Diritto tributario internazionale e dell’UE
The Metaverse: Why, where and what to tax
How to decline the ability to pay in the digital world
Dottore Commercialista – Revisore legale
ICAEW Chartered Accountant
Miccinesi Tax, Legal & Corporate
Disclaimer: This article is based on the speech at last edition of Bloomberg Tax Leadership Forum held in New York in November 2022.
Blockchain and the metaverse question the current allocation model of taxing rights between different jurisdictions. Consequently, policymakers must now rethink the existing tax systems trying to discover a new nexus for digital space to prevent it from becoming the next offshore tax haven.
II. The Metaverse
A. Taxation in the metaverse
1. Why tax?
2. Where to tax?
3. What amount to pay?
B. Metaverse Transactions and Indirect Taxation
Each industrial revolution led to significant economic transformations which, in turn, affected tax bases countries can rely upon. For example:
- Machine tools and factory processes, characterised the first and second industrial revolutions (from the 19 th century and the beginning of the 20 th century), significantly increased productivity per square meter of land used, switching the economic system from agricultural to industrial (“bricks and mortar” economy). The new production system entailed the first shift from land to income taxation and, from an international perspective,
brought with it the need to set new international tax standards to allocate taxing rights between different jurisdictions. These include: (i) Permanent Establishment (PE), representing a minimum threshold preventing the source country from taxing a foreign enterprise’s business income; and (ii) Arm’s Length Principle (ALP), establishing transfer prices for the exchange of goods and services between related parties;
- Computing power, Internet interconnectivity and global value chains characterised the third industrial revolution (from the mid-20 th century until around the first decade of the 21 st century). The new technology exacerbated the importance of intangible assets and posed significant difficulties in allocating taxing rights between different jurisdictions involved in the global value chain;
- Nowadays, artificial intelligence and augmented reality characterising the current fourth industrial revolution (the digital one) which gave rise to the evolutionary stage of the Internet (Web 3.0) which, together with blockchain technology, has given rise to the Metaverse. While Web 2.0 only allowed users to license digital content (for example, blogs, e-commerce sites and social media sites) according to intellectual property and copyright laws, the Metaverse represents a virtual space where three-dimensional objects circulate and can be virtually “owned” as non-fungible tokens (NFTs).
The current Digital Industrial Revolution, allowing productive activities between independent and decentralized private parties beyond the “brick and mortar” model, has called into question the allocation of taxation rights used so far between different jurisdictions. Furthermore, the use of crypto assets and the a-territorial nature of virtual transactions makes difficult (i) the establishment of the ability-to-pay principle and (ii) the application of indirect taxes in the Metaverse.
All this led tax policymakers to rethink and reinvent the existing tax systems after nearly a century, fundamentally changing the balance of power between tax authorities, taxpayers, and jurisdictions.
II. The Metaverse
The Metaverse has been defined as: “A massively scaled and interoperable network of real-time rendered 3D virtual worlds that can be experienced synchronously and persistently by an effectively unlimited number of users with an individual sense of presence and with continuity of data, such as identity, history, entitlements, objects, communications, and payments”1 .
Therefore, the Metaverse can be seen as the new “Agora”: a new public square where the virtual and real world will become increasingly intertwined and where real objects will have a digital counterpart in the virtual world. Thus, the Metaverse represents the business “fourth dimension”. In this new environment people may conduct new business through their digital identity, owning their data, and earning by creating and exchanging NFTs.
In general, Metaverse Transactions can involve the sale of:
- physical goods;
- virtual goods;
- a mix of virtual and physical goods, in which an individual purchases virtual goods and receives a physical items, or vice versa;
- services, such as renting digital land or purchasing a ticket for a virtual event.
A. Taxation in the metaverse
Under the general principles underlying the tax system, a transaction is relevant for tax purposes when it is possible to answer the following three questions: Why tax? Where to tax? What to tax?
1. Why tax?
Transactions in the virtual world should be taxed if they give rise to the ability to pay in the real world in terms of income, consumption, inheritance or gift. This ability depends on the concrete possibility of converting virtual wealth into realworld wealth (e.g., the ability to cash out).
In particular, income from virtual environments:
- should be taxed if it allows taxpayers to cash in the real world, thus increasing their ability to pay real taxes;
- should not be taxed when it prevents taxpayers from cashing in the real world, because it does not increase their ability to pay real-world taxes.
2. Where to tax?
The second step of the analysis is to determine whether the tax base should include virtual income under existing general principles of taxation. In general, under the Worldwide Taxation Rule, revenue should be taxed in the country where the taxpayer is a resident, wherever its source derives. At present, “wherever” means not just all the other countries where the taxpayer produces its income. Still, it also includes virtual places, which differ from the country where the taxpayer resides or other countries.
