Welcome to our first monthly round up of all things blockchain. Here, over the coming months, we will digest some of the biggest news that has…
Welcome to our July edition of all things blockchain.
This month, we overboard on NFTs, ponder on how safe our crypto is and get overly excited about HMRC announcements.
All things NFTs
by OP_Return & Aurora
Where do we begin? Genuinely? Do we talk about NFTs being Collins Dictionary’s word of the year in 2021 or do we just jump straight in with the technical explanation? And should we mention tax? Probably. Because not many people are…
What is an NFT?
NFT stands for non-fungible token. A fungible asset is something that can be interchanged with something else, such as money or bitcoin. A £5 note can be changed with another £5 note, and we’re all quite happy with that. So something non-fungible is therefore unique, and irreplaceable. This might be the case for a modified sports car, photos of great sentimental value etc.
Sure, but what does that mean in crypto?
Every NFT is a unique token to the blockchain it resides on, which contains some form of data. Commonly, the NFT points towards some media, such as artwork or videos that are commonly not stored on the blockchain but elsewhere, often on a decentralised storage solution like the InterPlanetary File System. When an NFT is purchased the ownership details are recorded on chain, and the NFT acts as provenance over whatever data is stored with the token.
What’s in it for the purchaser?
Ownership. Bragging rights. Sometimes the IP over the original image (in the case of Bored Apes Yacht Club). We live in a digital age where kids would rather spend money on Roblox than have physical toys. Maybe that’s the way the world is going, perhaps that’s our fault for shoving ipads in their hands at an early age. Digital ownership exists, and people enjoy the sensation of ownership. Owning something unique in the digital space is no different to holding the rarest Charizard pokemon card in your safe at home. There is also more to it than that. Many NFTs are based around communities. Ownership of a particular NFT may grant you access to IRL events, merchandise, or other benefits. In a post-pandemic world where we are all more remote, painted on a backdrop of web2, online tribalism is highly sought.
But I can just right click and save-as?
Of course you can. But you’re missing the point. I could take a photo of the Mona Lisa, crop it, print it, stick it on my wall, but I don’t own the Mona Lisa.
What’s in it for the seller?
This is where things start to get interesting, particularly in the creative space. As an artist, my art might get sold through a local gallery, I would get my money and the gallery would take a commission. That’s likely the last I would ever get from that piece, despite how famous I may become in future years, uplifting the value of that piece over time to the eventual benefit of its owner.
NFTs offer an alternative model, which offers rewards to creators indefinitely. As they reside onchain and are essentially governed by code, future sales provide royalties to the original artist, on a predetermined percentage. This means the more successful an artist is, the greater value the digital pieces sell for as they pass hands through different owners (possibly looking for profit), the artist continues to receive remuneration (in crypto). Not only that, but other factors may come into play, given the number of celebrities who are NFT collectors. Snoop Dogg famously revealed he had been collecting NFTs under the alias Cozomo de’Medici. Where NFTs provide a history of ownership (albeit pseudonymously), it is likely that any NFTs Snoop sells are likely to go at a premium.
No wonder NFTs are not being restricted to digital art. They are being used for other digital items such as music, gaming and fashion, but are also being used to sell real world items, such as pieces of art, sculptures, real estate… the list continues.
In a world where our TV can mimic a hung picture (like the Samsung Frame), why not display your fondest NFTs in your home?
What is the limit for NFTs?
We are only scratching at the surface. You could probably think of a number of a real-world scenarios where having digital ownership and traceability would better the existing system. I received a letter recently saying I’d forgotten to tax my car, but not to worry, I could go down to the post office, hand in my V5C to sort it all out.
Would it not be easier to have NFTs linked to cars, with details of the car, service history, replacements, accidents, tax etc. Previous ownership would already be provided as a result of the NFT history, and when I sold my car I simply transferred the NFT to the buyer, rather than us both filling separate parts of some form and sending off separately?
Or ticketing for events – surely this would make more sense to be done by an NFT, that would provide access to the event itself, some form of digital artwork to remember the event buy, but if I couldn’t go to the event and decide to try and sell it on for profit, the event organisers still profit from that?
NFT and Taxes
We are accountants. This section was going to happen eventually. What tax you are subject to will depend on your part in the process, whether you are the creator, an NFT marketplace, a buyer or lender. Taxes can range from capital gains tax for individual collectors, through to income tax, corporation tax and VAT for creators and marketplaces.
VAT on NFTs
Not commonly discussed. A google of VAT on NFTs is likely to get you hits on accounting websites (hopefully ours), rather than any official guidance, at the time of writing. Whilst we expect guidance to be released from HMRC later this year, HMRC were very reactive to the DeFi sector, and were the second country to release guidance when their manual was released in February early this year. They are currently reviewing the DeFi guidance (see our links section), which I’m sure would have had a knock on effect on the release of NFT guidance, and when it comes to NFTs, I don’t envy the task at hand.
How do you define an NFT for tax purposes? Ok, if I’ve sold you my car through an NFT, you’ve bought my car, but the lines can get blurry. Lets say you’ve bought an NFT and are very proud of your purchase. What have you bought? Is it a piece of art? Is it yours? Do you own the underlying IP, or have you simply purchased a copy of an original with limited rights attached? Are you able to exploit the underlying asset (e.g. bored apes yacht club)? Is the NFT a security?
Beeple sold First 5000 Days as an NFT last year for $69m, but the purchaser only acquired the rights to display the image.
Jack Dorsey sold the first tweet for $2.9m as an NFT. What did the purchaser acquire? It’s not an image. It’s certainly not tangible. Bragging rights?
You can start to see some issues here with the taxonomy of NFTs, and the problems don’t stop here.
If we consider the first principles of VAT to determine whether there has been a supply of goods and services, using cars as an example, if I sold you my car as an NFT then yes technically you have acquired a non-fungible token, but really, you’ve just bought my car. If we start expanding on this you can probably see where we get to.
Selling memberships as NFTs? You’re selling memberships. Selling digital art as NFTs? Selling digital art. The next stage is to consider whether that underlying supply is covered in existing VAT legislation. Maybe I’ve bought a piece of digital art, but at a later date it’s announced that piece of art acts as entry to an event. Or I receive other benefits as part of my original purchase. How are these aspects treated?
If the sale is considered an Electronically Supplied Service, then existing VAT legislation requires you to understand where the end purchaser is located. Sellers often have to register in the jurisdiction their customers are located for certain supplies. However, given the pseudonymity of blockchain, the fact that often at launch there is a race to mint NFTs for ownership or future profit, there is often no KYC, no understanding of customers location let alone whether they are present in EU or outside the scope of VAT, the only information held is the wallet addresses that have minted an NFT (at this point we realise we have not defined minting – this is just the process of publishing the token onto the blockchain to make it purchasable).
What regulations govern creating and selling NFTs?
OK, if you’ve made it this far through our mammoth article, thank you, it’s really appreciated, yet we’re also concerned that you have nothing better to do than to read an accountants ramblings on NFTs. The FCA is the anti-money laundering and counter-terrorist financing supervisor of UK cryptoassets businesses under the Money Laundering Regulations (MLR) . If you have the next great NFT idea, then we strongly suggest seeking financial (structuring, accounting and tax) and regulatory advice from solicitors before proceeding to ensure that you stay legal and ensure all of your obligations are met.
LAST BIT! Interesting legal cases
2 quick cases to mention.
1. In January this year two NFTs were taken from Lavinia Osbourne’s MetaMask Crypto wallet without her knowledge or consent. Lavinia took step towards establishing the first case of its kind in the world, which formally recognised NFTs as legal property and renders them subject to enforceable rights and protections. The court noted the NFTs were of low value, but they had a significant personal value to the claimant because of the ‘one of a kind’ aspect of NFTs themselves, and any compensatory future payment would not adequately compensate the claimant. Lavinia Deborah Osbourne v Persons Unknown; Ozone Networks Inc.
2. In June 2022, the High Court of England and Wales granted an order permitting service court proceedings via the transfer of an NFT in the case of D’Aloia v. (1) Persons Unknown (2) Binance Holdings Limited and others. In this case the claimant was defrauded to the tune of 2.1m USDT. Having knowledge of the wallets the scammers had used, notice was served to the wallet addresses in the form of an NFT.
