Metaverse And Taxes – Key Considerations and Challenges

The metaverse is expected to introduce a new world of economic activity, but one thing still remains unclear: taxation. How do real-world taxes apply to potentially infinite virtual worlds?

The metaverse seems like the stuff of popular sci-fi movies and novels: a series of virtual worlds allowing users to conduct business, socialize, play games, and explore unique environments without leaving their home. But existing enabler technologies are already being utilized, and in response. Global corporations in the tech industry are revising their strategies. We’re at the dawn of a new era of technology that is enabling many taxable activities.

While the metaverse may seem fresh and innovative, the concept is hardly new — similar versions of it have already been around for years. Such as? One example is Second Life, which went online in the early 2000s, and another is digital twins: these are utilized for exploring real-world situations in virtual spaces, popular in manufacturing and engineering.

Today, though, a combination of blockchain and alternative groundbreaking technologies are creating Web3, the Internet’s latest iteration. Web3 is expected to decentralize the existing Web2 internet and remove intermediaries, which would allow users to enjoy a persistent, shared 3D virtual realm.

The metaverse is predicted to make a substantial impact, with most people likely to use it in one way or another. Users will be able to do everything from speaking with a doctor to attending a rock show, from earning a living to buying goods. Conducting transactions will be a common occurrence, so it’s crucial that businesses, users, and tax agencies understand the changes that Web3 will bring. There are real tax implications of this new way of living, working, socializing, and playing.

The Metaverse’s Building Blocks

Thanks to Web3 and its artificial intelligence (AI) capabilities, we have already seen the growth of non-fungible tokens (NFTs), cryptocurrencies, and smart contracts (in which tasks are executed automatically after specific conditions have been met) powered by blockchains.

Combine all this with virtual and augmented reality, and the metaverse is clearly one of the most important technological creations of all time. Companies and governments are already planning ways to adapt or apply tax processes to these innovative concepts.

But it’s vital that we all understand what the metaverse is and how it differs from existing games or virtual platforms that already provide an immersive experience (e.g. Fortnite). To clarify what the metaverse is, let’s look at its five core concepts as defined by Matthew Ball:

• A strong economy: Future iterations of NFTs, cryptocurrencies, and alternative digital assets based on blockchain technology will likely be integrated into the metaverse. All of these introduce new tax issues to consider.
• Interoperability: Unlike Web2, the metaverse will provide users with a seamless experience, enabling them to switch from platform to platform while maintaining ownership of their data, their assets, and (crucially) their identity.
• Persistence: As the metaverse won’t be reset, it will theoretically go on and on without reaching an endpoint.
• Synchronous continuation: Life in the metaverse will continue regardless of whether or not a user stays signed in.
• No user cap: The metaverse will accommodate an unlimited number of users, each with a unique, persistent virtual identity.

Due to Web3’s explosion and various metaverse initiatives, users across the globe have an opportunity to embark on entrepreneurial exploits together, creating their own working methods and setting their own rules autonomously. These decentralized autonomous organizations (DAOs) are owned and controlled by members, but governed by smart contracts powered by blockchain technology.

Users can arrange DAOs around any project, and governance depends on voting rights and tokens. These are set up to suit the organization’s controlling members. However, in a lot of jurisdictions, DAOs’ tax and legal status are still unclear.

In 2021, Wyoming was the first state in the U.S. to give a DAO the status of a legal entity. Various organizations have sought advice from third parties to apply existing legal frameworks (e.g. an association, entity, or cooperative) around a DAO. This would provide a certain degree of comfort when there is so much uncertainty.

But one thing is certain: DAOs are evolving into a popular form of organization for projects related to WEB3 and the metaverse. With increasing DAO adoption, their tax and legal treatment must be made clear worldwide.

Major Companies Taking the Lead in the Metaverse

With the metaverse being built with impressive speed, brands operating on a multinational scale are moving into the metaverse cautiously. In early 2022, JP Morgan broke new ground with its Onyx client lounge: it became the first of the major international banks to set up a metaverse presence.

Other leaders include companies in the luxury sportswear and fashion fields. These are creating NFT clothing and accessories for user avatars, allowing people to customize their virtual selves with the latest gear.