Whether and how relevant Tax authorities can tax metaverse transactions will largely depend on the usual tax analysis, in accordance with the following criteria:
- The territoriality of the virtual transaction carried out by the real-world person or entity; from this perspective, can the “avatar” be considered as the digital representation of the taxpayer?
- The determination of the type of property or service involved;
- The determination of whether the transaction involves virtual property or services or real-world property or services and the related location, where relevant;
- The qualification and source of the income. At this regard, where buyers and vendors are residents in the same country, domestic law applies to determine who and how they are taxed. Instead, where relevant parties are residents in different countries, tax treaties should generally apply in
the same manner they apply to real-world transactions.
The way to determine how to allocate taxing rights among different jurisdictions is a political decision requiring a political solution that has not yet been found. Therefore, this analysis will be conducted mainly by analogy.
Concerning electronic commerce, the Organization for Economic Cooperation and Development (OECD) first defined Virtual Permanent Establishment as follows: “Where an enterprise operates computer equipment at a particular location, a permanent establishment may exist even though no personnel of that enterprise is required to be at that location for the operation of the equipment”2 .
In 2015, the final report of the OECD Action 1 addressing the tax challenges of the digital economy, developed the model of Significant Economic Presence (SEP) which identifies a PE within the “access/exploitation of the consumer market” by a company through the supply of exclusively “digitalized” products and services.
Since 2018, the Italian legal tax framework provided for the existence of a PE when there is “a significant and continuous economic presence in the territory of the State built in such a way as not to result in its physical consistency in the territory itself ” 3 . This provision extends the notion of PE, providing for its creation even for a foreign business which actively participates in the economic life of a country through the instruments provided
by digital technology and without a physical establishment in the state’s territory.
The European Parliament resolution of 4 October 2022 on the impact of new technologies on taxation stated that “digital economy operators can engage in significant business activities in a Member State without establishing a physical presence there, and therefore taxes paid in one jurisdiction no longer reflect the value and profits created there; […] the need to adapt the concept of permanent establishment, namely with a clear definition of virtual permanent establishment, in line with international standards”.
Therefore, with regard to the allocation of taxing rights in the metaverse, as already done for electronic commerce, it is necessary to understand in which jurisdiction the seller met a set level of transactions or sales activity (economic nexus) to be liable to be taxed there 4 .
3. What amount to pay?
Once determined why and where to pay, the additional challenge of attributing the relevant income to the digital PE arises. For this purpose, it is necessary to consider the “economic value” attributable to the functional activity carried out in a country by a global company, the so-called functionally separate entity approach. In this regard, it is not sufficient to consider the revenues from transactions produced by the PE; it is also necessary to consider its “functional” role within the “global value chain” and the related costs.
From this perspective, the ALP and the connected transfer pricing rules would prove unfit given that the “value” in relevant economic scenarios is not expressed by the transactions but rather by the intrinsic characteristics of the company.
For digital multinational enterprises (MNEs) with a global turnover above EUR 20 billion, G20 has mandated OECD to replace the traditional international tax standards (PE & ALP) with a proposed dedicated provision (Pillar One). Under this provision, worldwide extra-profits allocated to consumer jurisdictions are a flat-rate; while for routine income and unallocated extra profits, the tax discipline remains unchanged, including transfer pricing according to the ALP.
B. Metaverse Transactions and Indirect Taxation
In the EU, the European Commission cross-border VAT e-commerce package, which has been in place since July 1, 2021, stated that VAT should be paid where consumption of goods occurs.
In August 2019, the Regional Fiscal Court in Cologne (Germany) ruled renting of virtual land is taxable for VAT purposes 5 . In November 2021, on appeal, the Federal Finance Court of Germany (Bundesfinanzhof [BFH]) 6 deviated fundamentally from this decision stating that anything in a game is outside the real world and outside of the economic sphere where VAT applies. The BFH’s judgment may lead to a conclusion that everything happening in the virtual game world is not subject to VAT. Let’s call it the “what happens in Vegas, stays in Vegas” approach. However, sales between the gaming world and the real world should be subject to VAT. With particular reference to NFTs, on March 10, 2022, the Spanish Tax Administration (STA), noted in a ruling 7 that it would be incorrect to characterize the transfer of NFTs as a supply of goods since it does not entitle their holder to the purchase of any tangible property. Therefore, the STA qualified NFT transactions as the supply of services, which are mainly feasible just with information technology, requiring minimal human intervention.