We just wanted to share the project Doodles with you. Because we think they’re awesome, and generally make us feel happy when we look at them, and after the heavy last half to our article we need a bit of cheering up right now…
How safe is my crypto?
If you have any interest in crypto you will have had to have been asleep over the last month or so not to have caught at least some of the news of various high profile exchanges suspending the withdrawal of crypto from accounts. Some crypto lenders such as Celsius and Valud also faltered in turbulent times as clients withdrew holdings in huge amounts and hedge fund Three Arrows Capital went under. You have to ask yourself “How safe is my crypto”?
We’ve all heard of the various scams over the years, summarised nicely in a book I read called “Crypto Wars: Faked Deaths, Missing Billions and Industry Disruption” by Erica Stanford, and in large part, a lot of the crypto that has been scammed has been down to an individual’s willingness to invest in something highly speculative in the hope of winning the jackpot. Who doesn’t dream of getting in on another Shiba Inu before it went intergalactic (and then of course selling before the peak becomes the trough). While crypto at first was for the die hard who actually had the knowledge of how to buy it (it wasn’t always so easy), now it is as part of life as Uber or MacDonalds and anyone can have a piece.
The rise of Initial Coin Offerings (ICOs) mean there is always a wide array of coins you can pump our hard earned cash into hoping to strike it rich but be wary, statistics suggest 50% of ICOs will die within a year. That doesn’t mean there isn’t money to be made if you get in at the right time, but timing is EVERYTHING. The chances are that if you are hearing about it, it is already too late, and let’s not forget that anyone with the right knowledge and equipment can launch their own token for less than genuine reasons. DYOR!
So you play it safe and buy some ETH, some SOL and maybe for a punt some HNT or DOGE and are happy to ride out the rollercoaster for a longer term investment. Where do you then keep your crypto? Well the average investor will buy their crypto from an exchange like Coinbase, Kraken, Binance to name a few and then hold it there, but as we identified earlier, exchanges do fail. What happens to your crypto if they do? Well the chances are it is gone.
You might have seen the Netflix documentary “Trust No One: The Hunt for the Crypto King”? If not, to summarise it covers the fall of QuadrigaCX, an exchange whose founder died under mysterious circumstances taking with him the seed phrases to the wallets that contained funds totalling circa £250 million of customers’ crypto. One man lost a cool half a million dollars in the “event” and will never see it again. I’m not sure I could ever get over that. Did the founder fake his own death and is now living the dream with the spoils of the crime? Immoral and totally unethical, but you could perhaps see the temptation.
In a report published by HMRC on 5th July 2022, they identified that 46% of crypto investors hold their assets on centralised exchanges.
OH MY GOD? I think I’ve touched on the fact that this really isn’t 100% safe, especially having all of your golden eggs in one vulnerable basket. This isn’t a bank account where your money is guaranteed by the FSCS. This is the wild west. Another interesting fact from that research is that 75% of crypto holders are under 45, meaning crypto is dominated by millennials and the gen zs. Understandable given the knowledge required to enter this space.
The safest option may be to move crypto away from centralised exchanges and store it in a non-custodial wallet, which you have control over. I’m sure many people would rather take the risk of their own competence than have their crypto taken from than lose it like many poor souls to QuadrigaCX.
Whatever you decide to invest in and how to store it, always do your own research and understand the risk of your decisions. Centralised exchanges are not infallible and many of the smaller riskier exchanges have poor liquidity. They can fold and they do. Be sensible or take risks, that’s all down to one’s appetite but be always be safe!
What wallet is for me?
You want to purchase some crypto, but you don’t know where to start, you have a quick google and find out that you will need a wallet. However, the world of crypto is never simple you soon see hot, cold, hardware and custodial wallets with no clue what might be best for you or the advantages of each one.
What does temperature have to do with which wallet I want?
The term ‘Hot Wallet’ refers to a piece of software that is connected to the internet that stores the details to your cryptoassets. These wallets are easier to trade or spend crypto, however with anything connected to the internet hot wallets are vulnerable to be hacked.
