How Are NFTs Regulated: Legal Issues, Taxation Aspects and More

People are paying thousands and even millions of dollars for non-fungible tokens. In 2021 alone, the NFT market trading volume reached $25 billion. And where there are large sums of money there are also scams and fraud.

In 2021, a hacker stole NFTs worth $2.2 million from Todd Kramer, an art collector and gallerist. This and similar cases have led to many questions regarding the NFTs’ cybersecurity threat along with the need for regulatory frameworks.

Read on to find out about current NFT regulatory approaches and NFT legal issues, and to see if it is worth investing in non-fungible tokens.

NFTs explained: what makes them so popular?

NFTs are irreplaceable unique digital assets that record their identifying information on smart contracts.

Based on blockchain technology, non-fungible tokens ensure transparency and increased security. They also allow creators to prove the ownership of their work. That is why NFTs have begun to be used by more and more digital artists, galleries, and museums.

What’s more, 2021 was the year of the NFT boom. Numerous celebrities, athletes, gamers, investors, and business owners caught up with the trend in order to commercialize their brands.

Before diving into NFT regulatory challenges, introduce yourself to the most interesting NFT use cases. Check out the video below, where our blockchain consultant describes many real-life examples of using NFTs across multiple industries.

What are the NFT regulatory challenges and concerns?

The increasing popularity of digital assets has raised multiple legal concerns. At root is the fact that the NFT regulatory framework has yet to be designed.

The main challenge with establishing clear regulatory guidelines is that there is still no  consensus on how NFTs are to be treated.

At present, there are three main ways to view NFTs: as commodities, securities, and intellectual property. Let’s dive deeper into each interpretation.

NFTs as commodities

US law defines commodities as reasonably interchangeable services, goods and rights, which include currencies and interest rates and are traded as an article of commerce.

According to the Commodity Futures Trading Commission (CFTC), the definition of commodity includes cryptocurrencies, such as Bitcoin and Ether, along with renewable energy credits and other intangible assets.

If we take NFTs, they share some similarities with cryptocurrencies. They are based on blockchain technology and they can be purchased and sold. At the same time, CFTC focuses mainly on commodity exchanges and price manipulations rather than on the underlying assets and issuers.

If it is agreed that NFTs are treated as commodities, the Commodity Exchange Act (CEA) may be imposed. In this case, CEA’s regulations on manipulative trading may be applied to NFT transactions.

NFTs as securities

Another possible classification of NFTs is securities. However, for this to be the case, NFTs should pass the Howey Test, which is used as the basis for categorizing an asset as a security.

The Howey Test states that security is an investment of money, which is expected to bring profit as a result of the efforts of others. For example, if you buy Google stocks, you expect that Google’s future efforts will bring you profit.

Now, let’s imagine that you purchase an NFT from a famous artist like Beeple. It may appreciate in value depending on the artist’s popularity but it won’t bring you profit as a result of the efforts of others. Therefore, Beeple’s NFT won’t pass the Howey Test.

But if we take, for example, fractional NFTs (or F-NFTs), where an investor shares a partial interest in an NFT with others, these tokens may be considered an “investment contract” according to the Howey Test.

If NFTs are defined as securities, then the Securities Act of 1993 and the Security Exchange Act of 1934 must be applied. In this way only licensed brokers and exchanges will have an opportunity to trade NFTs, while all the markets will be strictly regulated.

NFTs as intellectual properties

Another classification of NFTs is intellectual properties. NFTs allow people to tokenize their assets and ensure that the original asset is assigned to one person.

However, because non-fungible tokens can represent ownership of some work or patent, the result can be problems and questions associated with intellectual property.

It’s true that many NFTs have intellectual property terms written in smart contracts. But the enforceability of these terms takes us back to legal frameworks, as NFTs cannot prevent replication and commercialization of the underlying asset.

In short, creators and issuers are advised to make sure that they have NFT intellectual property rights before issuing their NFTs.

NFTs taxation aspects you should be aware of

In common with stocks or bonds, non-fungible tokens fall under taxation laws, which means that you will need to pay tax on any profits that you make from NFT sales. Here are the standard activities that would generally trigger taxes:

• Buying an asset with fungible crypto. If you’re buying a collectible card at OpenSea using Ether (ETH), this action would incur a capital gain, which means that you are obliged to pay taxes.
• Offering an NFT for crypto. This activity can also result in a capital gain/loss. For example, you’ve bought a token for $50,000 to further sell it for $55,000 BTC. It means that you’ll earn a profit of $5,000 (and therefore be liable to tax).
• Trading one NFT for another one. If you’re buying a token for $5,000 of BTC and then trading it for another token worth $6,000, it would result in a taxable capital gain of $1,000.

At the same time, if you simply come up with a token, that won’t be considered a taxable action.

Some marketplaces, including Rarible and OpenSea, have their own NFT taxation rules. Any gain that you receive from NFT trading will be considered your personal income, and you will need to pay tax. Generally, income tax rates range from 10% to 37%. Your profit will also require you to pay self-employment taxes at a 15% rate.