This case meets the EU VAT definition of digital services, which are taxable in the country where the customer is established, has its permanent address or usually resides. Suppose the customer provides the seller with his/her VAT identification number (B2B transaction), the seller does not need to charge any VAT as the reverse charge mechanism will apply. This means the customer needs to account for VAT on the sale. In light of this framing, the STA determined the rules governing the place of supply of NFTs as follows:
- When the purchaser of the NFT is a final consumer (B2C service), the supply will be subject to VAT in the Member State of consumption (where the recipient of the service is domiciled), and the supplier of the service must charge to his customers the VAT rate applicable in that Member State;
- When the purchaser of the NFTs is a VAT-taxable person, the standard rules (B2B transactions) apply.
In the case of B2C provision of NFTs, this determination maybe complicated because the supplier often does not know the identity of the acquirers and is responsible for determining the place of domicile of the purchaser to charge VAT accordingly.
In this regard, the STA ruling deferred to Art. 24f of the Council Implementing Regulation (EU) No. 282/2011 of March 15, 2011, which provides that the customer shall be presumed to be established or have his domicile or habitual residence in the place determined by the service provider based on two non-contradictory pieces of evidence. These elements include, among other things, the billing address, the address of the IP used or any other commercially relevant information.
Portugal embraced the same approach in the Proposal of Framework for Taxation of Individuals, where the Sale of NFTs is deemed as electronically supplied services subject to the ordinary VAT rate, and the place of supply of these services is where the customer is located. Therefore, the service provider is responsible for determining where the customers are found to apply the applicable VAT rates.
Instead, in the United States in 2018 the Supreme Court 8 ruled a state may require a company to collect sales tax even if it does not have a physical store or sales representative there.
Since then, an “economic” presence, or reaching a set level of transactions or sales activities, was enough to trigger nexus status for that state. Therefore, entities are required to register in any state where they have a physical presence. Following this decision, Second Life, the virtual reality gaming platform referred to as the original metaverse, announced that it would charge sales tax on purchases made on the platform after March 31, 2022. This change will apply to purchases made within their digital world. Additionally, Second Life stated they would charge tax according to the user’s physical location.
Moreover, in the US, Indirect taxation is more heterogeneous from one Member State to the next. While some jurisdictions (such as California, Florida and Georgia) exempt digital goods and services because of their intangible nature, other jurisdictions apply sales tax just to some specific digital products, and the rules on what is taxable and what is not can be very complex 9 . Thus, it is necessary to examine on a case-by-case basis whether the sale of a particular NFT will be subject to indirect taxation.
Blockchain and the metaverse could fundamentally change established tax principles and how tax compliance works. For example, if tax authorities adopt them as a tool, they can automate tax collection with real-time compliance measures, minimizing the need for audits and reducing tax fraud.
Furthermore, in the absence of an adequate legal framework, just jurisprudence risks transforming the metaverse into a confusing and contentious environment.
An unregulated digital universe means a free pass for businesses to take advantage of an free-for-all economy. If that happens, the metaverse might become the next offshore tax haven. However, the OECD, US and EU are extending existing legislative frameworks about the exchange of information – such as the Crypto Asset Reporting Framework (CARF), by which the OECD broadened the scope of the Common Reporting Standard (CRS) to cover crypto-assets, the eighth Directive on Administrative Cooperation (DAC-8) and the Foreign Account Tax Compliance Act (FATCA) 10 – to digital intermediaries such as crypto exchanges, custodians and crypto wallet providers. From this perspective, despite the Metaverse remaining autonomous virtual space over which no country or tax authority has jurisdiction, transactions between the virtual and real world will fall on the scope of the exchange of information and then be taxed into the jurisdiction where taxing rights are allocated.
1. Matthew Ball, The Metaverse, New York 2022.
2. OECD Committee on Fiscal Affairs, Clarification on the application of the permanent establishment definition in e-commerce: changes to the commentary on the Model Tax Convention on article 5, Paris, 22 December 2000, par. 42.6
3. Art. 162, par. 2, lit. f-bis of the Italian Tax Consolidated Text.
4. Daniele Majorana, Tax Assessment of Deemed PE in Italy, Management of Reputational Risk, in: Bloomberg tax, 24 December 2019.
7. DGT V0486-22, 10/03/2022.
8. South Dakota v. Wayfair, Inc., 585 U.S.
9. “For example, states can treat digital products as taxable only if their physical equivalent is taxable or make the tax treatment dependent on whether a product is downloaded or accessed online” (Aleksandra Bal, Tax Rules for the Metaverse Stymied by a Lack of Understanding, in: Bloomberg Daily Tax Report, January 26, 2023).
10. Department of the Treasury March 2022 – General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals.