NFTs and Tax Evasion: a brief overview of the crypto market and EU tax law

NFTs and Tax Evasion: is it possible to strike a balance between the profitability of the emerging crypto business and the tax interests of the EU and its Member States?

Non-Fungible Tokens (NFTs) are in the spotlight of the financial market, having reached a market cap of $40bn by the end of 2021. The European Union (EU) has turned its eyes to this volume of transactions which, for the most part, are still made without due control by the tax authorities. NFTs are trending on social networks, in the media, in the financial market, and in academia. But what are NFTs and what risks do they pose to the tax system of the EU Member States?

NFT is a representation of a unique asset (usually digital) that cannot be changed or traded for another NFT of the same type. It thus serves also as a digital certificate of authenticity that cannot be replicated. As a fictional example from the physical world, if someone wants to buy a Van Gogh painting, the buyer will request a certificate of authenticity issued by the competent authorities and it is expected that this certificate will be forgery-proof.

NFTs are stored in a distributed ledger technology (DLT) or a blockchain and used to prove ownership of unique assets. Due to the structure of the blockchain technology, this proof of ownership is always available, immutable, and guarantees that the given asset has only one owner.

The assets represented by NFTs may be exchanged in specific marketplaces (e.g. OpenSea and Nifty Gateway), creating a process of tokenization from reality to digital. NFTs can be used to create verifiable digital ownership over several assets e.g. crypto art, digital collectibles, online games, intellectual property rights, real estate, jewelry, vehicles, licenses, and financial documents.

On the one hand, NFTs may create wealth by helping artists, collectors, and interested parties negotiate in a secure and decentralized environment. On the other hand, concerns related to taxation may arise due to the weak regulation, the anonymity in the DLT, and the borderless nature of the cryptoassets. Since NFTs are mostly exchanged as crypto-collectibles and digital art, it is difficult to appraise their value. Additionally, the NFT price fluctuations may represent an issue for their valuation, a key factor to calculate the overall capital and capital gains for tax purposes.

The EU does not have a direct role when it comes to tax law, as this is the competence of the Member States. However, the EU oversees tax rules in key areas to ensure and promote the free flow of goods and services within the Union, to make sure that one country does not have an unfair tax advantage over another, and to guarantee that taxes do not discriminate consumers, workers, or businesses.

In the current scenario, national tax authorities and the EU do not have sufficient information about the NFT trading business, thus, possibly resulting in losses related to non-taxation. Additionally, the disparity between the Member States’ tax laws may be contributing to tax evasion within the Union.

On the one side, “crypto-friendly” countries like Portugal, Germany, and Slovenia have favorable laws that may benefit certain types of investors (e.g. by only taxing crypto in specific scenarios). On the other side, countries with stricter tax laws like Spain, Norway, and Italy have opted, for instance, to tax the capital gains arising from the crypto business.

Different tax regimes for cryptoassets within the EU may give rise to a “race to the bottom” where crypto investors are constantly moving their assets to more favorable Member States. Legal uncertainty may also lead to crypto businesses moving outside the EU or to crypto holders sending their assets to unhosted wallets that are not required to conduct customer due diligence (CDD) – posing a significant risk of tax evasion.

To address these discrepancies and prevent such risks, the EU needs fair, efficient, and sustainable taxation schemes. Bearing this in mind, the European Commission (EC) is working on the DAC-8 that will amend the current Directive on Administrative Cooperation (DAC) to expand the information exchange framework in the field of taxation to include cryptoassets and e-money.

The existing DAC obliges financial intermediaries to report financial activities to the tax authorities and provides for an information exchange requirement between the Member States. Nevertheless, this obligation does not apply to cryptoassets as the intermediaries of the crypto sector (i.e. cryptoasset service providers – CASPs) are not covered by the Directive.

The introduction of the obligation to report financial activities in the crypto sector accompanied by the mandatory information exchange between the Member States will enable tax authorities to obtain the necessary information to conduct a risk-based approach to cryptoassets and facilitate tax control over them.

Article 115 of the TFEU stipulates that the main rationale underlying EU taxation lies in the well-functioning of the Internal Market, which shall not be hindered due to uncoordinated national legislation. Promoting EU-wide standardization of reporting rules would make it easier for taxpayers to comply with reporting obligations and help tackle tax evasion. Additionally, this would ensure that taxpayers, particularly those who earn money with crypto, pay their fair share.

Keeping the EU perspective, the Markets in Cryptoassets Regulation (MiCA) also provides an interesting framework for tax purposes. In Articles 84, 85, and 110, MiCA states that the competent authorities responsible for carrying out the functions and duties provided for in the Regulation should cooperate with the European Banking Authority (EBA) and European Securities and Markets Authority (ESMA) for tax purposes.

The EU should guarantee its legal system is ready to combat tax evasion arising from the crypto business, particularly concerning the NFT trading, while making sure the investors can profit in the Union. To do so, the EU legal framework should:

– Establish where NFTs stand on the grounds of taxation (i.e. if they should be considered virtual currencies, collectibles, digital art, or securities);

– Enable a risk-based approach to the cryptoassets business avoiding unnecessary burden over low-risk investments and transactions;

– Encourage that actions to combat tax evasion are aligned with the precepts of the Financial Action Task Force (FATF) and the Organization for Economic Cooperation and Development (OECD);

– Ensure that the tax information provided by the CASPs is used and disseminated in compliance with the GDPR.

By implementing these measures along these lines, the EU may continue to play an important role in the cryptoassets business and have an advantage over global competitors who are also in the process of regulating this novel market. In addition to this, by making tax evasion in the cryptoassets market more difficult, the EU and its Member States may access significant resources that can be directed to key areas for the development of the Union.

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