NFTs and the law

Answer

‘NFT’ (or ‘non-fungible token’) has become a buzzword, namely in relation to the buying and selling of digital art on a blockchain for up to millions of dollars. However, an NFT is not just a piece of tradeable digital art but a technology that allows for unique identification and proof of ownership of different types of asset, both digital and physical.

The appeal of NFTs to the art market is clear, but as the popularity of NFTs grows and different use cases are developed, the spotlight has highlighted significant legal and regulatory implications.

In order to understand those implications, it is key to understand the way NFTs work.

What are NFTs?

‘Non-fungible’ means something that has its own unique, identifying characteristics; it is not interchangeable because its value derives from its uniqueness. This is different to currency or cryptocurrency, which are ‘fungible’ because their value defines them.

Therefore, in its most basic form, an NFT is a technology that attaches a unique string of code to a digital (or physical) asset (‘tokenisation’). The token usually consists of a:

• unique identification number; and
• smart contract containing predefined terms and conditions of the NFT.

This token is stored on a blockchain that prevents alteration of the ownership records. Information about the underlying asset of the NFT (eg, the digital artwork) is contained in the metadata. This may include a description of the asset, including any individual characteristics and a reference or link to the asset. This is an important distinction – the asset itself is almost never stored on the blockchain, but rather a link, or file that points to or references such asset.

Creating and trading NFTs

‘Minting’ is the process of creating an NFT and rendering it into a blockchain – usually through an existing platform. Once minted, the owner can then trade the NFT by transferring ownership of the token.

The owner has access to their NFT(s) through a ‘wallet’ secured by a private key, similar to a PIN, that allows owners to authorise transactions. The token (and its metadata) transfers to the new owner on the predefined terms of the embedded smart contract.

Technology or property?

The distinct make-up of an NFT has raised the question of whether the NFT itself, (ie, the unique string of code) is distinct from the underlying asset that it represents. This considers the fact that only information pointing to the asset is stored in the metadata of the NFT.

A recent application for a freezing order to the High Court considered whether such tokens were to be considered as property for the purposes of the law of England and Wales. The NFTs in question were stolen from a digital wallet, and the claimant filed for a freezing order to prevent the further sale of the NFTs. The judge held that NFTs were ‘property’ and, therefore, could be subject to the order.

The judgment provides clarification, and allows certain existing legal and regulatory frameworks to govern disputes. Other jurisdictions are following suit. For example, in Singapore, the High Court granted a worldwide proprietary injunction against the sale of an NFT used as collateral for a debt obligation, thus also recognising NFTs as property.

Tax treatment

In the UK, recognition of NFTs as property may also provide clarity on their tax treatment. As of yet, no official governance has been given as to how NFTs should be treated for tax purposes, but following the judgment it is likely that NFTs may be subject to capital gains tax. Therefore, when an owner sells an NFT, they would be required to pay tax on any gain they make (subject to certain conditions and reliefs).

However, further questions remain as to the tax treatment of NFTs. For example, when determining the location of the NFT for tax purposes, will it be where the owner of the NFT is situated, or where the underlying asset is located? What other tax issues may arise in the continued development of NFTs? Will tax treatment affect the future development of NFTs?

The UK tax authority has released internal guidance on cryptoassets, and the US has begun to contemplate the tax consequences of NFTs in draft legislation, but these questions remain due to the current rate of development outpacing the legal and regulatory environment within which they operate. It will be important for lawyers to partake in and understand the application of both existing and developing tax laws regarding NFTs.

Smart contracts, IP rights and royalties

Although the NFT constitutes property that the owner can sell and transfer, the IP rights attached to the underlying asset do not automatically transfer to the NFT owner. A smart contract embedded in the NFT allows artists and creators of tokenised digital assets to control IP rights, even if the NFT is traded repeatedly.

A smart contract is a sequence of coded conditional statements (eg, if X happens, then Y happens), which self-executes when those conditions are fulfilled. Basic conditions include verifying the ownership and the transferability of the NFT, as well as more specific terms such as the licensing or transfer of copyright and royalty payments to the original artist or creator. It would suggest that there are still opportunities to be explored in their utility. As smart contracts develop, so does the potential of NFTs.

Conclusion

There are still unanswered questions as to the legal and regulatory status of NFTs. Solutions are developing as cases are heard, and government and regulatory bodies realise there is a need for clarification. However, it is clear that to properly advise clients and contribute to those solutions, lawyers must have a solid understanding of the technology that lies behind the buzzword.

Holly Cook is a trainee solicitor at White & Case LLP.

“Any views expressed in this publication are strictly those of the authors and should not be attributed in any way to White & Case LLP.”