Laws and regulations regarding NFT taxation generally differ depending on the country.

For example, in the US in 2021, President Joe Biden signed the Infrastructure Law, according to which all brokers, such as Coinbase, must record transactions, tracking them for both the customers and Internal Revenue Service (IRS). Also, companies that receive payments from $10,000 in crypto are obliged to report the identity of the sender to the government.

In the UK, Capital Gains Tax (CGT) is applied to anyone who holds crypto assets and makes a profit on them. This means that you have to pay tax on the difference between the cost of your cryptocurrency and how much you sold it for. You only need to pay CGT on your overall gains that are above your tax-free allowance or the Annual Exempt Amount.

In Hong Kong, there are no specific regulations in terms of NFT taxation. Its Inland Revenue Department (IRD) generally adopts rules and guidelines applied to traditional business when defining the taxability of income generated from digital assets.

In Australia, the Australian Taxation Office (ATO) released directions for NFT taxation. According to this, the tax treatment of non-fungible tokens depends on such things as user circumstances, the way they use the NFT, and their reasons for holding and transacting with it.

Bearing in mind these global and regional differences in taxing NFTs, we recommend you check your local laws and regulations before engaging in NFT sales.

Current NFT regulation laws and standards

Non-fungible tokens have raised many questions about NFT regulation, such as whether or not they are subject to anti-money laundering laws and if they are subject to state laws governing virtual currency.

Let’s discuss these issues in detail.

Are NFTs subject to anti-money laundering laws?

At present, most governments have just started drawing up laws aimed at trying to deal with NFTs money laundering issues. Indeed, NFTs were the reason for creating these new laws and expanding the existing ones.

In 2021, US Congress passed the Anti-Money Laundering Act, intended to regulate the activity of financial institutions. The Act doesn’t directly set out regulations regarding NFTs, yet it expands the definition of financial institutions by including businesses involved in the medium of exchange that substitutes for currency. This is relevant to cryptocurrency in general, and NFTs in particular.

The Office of Foreign Assets Controls (OFAC) has likewise not given any particular recommendations on NFT standards. However, they stated that US sanctions apply to digital transactions in a similar way to traditional ones.

The US government also added some anti-money laundering provisions to the National Defense Authorization Act (NDAA). These include updates to some anti-money laundering regulations, such as the Corporate Transparency Act (CTA) and Anti-Money Laundering Act (AMLA). AMLA expanded the Bank Secrecy Act to everyone who trades art pieces (consultants, advisors, sellers, and so on).

The EU approach towards NFT and money laundering is similar in that they haven’t designed anti-money laundering regulations specific to NFTs. However, in 2021 the European Commission adopted the Markets in Cryptoassets Regulation (the MiCA Proposal). This digital finance package includes a legislative proposal for regulating crypto assets.

MiCA features rules that would be applied to NFTs and, for the first time in the EU, provide a definition of crypto asset. Its main goal is to streamline blockchain technology and virtual asset regulation in the EU.

Are NFTs subject to state laws on virtual currency?

The situation with virtual currency looks broadly similar to the state of play regarding anti-money laundering — governments haven’t yet released any specific guidance about NFTs. However, some US states have passed laws that regulate the operation of companies involved in virtual currency business.

For example, New York has a list of activities — including exchanging, transferring, administering, and issuing virtual currency — that require companies engaged in these activities to have a license and post surety bonds or fund an account, all of which helps protect customers.

NFTs and consumer law

As non-fungible tokens are offered to the public and not restricted to professional buyers only, they generally fall under the local consumer laws.

The consumer law requires NFTs to operate with a high level of transparency and follow consumer protection laws, including the right for consumers to get appropriate data about NFTs in their local language, subject the sale of non-fungible tokens to their local law, and more.

What are the NFT legal issues that you should keep in mind?

As we mentioned earlier, NFT standards and the legal environment were not designed to accommodate these digital assets. All the same, while NFT investors, buyers, and sellers explore this field, new NFT legal issues continue to emerge.

Currently, the two most common NFT problems include issues with intellectual property rights during NFT sales and cybersecurity threats.

Do NFTs give you intellectual property rights?

If you want to purchase NFTs, you should understand that the intellectual property rights are determined by the NFT seller.

In cases where the issuer of an NFT is a content creator, they are considered to own intellectual property rights to this NFT: they have the right to use, copy, or modify the content, and can grant these rights to the buyer.

However, if an issuer receives content from the creator, then they will receive only the rights that the creator assigned to them. When selling an NFT they will only be able to assign these limited rights to the buyer.

To avoid buying unauthorized digital assets, make sure that the NFT you purchase contains metadata describing the corresponding assets to which they are bound, such as token ID or original creator. Doing this will allow you to check who actually owns the underlying asset.