Hot wallets are normally, web based, desktop based, or mobile phone based, examples of a hot wallet would be MetaMask, Coinbase Wallet or Edge Wallet. These wallets are always available so spending crypto doesn’t involve any additional steps simply load up the app and send like you would in a standard banking app.
Coinbase wallet interface shown, it’s simple and easy to use like any mobile finance apps.
In the digital world think about a hot wallet as you cash in your pocket, it’s convenient, easy to spend but liable to be taken from you. Would you walk around with £10,000 cash in your pocket? If not probably don’t have it sat in a hot wallet.
There are instances where individuals or businesses will keep large amounts in hot wallets, if you need cash easily accessible for things like cryptocurrency arbitrage you would not have a choice but to keep a lot of crypto in a hot wallet.
The term ‘Cold Wallet’ refers to a software run on a physical piece of hardware that is typically not connected to the internet. The lack of constant connectivity makes them more secure, taking assets from a cold wallet generally would require, you or a third party, to have access to the physical wallet.
Cold wallets often look like a USB drive, examples of these would be Ledger Nano, Trezor Model T or KeepKey. To transfer crypto currency from a cold wallet you need to attach them to a computer or mobile phone and then send them to a hot wallet where they can then be used for purchases or trade.
Ledger Nano cold wallet devices shown to the right of the mobile app used to manage cryptoassets stored on them
There are other ways to store crypto currency in cold wallet form, this could be a secondary offline computer or mobile phone however the purpose-built cold wallets listed above are simpler for most small investors. These hardware cold wallets are designed to prevent the hacking that hot wallets are susceptible to, the purpose-built wallets should prevent hacking even whilst connected to an internet connected device whilst transferring. The transaction taking place between your hardware wallet and your computer all happens on device so your private key never leaves your device.
Hardware wallets are less convenient as they are a physical device that must be connected to a computer or phone before being able to access your funds, they also cost between £70 and £200 which is a barrier to entry. Hot wallets are generally free and make money by charging you fees for transfers.
Ultimately if your funds are held in a hot wallet, you aren’t in complete control of them, however if you don’t lose your passphrase and private key you will be able to access your wallet in the event of a disaster. If your house burnt down with a cold wallet inside of it that crypto will never be recoverable. If your house burns down and all your crypto is in a hot wallet you can simply buy a new PC load it up input your keys and it will all be there safe and sound.
What suits you?
For most people a combination of a hot wallet and a cold wallet is ideal, people often have different wallets for different purposes. You could have individual hot wallets for trading, spending, and storing NFT’s all provided by different companies. You could then also have a single hardware wallet for all three or one for each type of asset.
Some people use an old mobile phone as a hybrid cold and hot wallet, they store crypto locally on the device only turning it on when they need to transfer crypto and leaving it off in a safe place whilst not in use.
When choosing a wallet, it will always come down to your own use case and your tolerance to risk, be that risk from physical disaster or from online threats.
Where have we been this month in the metaverse?
Honestly this month we’ve just been mooching. We seemed to miss some of the events that were available, but instead just went exploring – this month was all about swords and dragons!
We were so caught up in NFTs we didn’t even mention HMRC’s call for evidence. HMRC are reviewing the DeFi guidance, and are asking questions to advisors and those in the industry for input about DeFi & taxation. A link to the call for evidence is here.
Herodotus also mentioned HMRC’s commissioned research document which can be found here.
CryptoCompare 2022 Outlook: Winter is Here Q3 (you will need to sign up to access – but a great read)
July’s book: “Crypto Wars: Faked Deaths, Missing Billions and Industry Disruption” by Erica Stanford, released July 2021
What is it about? A jaw dropping eye opener into crypto’s troubled past. Covering the biggest Ponzi Schemes, espionage, faked death, FBI most wanted list, this book highlights the wrong and rights about the progressive world of cryptocurrencies.
What did we learn? Everything. Once we’d picked our jaws up off the floor.
Nothing included within this article is considered or intended to constitute tax, investment or financial advice.
For disclosure purposes the authors contributing to this article hold a number of different cryptocurrency tokens.
For more information contact the cryptocurrency tax team.