Automotive companies have established partnerships with metaverse platforms to present exciting concepts for new vehicles. Additionally, a number of major brands in the U.S. entertainment and retail worlds appear to be preparing to introduce metaverse products or services of their own (according to trademark and patent filings).

While these organizations are working towards establishing a metaverse presence gradually, their tentative steps demonstrate that they’re aware of the potential of the metaverse and want to be recognized as early adopters. Grayscale found that the metaverse could generate yearly revenues of over $1 trillion, creating new opportunities in virtually every area of the economy.

Making Taxes More Complicated for Companies and Authorities

As the metaverse is expected to add a fascinating (and potentially very lucrative) layer to the ecommerce industry, we’re already witnessing the arrival of new taxable activities.

And that means that tax teams face certain challenges, including determining which jurisdictions can apply taxes to digital transactions, not to mention the way in which cryptocurrencies will be taxed when buying digital assets. The speed with which the metaverse is being adopted, and will continue to be, means that the digital economy’s existing issues will increase the level of market uncertainty and confusion already seen.

For example, let’s consider Ariana Grande’s series of shows broadcast on Fortnite in 2021. Around 78 million fee-paying users watched her virtual tour, and it’s believed that the singer made over $20 million directly from her virtual appearance (which includes sales of merchandise). But at the time of writing, there is still no concrete understanding of who may legally tax this or similar events. Should it be the jurisdiction in which the star performed? Or should it apply to each member’s location at the time of viewing?

Issues relating to indirect tax in the metaverse still need to be resolved. For instance, if a user buys a piece of NFT real estate, should VAT be applied to this transaction? Or should it be considered a bartering transaction that triggers a capital gains tax?

At the time of writing, the Organization for Economic Cooperation and Development (OECD) is working towards possibly establishing a common tax framework for cryptocurrency, to try to establish a consensus between jurisdictions. However, it’s unclear how much time this will take to be completed and even how many nations are likely to sign up eventually.

Between then and now, countries are taking varied positions on tax, with different approaches to classifying digital assets and applying tax treatments to sales and purchases. For international companies that need to make their way through this tax landscape, which continues to evolve at a rapid rate, all this has added another layer of risk and complication.

The tax function’s part is to ensure regulatory compliance and to advise the company on how it should be structured to achieve the necessary compliance. It can be challenging, though, to build a plan and operating model that works when the rules are either hard to pin down or don’t actually exist. As a result, there is a risk of tax functions living in an uncertain world.

Adjusting Current Tax Frameworks to Solve Metaverse Complications

Solutions for the metaverse-related tax problems can be expected to reflect the general worldwide response to the dotcom boom of the ‘90s and, ultimately, the global economy’s subsequent digitalization. Historically, jurisdictions have fought against drawing up fresh legislation when faced with challenges like these. Instead, they have adjusted current tax frameworks and concepts to tackle new digital activities, while still discreetly managing to fill any gaps in legislation.

Some jurisdictions appear to be taking this approach to fix tax issues created by the metaverse. Cryptocurrencies, NFTs, and other digital assets bypass traditional intermediaries and operational tax reporting systems. The OECD, UK, and U.S. are working on extending legislative frameworks that already exist to cover crypto wallet providers, crypto exchanges, and other digital intermediaries. Examples include the eighth Directive on Administrative Cooperation (DAC-8), the Common Reporting Standard (CRS), and the Foreign Account Tax Compliance Act (FATCA).

With regards to metaverse-related tax challenges, effective solutions could exist within the metaverse or its Web3 infrastructure. There are two perspectives to consider here. In one, the metaverse could be a virtual environment that is decentralized, almost anonymous, and mostly without regulation. In the other, the blockchain technology is transparent so it’s easy to view transactions in real-time as they occur across distributed ledger networks.

It’s possible that tax reporting engines, operating in real-time, may be constructed on top of blockchain transactions. These would provide tax authorities with details on transactions automatically, as they take place, leaving the traditional reporting method behind.

Furthermore, the U.S. Government and others are exploring programmable central bank digital currencies, and finding ways to digitize customs duties and other gross-basis taxes via crypto token utilization.

Conclusion

Major tax challenges may emerge with the growth of the metaverse and Web3 tech. However, these innovations could also introduce fascinating new tools that make collecting tax correctly easier, more efficient, and more cost-effective for everyone.