By Alex Ruffel and Daniel Shutt
In a year that saw the original photo behind the 2005 Disaster Girl meme sell for over £350,000, Collins Dictionary made NFT its word of the year for 2021. NFT stands for ‘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 is an NFT?
An NFT is a type of cryptoasset. Cryptoassets are ‘tokens’ – digital representations of value or rights (in the same way as a bank note is a paper representation of value).
A unit of cryptocurrency such as bitcoin is a token that represents value – it can be sold for fiat currency or exchanged for goods or services. It is also fungible, meaning that it is not unique - one bitcoin can be replaced by another bitcoin.
A non-fungible token is a digital representation of unique rights. When a collector makes headlines by buying an NFT that is a digital work of art, they are buying the ownership rights to the artwork to which the NFT relates. Their ownership is recorded on the blockchain via distributed ledger technology (see our guide to some of the basic principles and terminology). This makes use of NFTs particularly useful when it comes to tracking the provenance of digital content, such as music or videos, although the principle can also be applied to tangible assets.
As with all things crypto, it can be difficult to discern meaning from jargon and a more tangible example can help get to grips with NFTs. In the UK, ownership of land and any rights relating to it is recorded on a central Land Register maintained by HM Land Registry. In theory, it would be possible to create NFTs representing land. An NFT representing ownership of a particular piece of land would be ‘minted’ by creating a smart contract that would act as a certificate of ownership of the land. The owner of the NFT could give it to someone, who would become the owner of the land and their ownership would be recorded on the blockchain, as opposed to ownership of the land being recorded on the Land Register. It might also be possible in future for smart contracts to be written for sale of land-related NFTs that replicate elements of the current conveyancing process for real property.
As it is unique and stored on the blockchain, an NFT helps the owner prove the ownership of their asset in a safe and secure way. However, it is not risk-free. While the NFT might be forever on the blockchain, the asset of which it proves ownership might be deleted (if it is digital and exists elsewhere on the net), burn down (if it is property) or be stolen if the wallet in which the NFT is held is compromised.
Purchasers of NFTs also need to understand what they are buying. Whilst the purchaser of an NFT may have ownership rights over the NFT which they can store, display, sell or transfer, this may not always include the copyrights or intellectual property rights relating to the underlying asset (which can often remain with the creator). Original owners of NFTs can, for example, automatically receive royalties every time an NFT is sold from person to person by including the creator’s address as part of the NFT’s metadata.
How are NFTs taxed?
NFTs can of course be bought and sold. However, when it comes to the UK tax consequences of doing so, the UK is not alone in not having specific legislation and, as yet, only limited practical guidance to assist taxpayers.
For UK income tax purposes, it is expected that NFTs will be taxed in a similar way to other cryptoassets such as digital currency, although HMRC have not explicitly commented on this. If this expectation is correct, taxation will depend upon what is being done with the NFTs. For example, if a person receives an NFT in exchange for providing a service, that NFT would probably be treated as taxable income earned from providing the service. An individual running a business which carries on a trade in NFTs would be as receiving taxable trading profits (and assessed to income tax accordingly). An artist who creates an NFT of an artwork as part of their profession as an artist would also be subject to income tax on their trade profit from selling the NFT.
HMRC’s crypto-assets manual also reflects this: it refers to NFTs issued by lending platforms to those who transfer crypto-currency to the platform to make loans. The lending platform may issue transferors and borrowers with an NFT to record the terms of the loan. The return on the loan will be taxed to income tax or capital gains tax depending upon how the transaction was structured, not the bare fact that an NFT was involved.
Some NFTs may also automatically pay out royalties to their creators when sold from person to person. Whilst this is still a developing area, it is probable that such income will be taxed in accordance with the usual rules for royalties (i.e. the income will be taxed as income from intellectual property if it does not otherwise fall to be taken into account as trading income).
If income tax does not apply, gains on the disposal of NFTs will be chargeable to capital gains tax. Apart from in connection with DeFi, only one sentence of HMRC’s recently updated crypto-assets manual is expressly dedicated to NFTs. It states that “Non-Fungible Tokens…are separately identifiable and so are not pooled” (referring to the way in which disposals of ‘cryptoassets’ should be calculated for capital gains tax purposes). Presumably, therefore, the capital gain or loss on the disposal of an NFT is calculated by simply comparing the proceeds on disposal to the cost of acquiring the NFT.
Where are NFTs situated?
One of the more problematic issues in relation to all cryptoassets, including NFTs, is their location or ‘situs’.
For UK inheritance tax and capital gains tax purposes, it is a safe bet to assume that an NFT will be a taxable asset. NFTs are not specifically referred to as a specific class in HMRC’s guidance at present, which focusses more on ‘exchange tokens’ such as bitcoin. However, looking at what HMRC has said, we anticipate that their approach to situs of NFTs for capital gains tax purposes is likely to be that the situs relates to the asset of which the NFT gives ownership.
That would mean that where an NFT gives ownership of a non-digital asset (such as, in our example above, land) the NFT will be situated where the asset physically is.
However, the situation is more complex where there is no underlying asset (which might be the case if the NFT is a right to services, for example) or the underlying asset itself is digital, such as a digital artwork. In that case, we anticipate that HMRC will treat the NFT as situated where the beneficial owner is tax resident, so an NFT owned by a UK resident person will be a UK asset.
This would match HMRC’s current approach to the CGT situs of cryptocurrencies such as bitcoin but would not be without controversy. There is no strong basis in law for cryptoassets being situated where its owner is resident and it contrasts with two decisions of the courts which held that the situs of a cryptoassets is the place where the owner is domiciled (see Fetch.ai Ltd v Persons Unknown  EWHC 2254 and the unreported 2020 case of Ion Science v Persons Unknown). The Society of Trust and Estate Practitioners has also published its alternative view in the form of a guidance note highlighting that the situs of a cryptoassets is not only of critical importance for UK tax purposes but also succession and offering the alternative view that the situs of a cryptocurrency should be based on the jurisdiction with which the relevant participant has the closest connection.
Time will tell whether HMRC shifts its standpoint or provides a more nuanced approach on this thorny issue. Inevitably, the matter will be litigated and further guidance will be forthcoming. In the meantime, UK resident non-UK domiciliaries (particularly those who opt to be taxed on the remittance basis) should take professional advice on their potential UK tax exposure deriving from their ownership of NFTs and other cryptoassets.
What happens to your NFTs when you die?
The law and practice relating to how cryptoassets are dealt with when their owner dies deserve a separate article and that is one that we will write, but this section gives a very brief overview.
If NFTs are property, which they clearly are, they can form part of a person’s estate and be inherited by the beneficiaries of their estate under a will or intestacy rules.
The issues that arise are then mainly practical. The first question is how a person’s executors or heirs will know that the person owned an NFT. There is no central register of NFTs and therefore it is likely that the owner will need to inform at least one person who can be trusted to outlast them of what their NFTs are and where they are, or at least ensure that the chosen person can access these details when necessary.
The second problem that is likely to be encountered relates to how can executors or heirs gain access to an NFT so that they can sell it or pass it on to the person to whom it has been left.
NFTs are usually stored in wallets, like other cryptoassets, that can be connected to the internet (i.e. hot) or offline (cold – usually hardware-based). Whatever wallet is used, a password will invariably be needed to access the wallet and so the NFT. Therefore, executors or heirs will need to be told password, or how to get to it, to access the NFT. This comes with security risks, which can be mitigated.
In short, owners of NFTs will need to undertake carefully considered steps in their lifetime to ensure that NFTs are accessible and can pass to chosen beneficiaries when the time comes.