State Tax Considerations for NFTs
Amid the rise of non-fungible tokens (NFTs), state tax laws are grappling with these new digital assets. In last year’s Marcum year-end tax guide, we delved into the trend of states expanding their sales and use tax bases to include digital products like NFTs. This year, our focus shifts to the potential tax strategies related to those digital assets, primarily from a sales/use and gross receipts tax viewpoint. But caution remains paramount: As the NFT landscape evolves, so does the uncertainty over its state tax implications. Notably, while Mattel’s recent venture into NFT-linked tangible products like Barbie and Hot Wheels may serve as an innovative marketing blueprint, it also spotlights the intricate tax questions that arise from the blend of tangible and intangible assets.
Over the last year, while the NFT market has slowed, some businesses have introduced NFTs as service or product offerings. For example, Mattel markets both Barbie and Hot Wheels collectible NFTs in conjunction with tangible product sales. Typically, a consumer will purchase a Mattel NFT at launch and, shortly thereafter, be entitled to claim a time-sensitive “air drop,” allowing them to redeem a physical form of the NFT purchased. While this may be a great marketing strategy to boost physical product sales, the intangible NFT sometimes continues to appreciate.
For sales and use tax purposes, numerous questions around tax implications remain unanswered. The two primary issues sellers and taxing authorities face in the NFT space are (1) taxability and (2) sourcing. In the Mattel example, several questions arise from a taxability perspective, “is the consumer purchasing a collectible digital asset, tangible personal property, or both?” For sourcing purposes, it’s also important to ask, “Is tax assessed at the purchaser’s location, where the physical air drop will be shipped, the retailer’s physical location, or somewhere else?” As with nearly all aspects of state and local taxation, the answer is, “It depends.”
Washington’s guidance is the most robust among states that have issued guidance on the sales and use tax implications of NFTs. Washington generally imposes a sales or use tax on certain digital goods, and many NFTs are likely subject to the state’s tax. The state’s guidance indicates that if the NFT confers certain rights or benefits, the true object of the sale will determine whether a tax applies. Traditionally, the true object test comes into play in the case of the sale of a service or intangible that incidentally includes some tangible personal property. Under the true object test, the purchaser’s intent (whether the purchaser intended to receive a service or to acquire tangible personal property) typically controls the classification of the underlying sale. Unfortunately, this standard is much more challenging to assess in the digital asset space. Some consumers purchase NFTs as collectibles or investments and may ignore any potential underlying benefit or rights the NFT may confer. In contrast, others simply want the underlying benefit or rights. Due to this subjectiveness, should the retailer decide what the true object of the transaction is? This is another of the many unanswered questions that taxpayers and taxing authorities will need to address.
In the case of transactions that are considered bundled transactions, generally defined as a transaction that includes both taxable and nontaxable elements, the entire transaction is generally deemed taxable if the sales contract or invoice does not clearly separate or clearly state the sales price of each element. For some marketers of NFTs, this could be a trap for the unwary. Accordingly, prudent tax planning and a risk assessment should always be conducted before adopting NFT technology.
From a sourcing perspective, many blockchain transactions (NFTs included) are often decentralized. In other words, the seller’s identity is not required or disclosed to the buyer, and the buyer’s identity is not required or disclosed to the seller. This clearly creates a sales and use tax nightmare for all parties involved and makes it difficult for state taxing authorities to enforce their state laws. In the case of Washington, based on the interim guidance available, cascading rules apply with the final rule requiring sales to be sourced to the state where the seller’s servers are located when insufficient information is available to ascertain the purchaser’s location.
While many questions and uncertainties remain unanswered in the NFT space, a tax professional can help taxpayers take advantage of these uncertainties through tax planning. Consider the following examples:
Example 1: A Washington-based concert hall generates approximately $10 million in annual sales. It is subject to a B&O tax under the “Service & other activities” classification and is taxed at 1.75%. Its annual B&O tax liability is calculated to be $175,000. For sales tax purposes, ticket sales are subject to sales tax.
Example 2: Same facts as Example 1 except that the company’s sales are now exclusively sold via a bundled NFT package that includes ownership of a digital code (digital music) plus one admission to a concert performance. The $10 million in NFT package sales are taxed under the “Retailing” classification at .471%. The annual B&O tax liability is calculated to be $47,100. By implementing NFT technology into the business, the taxpayer will save $127,900 for the taxable year. For sales tax purposes, NFT sales are subject to sales tax as taxable digital goods.
Example 3: Same facts as Example 2 except that 10% of the NFT package sales ($1 million) occur at a cryptocurrency convention held in Las Vegas. Because the B&O tax is calculated using market sourcing rules, a bifurcation between the NFT and the admission tickets should be done to estimate the portion attributable to Washington. Assuming the admission ticket is estimated at 70% of the NFT package sales price, 30% will be sourced outside Washington (where the NFT package sales took place). The annual B&O tax liability is calculated to be $45,687. Additionally, following Washington’s interim guidance, the sales transactions in Nevada will neither be subject to Washington sales tax nor Nevada sales tax, as Nevada does not tax digital goods.
Example 4: To promote its business during a cryptocurrency conference, a Seattle-based hotel offers NFT packages for sale. The NFT package is marketed as a limited-edition digital goods collectible but also confers a 3-night hotel accommodation, daily meal benefits, admission to special events, and a 20% discount on all future hotel stays, including meals, good for two years. Given the number of offerings in the NFT package, the transaction’s taxability is unclear. Should the transaction be taxed as the sale of a digital good or under the Seattle hotel tax rate? If the purchaser resides outside Seattle and purchases the NFT remotely, should the customer’s local rate apply? While the answer is unclear, an experienced tax advisor can assess the potential risks of taking various tax positions. Under the right set of facts, it may be possible that the transaction will be assessed a lower tax than had each element of the transaction been sold separately.
The examples above illustrate how NFT adoption can result in tax savings for a business. NFT adoption can also result in tax savings for consumers, which may give companies adopting such technology a competitive market advantage. There are many other instances where proper, well-planned NFT adoption can result in significant tax savings for a business or its consumers. These opportunities may also expand beyond state and local income and sales/use taxes into state excise taxes, gross receipts taxes, income/franchise taxes, local taxes, Value Added Tax (VAT), and others. While taxpayers should be aware of the uncertainty in the NFT space, prudent tax planning can result in material tax savings.