Through The Looking Glass: Will A Look-Through Rule For Taxing NFTs Clarify Or Further Distort? – Capital Gains Tax

In a recent article, we observed that the Treasury and the
Internal Revenue Service (“IRS”) could address the
complex tax issues presented by emerging digital assets either by
developing a cohesive framework for taxing these unique assets or
by attempting to shoehorn them into existing legal constructs. The
recent IRS announcement that it intends to classify some
nonfungible tokens (“NFTs”) as “collectibles”
for tax purposes indicates its continued inclination toward the
latter approach. See Notice 2023-27 (the “Notice”).

NFTs are digital identifiers typically used to certify ownership
of distinct rights or assets (either physical or digital) where
such ownership is recorded on a distributed ledger. Like units of a
cryptocurrency, an NFT represents a distinct and transferable
digital asset. However, unlike units of traditional cryptocurrency
(whose value is fungible and typically untethered to any other
asset), an NFT is nonfungible and its value is tied to the value of
the underlying right or asset with which an NFT is associated. The
close relationship of an NFT with its underlying right and/or asset
raises the question of precisely how the NFT should be
differentiated, if at all, from its underlying right or asset for
tax purposes.

The Notice announces the IRS’s and Treasury’s intention
to issue guidance that treats certain NFTs as
“collectibles” under Section 408(m) of the Internal
Revenue Code. Collectibles (e.g., works of art, antiques,
gems, etc.) are subject to specific federal income tax rules,
namely, increased long-term capital gains rates of 28% as well as
restrictions on acquisitions of collectibles by individual
retirement accounts (i.e., treating the transaction as a
deemed distribution of money to the taxpayer equal to the cost of
the collectible and possibly subject to a 10% early withdrawal
penalty).

While the Notice asks for comments regarding the shape and scope
of its intended guidance, in the interim the Notice states that the
IRS will utilize a look-through approach to determine if an NFT
constitutes a collectible. Thus, if the underlying right and/or
asset would constitute a collectible, then the NFT itself will
constitute a collectible. While it may seem intuitive that merely
tokenizing a collectible using an NFT should not allow a taxpayer
to escape collectible treatment for the underlying asset, it is
unclear whether applying a traditional look-through rule to NFTs is
the best approach. In particular, the Notice offers no indication
of whether a look-through approach would be applied more broadly or
be limited to the collectibles context. A broadly applied
look-through approach could have wide-ranging implications for the
nature and source of income generated by an NFT as well as for tax
rules that key off the status of the owner of an underlying asset.
For example, if a broad look-through approach is applied to an NFT
with securities as underlying assets, an NFT holder that is
otherwise a dealer in securities could be subject to the
mark-to-market rules on its NFT.

Applying look-through concepts could be particularly difficult
where the NFT certifies ownership of multiple rights and/or assets
or conveys only limited or proportionate rights in assets, such as
where an NFT has been created with dual purposes. For example, a
single NFT might facilitate a customer reward program by both
tracking participation in the program as well as digital or
physical rewards elected to be received under the program. In this
regard, Starbucks is currently testing this type of unique NFT
usage with its Odyssey Rewards Program, which allows users to
both collect points that can be redeemed for “immersive coffee
experiences” as well as purchase “coffee themed
artwork,” which artwork can be bought or sold through a
marketplace to other users. Arguably the coffee themed artwork
could constitute a collectible for tax purposes, although the
remaining rights associated with the coffee rewards would not
appear to be collectibles. Whether merely applying existing tax law
concepts (like a look-through rule) will be flexible enough to fit
these unique NFT uses remains to be seen.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.