NFTs: What Are They and Who Is in Charge?

Introduction 

Non-fungible tokens (“NFTs”) are one-of-a-kind digital assets that are purchased and sold using blockchain technology. Unlike cryptocurrencies, these assets or tokens are non-fungible, meaning they cannot be replicated or replaced with an identical unit. The NFT market is relatively new but gaining momentum amongst artists, musicians, collectors, and video game enthusiasts. While NFTs can be an efficient and transparent method for artists and fans to connect, there are regulatory concerns and those involved should be aware of the risks. Regulatory agencies like Financial Crimes Enforcement Network (FinCen), Office of Foreign Assets Control (OFAC), the Internal Revenue Service (IRS), and the U.S. Securities and Exchange Commission (SEC) have not provided clear distinctions on the treatment of these digital assets and are continuing to monitor the industry. Some consumers are jumping on the bandwagon without knowing exactly what they are buying and the potential ramifications of their purchase. Consumer protection requirements should be at the forefront when discussing NFT and digital assets.

OFAC Compliance

NFTs can be purchased and sold from virtually anywhere in the world. This provides new, upcoming, and well-known artists with the opportunity to reach a far greater audience when compared to conventional methods of distribution. The global NFT market presents its own risks when looking at NFTs through the lens of OFAC compliance. “The Office of Foreign Assets Control ("OFAC") of the US Department of the Treasury administers and enforces economic and trade sanctions based on US foreign policy and national security goal….”(1) OFAC’s Specially Designated Nationals (“SDN”) and Blocked Persons list continues to grow and is updated regularly to identify organizations and individuals who control or are acting on behalf of a targeted country. The inherent nature of blockchain technology promotes user anonymity, making compliance efforts difficult for NFT marketplaces, buyers, and sellers. Currently, individuals who have been placed on the SDN list can create and sell NFTs to U.S. citizens as they please. This activity at face-value could potentially implicate theses citizens in an OFAC violation.

FinCen and KYC

FinCen’s mission is to “safeguard the financial system from illicit use, combat money laundering and its related crimes including terrorism, and promote national security through the strategic use of financial authorities and the collection, analysis, and dissemination of financial intelligence.” In some cases, there may be an obligation to perform know-your-customer (“KYC”) procedures under the Bank Secrecy Act (“BSA”). The goal of KYC is to restrict money laundering activities in financial markets. NFTs, like many art transactions, provide an opportunity for money launderers to circumvent the regulators and fund criminal activities. Platforms, marketplaces, creators, and collectors must be diligent and aware of these restrictions and how they can be in violation of FinCen rules. As of January 1, 2021 Congress passed the Anti-Money Laundering (AML) Act of 2020 which notes that the term “financial institutions” includes “dealers in art” (Title 61 Section 6110). This new treatment of art dealers with respect to BSA/AML activities may pose a threat to the adoption of NFT marketplaces when the specific rules are issued by the Secretary of the Treasury. Issuers and marketplaces should consult an attorney to discuss the applicability of these issues to their NFT activity.

State Compliance

Another area of concern for the growth of NFTs is at the state level. Forty-seven states and the District of Columbia require licenses for money transmitter businesses. With the revised definition of financial institutions including “dealers in art,” NFT marketplaces may have to submit applications for licensure if the terminology is adopted at the state level. These requirements are accompanied by costs of maintaining compliance and could create a barrier for entry into the industry and adversely affect current NFT platforms.

Copyright and IP

While government agencies continue to observe the NFT market, NFT creators, collectors, and fans must manage their own risk when buying and selling NFTs. When an individual purchases an NFT of music or art, it may be unclear to them what they are actually purchasing if they do not possess an understanding of blockchain and its capabilities. NFT marketplaces in general do not specify exactly what is being purchased. There are 2 possibilities:

• The purchase of an NFT represents the “master” copy of the media. In the music business, a master recording is the official original recording of a song, sound, or performance. Also referred to as “masters,” it is the source from which all the later copies are made.
• Conversely, artists could equate an NFT purchase to purchasing a collectible. While the purchaser owns the license to use the digital media they may not distribute or resell the original work of art or music for personal gain. With blockchain this becomes difficult to manage since wallet owners can transfer tokens to whomever they please.

Counterfeiting

Another area that must be considered when dealing with NFTs is the risk of counterfeiters. Many NFT marketplaces allow anyone to create tokens and sell them through their platform. As noted above, many of these platforms have not been required to implement KYC procedures and could be providing a market for counterfeit art and/or physical goods. Buyers must become knowledgeable of blockchain and the marketplace to avoid the purchase of counterfeits. Blockchain tracing tools can help the average collector or fan determine the legitimacy of NFTs, but this requires that the buyer invest the time to do so.

Are NFTs Securities?

One more consideration is the possible treatment of NFTs as securities. Although the SEC has not taken a stance on the topic, the SEC has entered into several lawsuits claiming other non-NFT digital assets are securities. Many factors would need to be considered to determine whether or not an NFT is a security including, but not limited to, the design of the NFT, how it is sold and promoted, as well as the rights provided as a result of purchase.

Are NFTs Collectibles?

The IRS classifies digital assets (or “virtual currency,” as the IRS calls it) as property, and as such, sales of digital assets are taxed as capital gains. Capital gains on property held for more than one year are taxed at a favorable “long-term capital gains” tax rate ranging from 0% to 20% for federal income tax purposes. Sales of “collectibles,” however are taxed at a 28% capital gains rate. Should an NFT be considered a collectible for tax purposes? Or something else? The answer is not clear. Owners of NFTs should work closely with their accountants to consider the tax impacts of their transactions.

Conclusion

Regulators are scrambling to determine how these assets should be treated and how involved they should be within the market. As these regulators provide more definitive guidance, Citrin Cooperman has a team of professionals to keep you and your customers up-to-date and help navigate the world of blockchain.

(1) https://home.treasury.gov/policy-issues/office-of-foreign-assets-control-sanctions-programs-and-information#:~:text=The%20Office%20of%20Foreign%20Assets,traffickers%2C%20those%20engaged%20in%20activities