Taxing the Metaverse

The metaverse has gained popularity following Facebook (Meta)’s announcement that it would bring the “Metaverse” to life and the excitement around cryptocurrency and NFTs. The metaverse acts as a social network where people participate in virtual activities, like purchasing digital real estate with digital currencies. Economic activity spans from buying and purchasing virtual goods, to offering virtual services such as legal counseling and accounting. In a new paper, I define metaverse as any network of virtual worlds wherein participants engage in economic activity, including the ability to consume, create, trade, and accumulate digital items with real economic value. (An item has real economic value if it can be converted or at least valued in a taxable currency such as crypto or the U.S. dollar.) Under this definition, only virtual worlds that go above and beyond traditional video games are considered a part of the metaverse.

My paper argues that this virtual world should be subject to income taxation. First, the economic activities satisfy the Haig-Simons definition of income. Online video games of the past that may be considered a precursor to the metaverse existed for the users’ consumption. Yet the metaverse allows users to produce real income and accumulate wealth as well as consume. Second, the recent collapse of cryptocurrency markets and FTX, which are closely related to the metaverse, showed the downside of a lack of regulation. Introducing taxation may enhance transparency and regulatory monitoring.

Taxation, however, will come with several challenges. One is size. Currently, there is a relatively small tax base and a small number of taxable transactions within the metaverse. Most of its 400 million monthly users are children playing  video games, Roblox, Minecraft, and Fortnite (which are part of the metaverse). The heavy users of the metaverse that this paper targets make up only a minority of users as a whole. Another issue is volatility. The value of digital assets has swung widely, making the future of the metaverse uncertain.

Despite these challenges, there are theoretical and practical justifications for taxation. The income from economic activity, as mentioned, falls within the Haig-Simons definition of income, which is the sum of the value of a taxpayer’s consumption and the net change in wealth during the period in question. When participants in the metaverse receive profits from activities like operating a virtual store or buying or selling digital property with real economic value, that is Haig-Simons income. Furthermore, this income fits within the statutory definition of income, which is that gross income includes income “from whatever source derived.” Taxation of the metaverse can also untap a significant revenue source and help avoid the risk of the metaverse’s becoming a tax haven. For practical justifications, taxation can play a regulatory role in a largely unregulated market by enhancing information reporting and transparency. We already see some of this strategy in action. The IRS issued ad hoc guidance on cryptocurrency reporting in 2014, which required the reporting of any gain or loss from the sale of cryptocurrency. Further, under the Infrastructure Investment and Jobs Act, digital-asset brokers are required to collect customer information and report all transactions involving digital assets to the IRS. If taxation in the metaverse is implemented, we could see similar reporting requirements.

The next step would be to determine the tax base. The different types of income to consider include earnings and profits, self-created or produced assets (like NFTs), rewards (like loot drops), and gains derived from virtual assets. The paper explains that all those categories satisfy the definition of income.

However, two issues arise when we include those types of metaverse income in the tax base – valuation and liquidity. The volatile price swings of digital assets can make it hard to value profits. Liquidity may become an issue if virtual income is in the form of assets and not cash, making payment of taxes difficult. Because of these issues, current practice is to defer taxation of metaverse income and wealth until it is converted to actual cash. This approach is more regressive than real world taxes, which apply upon receipt of income or are deferred until realization of income occurs. However, no taxation occurs in the metaverse even upon realization.

My paper argues that we should harmonize metaverse taxation with current tax law. That is, when realization occurs, as when income is received or virtual assets are sold, it should be a taxable event. The paper also offers a more aggressive proposal: Assets or wealth in the metaverse should be taxed immediately upon receipt. This can be a more efficient and equitable method than the realization requirement. The approach would use a mark-to-market method known as the ULTRAs (unliquidated tax reserve accounts) system to overcome the valuation and liquidity challenges of metaverse taxation. The ULTRAs system gives the government a notional percentage stake in a taxed asset upon receipt but defers actual tax collection until the sale of the asset. The ULTRAs may eliminate the deferral incentive, as do other mark-to-market proposals, and resolve the valuation and liquidity issues because of its deferred collection scheme. But it requires closely tracking changes in net wealth and value in unliquidated assets. The good news is that the digital world records all digital activities, affording new methods of monitoring and tracking individual wealth. Thus, the metaverse, in conjunction with the ULTRAs system, might present the perfect opportunity to experiment with taxing income that has escaped the tax base or been deferred for administrative reasons.

Finally, my paper explores potential compliance issues. It first identifies the proper tax jurisdiction between the residence of the taxpayer and the source of the income. The tax authority will likely rely on the users’ IP addresses for residence taxation. However, it will be challenging to find the correct address since individuals can easily disguise their IP addresses using VPNs. For source taxation, the metaverse’s server location is a plausible tax nexus. However, it is still only a proxy for the metaverse, which has no physical location. If server location is considered an improper nexus for sourcing income, the locations of metaverse platform companies might be a practical option.

Overall, the task of taxing the metaverse comes with many challenges and questions. The paper argues for speeding up the taxation timeline for income generated in the metaverse. Further, it argues for the implementation of the ULTRAs system to solve valuation and liquidity issues. By taxing the metaverse, the government could avoid making the metaverse a new tax haven. We could also learn more about the many aspects of human activities by testing tax proposals and policies on the metaverse.

This post comes to us from Professor Young Ran (Christine) Kim at Benjamin N. Cardozo School of Law. It is based on her recent article, “Taxing the Metaverse,” available here.