Over the course of two years, several legacy brands have launched their own NFT collections with a physical product tied to their digital asset. As NFTs offer more than just digital artworks that live on the blockchain, companies are exploring new ways to use NFTs to authenticate their inventory. The distinction between digital and fiat currency becomes blurred as retail leaders start to explore different avenues and revenue streams that deliver virtual experiences for their customers.

According to the IRS, digital assets are “broadly defined as any digital representation of value which is recorded on a cryptographically secured distributed ledger or any similar technology”. They include but are not limited to: “Convertible virtual currency and cryptocurrency, stablecoins and Non-fungible tokens (NFTs)”. The website makes it clear that digital assets are not to be deemed as “fiat currency,” as they are not issued by the central banks (yet).

The IRS lists multiple scenarios where taxpayers need to report their realized crypto income, and that includes: gains/losses from trading cryptocurrencies, mining or staking revenue, and even receipts of airdropped assets. However, because the space is rapidly expanding, and decentralized technology spreads beyond borders, reporting regional and international transactions can be challenging.

We spoke to one of our tax advisors to get his perspective on how to navigate the evolving tax regulations in regards to digital assets. He was able to share his professional input on how to calculate taxes for NFTs that provide physical utility, understanding KYC regulations, and how to avoid capital loss in crypto to fiat conversions.

Domestic and Foreign Sales Taxes Associated with a Physical Item Redeemed by an NFT

To begin, we discussed the possible tax implications of selling a physical good with an NFT attached with our tax advisor. Since the Web3 community is scattered across time zones and borders, it can be hard to determine how to properly tax and identify buyers and sellers, or even gather their location for tax jurisdictions. As mentioned earlier, different states in the U.S believe sales tax applies to some NFT sales and other digital assets. To comply with your state’s rules, smart contracts can streamline and standardize the KYC process. Businesses or marketplaces can use automated smart contracts to remove the need for manually collecting and verifying each user’s identity, and access KYC data transparently on an accessible smart contract record.

To answer our team’s inquiry about calculating sales tax for shipping goods abroad, our tax advisor recommends that businesses should “set aside sales tax costs for any and all foreign sales, and collect sales tax from the buyer at the time of purchase.” He adds, “Sellers can calculate the buyer’s tax rate through the buyer’s shipping address, or through the location of the store (if the client chooses to pick up their tangible item in-person).”

Next, we asked our advisor how to determine the value between an NFT and its tangible utility, he answered “The real world value of the physical good should be ascribed against the NFT. When you issue two goods (an NFT and physical item), it is important to distinguish between the value of each asset and establish a cost basis for each”.

In instances where the NFT is used as a “certificate of authenticity” or “digital receipt”, then the real world value of the physical export may be considered to hold 100% of the tax basis (the cost or value of the item when it is sold). This assumes that the digital certificate/receipt isn’t an asset that is severable from the physical export as is.

Existing law currently requires businesses to report transactions involving more than $10,000 in cash payments. That reporting will also apply to transactions involving digital assets over $10,000 in 2023.

Collecting Customer Details via Know Your Customer (KYC) or Know Your Transaction (KYT)

Recently the OECD published the Crypto-Asset Reporting Framework (“CARF”). It established a framework for tax authorities to adopt when writing tax reporting rules, that are applicable to exchanges that have customers invested in crypto outside of their country of tax residence.

For businesses confused as to how they can collect customer information safely and securely on a decentralized network, this can be done through a KYC process, or collecting information via smart contracts (which should be transparent for customers).

As there is a multitude of AML (anti-money laundering) laws that apply to fiat currency, businesses transacting in crypto need to participate in customer due diligence procedures by implementing “transaction monitoring technology” or KYT. The software would essentially enable businesses to verify the source and destination of the funds, and any possible connections linked to money laundering.

To comply with these AML requirements, smart contracts can be programmed to run “sanction screening” queries to alert businesses every time a wallet address matches the criteria of being “high-risk” or “involved in illegal activities”. Implementing these smart contract functionalities can give customers reassurance that their wallets will not be tainted by association with internet crime.

Avoiding Capital Loss for Unforeseen Volatility

The final topic we covered was volatility. For legacy companies who are interested in enabling crypto transactions to their platforms, we wanted to know the best practices to avoid exposure in a highly volatile market. Our tax advisor reminds us that capital losses are very limited from a “tax write-off” standpoint, and recommends three options for minimizing the volatility associated with crypto payments.

The first is for sellers and business owners to “align fiat prices (of their goods) with crypto prices on a real-time basis”. The second tip is to convert crypto assets to fiat currency immediately at the end of the business day,” — as leaving funds in a centralized wallet or exchange is at risk of being compromised. Finally, he suggests that businesses should implement a “crypto payment processor”, which converts crypto payments into fiat at the time of sale, so sellers will only receive fiat.

Final Thoughts

As we hope to peel away at the many layers of the Web3 onion, there will undoubtedly be more laws and regulations written for our emerging industry, and many of these laws are similar to existing regulations in finance. Not every business is running towards Web3 business models just yet, or even sure how they can implement blockchain systems into their daily operations.

Chain is actively developing software solutions for Web2 brands breaking into Web3, and is determined to inform readers about the latest trends and developments within the industry. Most of the rules and regulations mentioned in this article are set in place for January 1, 2023. Due to the endless use cases for crypto and NFTs that span across industries, Chain will continue providing educational material and research that supports the needs of our clients, and reduces the barrier of entry into the space.

Disclaimer: Chain and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for educational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.