Digital assets - Beyond Bitcoin

The digital asset/crypto market has expanded significantly since the advent of Bitcoin. For indirect tax, this brings with it a number of complexities, with it being particularly difficult to ascertain whether the exemption can apply in all circumstances.

The nascent, but blossoming market in digital assets is resulting in a wide range of queries from businesses across a number of sectors in respect of the associated indirect tax implications.

This is partly due to the limited tax authority guidance, but also the complex nature of the assets and supply chains involved.

In the UK and the EU, it is accepted that some transactions involving Bitcoin (and by extension, similar cryptocurrencies), can fall to be VAT exempt as financial services transactions.

However, whilst cryptocurrency is the oft-used term for various digital assets, it is important to understand both the unique characteristics that the different types of digital assets can take, and the transactions involved in their supply chain to properly determine the indirect tax treatment.

In this respect, common asset types we have encountered include:

Given the wide variety of digital asset types and attributes, it is unlikely that VAT exemption can be assumed, and the VAT treatment should be considered on an asset-by-asset basis. This is likely to lead to different analyses, with differing indirect tax consequences/reporting requirements and costs, some of which we have considered further below.

Digital communities

With the expanding digital economy, businesses are increasingly seeking to establish digital platforms and online spaces where they can continue to interact with their customer base.

To encourage engagement and loyalty to platforms, some platforms are introducing their own virtual currencies which can be purchased to access products and services, either directly from the platform provider or from other users. These virtual currencies can often also be gifted or traded between users.

From an indirect tax perspective, this creates questions concerning both the issue, exchange, and redemption of any in-platform currencies, and the treatment of on-platform transactions between users.

In particular, if the virtual currency cannot be viewed as equivalent to a fiat (i.e., central bank-issued) currency, alternative analyses should be considered, such as whether it should be treated as a voucher (potentially multi-purpose if there is capacity for the user to transfer the virtual currency to other users globally before any ultimate redemption), or whether purchasing the virtual currency is simply purchasing additional/enhanced content provided by the platform.

Regardless of the treatment applied to the virtual currency itself, platforms should also take steps to understand and consider what in-platform transactions may be occurring between users, and whether they have an obligation to ensure that any indirect tax that arises on such transactions is appropriately declared, given both individuals and corporates are seeking to leverage digital communities to generate income. This is of particular concern in jurisdictions where joint and several liability can arise for those facilitating supplies of electronically supplied services.

The complexity can increase further given the lack of harmonisation of indirect tax regimes. As such it will be pivotal to understand the indirect tax implications of how and where your business operates on these platforms either as the creator or a third party.

NFTs

The current market for NFTs is significant, with new announcements appearing almost daily. NFTs are most commonly digital assets that are intended to provide access to a specific application or service but differ from cryptocurrencies in that they are not accepted as a means of payment for other applications.

The most common form of NFTs relate to digital images, but there are numerous examples where the underlying rights associated with an NFT extend further, including access to exclusive content, physical goods (e.g., a real version of the item depicted in the NFT, or access to certain events).

Part of the benefit to creators in using blockchain technology to release their content via NFTs is the ability to retain a degree of control and financial interest. For example, using smart contracts, creators often include a recurring royalty fee payable on each subsequent sale of the asset, allowing them to benefit directly from an increase in value.

These transactions present several key questions and considerations from an indirect tax perspective, including:

1) What is the nature of the supply?

What is an ‘NFT’ for indirect tax purposes?  Is it an Electronically Supplied Service (ESS), a supply of rights, or something else?  The rules vary by country which can therefore result in different outcomes on the treatment of the NFT (e.g., on the place of supply).

2) What is the place of supply/taxation?

This usually determines where indirect tax is due, and this is influenced by the nature of the supply, the customer status etc. For example, ESS are generally taxable where the customer is resident when supplied B2C, whereas general rule services are usually taxable where the supplier belongs.

3) Who is the supplier? 

This is particularly complex and on-point where sales of ESS are made through an electronic marketplace, platform, interface, or portal, as quite often the indirect tax due on the sale to the customer is the responsibility of the marketplace.

4) What is the value of the supply? 

The liability of the NFT could also vary depending on the precise rights involved, with potentially multiple supplies taking place with different indirect tax consequences arising and a requirement to apportion the valuation accordingly.

5) How to treat subsequent and future sales? 

Finally, the treatment of the recurring royalty requires consideration in terms of direction of the monetary flow, and the place and the liability of supply from an indirect tax perspective.

Tax fraud risks

Indirect tax systems have historically been subject to significant levels of abuse through fraud and, taking advantage of the self-accounting mechanisms for charging and paying the tax. In very simple terms, a typical fraud, often referred to as “missing trader” fraud, would involve a customer paying a supply for goods or services, including an element of indirect tax. The customer assumes the supplier will make a payment of that tax to the tax authority, but instead, the fraudulent supplier pockets the tax amount and goes missing, often setting up a new entity to repeat the process.

Often the customer may not be aware of the fraud, however, there can still be serious consequences where it “knew or should have known” about potential fraud happening in the supply chain. Consequences could include significant assessments, penalties, increased scrutiny from tax authorities and potential criminal prosecution.

Whilst previously fraudsters have often targeted fast moving consumer goods, per a recent BBC article it now looks as though fraudsters have focussed their attention on the emerging NFT market. HM Revenue & Customs arrested three individuals attempting to carry out a VAT fraud valued at £1.4m, involving up to 250 alleged fake companies. They also were the first UK law enforcement agency to seize an NFT, along with other crypto assets.

It is hard to deny that NFTs represent a tempting prize for fraudsters, they are often high value, easy to store and transfer, and relatively hard for law enforcement agencies to trace, allowing the fraudsters to generate significant indirect tax amounts and then disappear and resurface to repeat the process.  

Therefore, it is crucial that businesses engaging in the purchasing or selling of NFTs, like any other goods or services, take steps to ensure they have in place suitably robust and proportionate measures to detect and deter fraud. The ability to “know your customer” or “know your supplier” could prove more challenging than in traditional goods-based supply chains, and where they are relying on steps taken by third parties such as online marketplaces and exchanges, they should understand the steps those parties take to mitigate the risks posed by indirect tax fraud and other forms of tax evasion.

In relation to other sectors and products, tax authorities have often moved very quickly to introduce a domestic reverse charge (DRC), which flips the obligation to account for the indirect tax from the supplier to the customer. This mechanism is usually very effective in removing the ability of the fraudsters to carry out this type of “missing trader” fraud for the specific product subject to the DRC. It will therefore be interesting to see whether tax authorities contemplate a specific DRC for NFTs in the near future.

What's next?

As a result of the above considerations, there is an ever-growing focus from tax authorities across the globe to ensure that supplies are being taxed appropriately in the correct jurisdiction. With both legislative and regulatory change on the horizon, tax professionals should work with retail, fintech and online platform operators to understand how they are adapting to changing consumer patterns, diversifying revenue streams, and applying traditional indirect tax principles to these innovative products and business models.