an NFT will be a taxable asset for inheritance and capital gains tax purposes. At present, HMRC’s guidance focuses more on “exchange tokens” such as bitcoin, but NFTs are not specifically defined as a distinct class. However, HMRC’s statement suggests that the site of NFTs for capital gains tax purposes will be determined according to the asset to which they give ownership.
That would imply that the NFT would be located where the asset is physical, as opposed to where ownership of a non-digital asset (such as land in our example above) is assigned.
However, when there is no underlying asset (which may be the case if the NFT is a right to services, for example) or the underlying asset itself is digital, as digital art, things get a lot more complicated. If that’s the case, we expect HMRC to consider the NFT to be situated in the United Kingdom where the beneficial owner is a tax resident.
This would conform to HMRC’s current policy on cryptocurrencies, such as bitcoin, and would not be without dispute. There is no clear legal basis for cryptoassets being located where their owner is domiciled, and it contradicts two judgments by the courts that the location of a cryptoasset is where the owner is domiciled. (see Fetch.ai Ltd v Persons Unknown [2021] EWHC 2254 and the unreported 2020 case of Ion Science v Persons Unknown). The Society of Trust and Estate Practitioners has also issued a guidance note, which states that the location of cryptoassets is not just vital for UK tax purposes, but it’s also essential for succession and foundation.
This is a question that will be answered over time. HMRC’s position on this contentious issue may change as the court case progresses. The issue will undoubtedly be discussed in court, and further advice will follow. Meanwhile, UK non-resident non-UK domiciliaries should seek specialist advice on their possible tax exposure as a result of their ownership of NFTs and other cryptocurrencies.
What happens to your NFTs when you die?
One that we will compose, but this section provides a quick overview of the law and practice surrounding how cryptoassets are handled when their owner passes away.
NFTs can be included in the estate of a person who died intestate and are inherited by the persons named in their will or intestacy rules. NFT property is clearly property.
The problems that arise are mostly practical in nature. The first question is how the executors or heirs of a person who owned an NFT will know about it. There is no single database of NFTs, so it’s reasonable to expect the owner will have to inform at least one person who could be trusted to outlive them about their NFTs and where they are.
The second problem that is likely to be encountered is how do executors or heirs get access to an NFT so that they can sell it or pass it on to the person to whom it has been bequeathed.
NFTs are generally kept in wallets connected to the internet (i.e. hot) or offline (cold – usually hardware-based), just like other cryptoassets. A password will always be required to access the wallet, therefore the NFT, so whatever wallet is used. To access the NFT, executors or heirs must be informed of the password, or how to get there. This entails security risks that may be reduced.
In a nutshell, owners of NFTs must take great care in their lifetime to make sure that they are accessible and can be passed on to designated beneficiaries when the time comes.