You should also remember that when purchasing an NFT you are not acquiring the underlying work of art and all its accompanying rights. Instead, you buy the metadata associated with the work (this is not the same as the work itself). Your purchase guarantees your exclusive rights to possess this NFT but doesn’t guarantee anything beyond that.

Let’s see how this all works in a real-life example. Jack Dorsey sold his tweet through the Valuables platform, which characterized the purchase as “an autographed certificate of the tweet” and wrote in the terms of sale that any such purchase will not transfer the copyright in the tweet to the purchaser.

That is why, despite spending $2,9 million on the NFT purchase, the buyer will not be able to use the tweet itself — for example, printing it on a shirt — without the permission of Dorsey, who still owns all the copyrights. The tweet could only be used if Dorsey transferred those intellectual property rights to the NFT buyer.

Currently, courts are seeing an increasing number of cases related to NFT copyright infringement. An example of an early case is the Roc-A-Fella Records (RAF, Inc.) case. RAF Inc. was founded by Shawn Carter (Jay-Z), Dame Dash (Dash), and Kareem Burke. RAF Inc. had rights to all the recordings of the trio, including the album Reasonable Doubt. In 2005, the trio decided to cut their business ties, with each of its members retaining a one-third state in RAF Inc.

In 2021, Dash minted an NFT of the Reasonable Doubt album, promising that this NFT would prove ownership of the album’s copyright, transferring the rights to all the future revenue from the album to the NFT holder.

Technically, as Dash is a shareholder, it does not have direct ownership of the album. Therefore, this action prompted RAF Inc. to file a complaint aimed at stopping Dash from auctioning the NFT. The court agreed with RAF Inc. and barred Dash from selling, reproducing and exploiting the album.

Similar cases are likely to continue to appear in the courts, in turn helping establish the framework for the regulation of non-fungible tokens.

Do NFTs contribute to cybersecurity threats?

The growing popularity of NFTs, including the ease of their creation and sale, is also throwing up a variety of cybersecurity concerns, with NFT scams and account takeover being the most common. Let’s take a closer look.

Fake NFT selling and plagiarism

Fake NFT selling involves taking an item on the internet without having intellectual property rights to it and selling it on a marketplace. It can also involve selling copies of famous works and passing them off as originals.

For example, Aja Trier, an artist who is well-known for painting riffs on Van Gogh’s Starry Night featuring different breeds of dogs, recently reported that she had found 86,000 NFTs based on images of her work. Moreover, Trier found that at least 37 NFTs based on her stolen works were purchased on OpenSea till it took down the fraudulent listing. And the artist didn’t see any of that money returned to her.

Fortunately, governments have started to take action to prevent such activities. For example, the US Attorney for the Southern District of NY recently announced charges against two defendants who were involved in an ongoing fraud associated with NFT sales.

The defendants were accused of offering bogus NFTs via different social media channels. Both defendants were charged with one count of wire fraud and one count of conspiracy to commit money laundering. Each charge carries a maximum sentence — 20 years in prison.

This criminal case is among the first that involve NFTs and, hopefully, it will lead to further regulatory scrutiny of these digital assets.

Account takeover

Account takeover is another pain point for NFT holders. It allows cybercriminals to access, control, and sell NFTs that do not belong to them.

For example, in March 2021 the Nifty Gateway NFT marketplace reported that some of their user accounts that didn’t enable two-factor authentication had been hacked. Victims claimed that their NFT art was stolen and some of the NFTs were then resold.

To avoid situations like this, it is imperative for NFT marketplaces to reconsider their administrative and technical safeguards. Users should also take some preventive measures, such as activating two-factor authentication on their account.

Are NFTs a good investment after all?

As we’ve seen in this article, there are some risks involved in NFT investment. And the lack of a real regulatory framework only complicates the situation.

At the same time, non-fungible tokens provide a variety of benefits for all participants. NFT trading doesn’t require intermediaries and associated commissions — a big plus for both NFT creators and investors.

Also, by investing in a promising NFT project you can go on to resell your NFTs and gain huge profits. Consider the example of an NFT by XCOPY called Reflection. Initially sold for $98,500, two weeks later the artwork was resold for $872,500 at the SuperRare marketplace.

So if you are considering investing in the NFT market, we recommend you spend time analyzing the project you are interested in and start small. The traditional principle of investing, known as” buy low and sell high”, also works here.

Closing thoughts

As we can see, the NFT market is still developing and it will take time for a proper NFT legal framework to be established. That said, governments around the world have already taken their first steps towards the creation of NFT rules and standards, demonstrating that they are paying serious attention to these digital assets.

You must also be aware that the astonishing popularity of NFTs will inevitably lead to fraudulent activities, which is why it is increasingly important to do your own research before buying or investing in NFT collections or projects.

If you still have questions regarding NFT legal aspects or need advice on how to capitalize on non-fungible tokens, reach out to our PixelPlex developers and consultants. With certified specialists on board, and a portfolio of 80+ blockchain-based projects, we can help you get the most out of the NFT market.