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Non-fungible Tokens Explained: A Guide for CPAs

February 17, 2022

Non-fungible tokens (NFTs) exploded in popularity in recent months, empowering digital artists to monetise their work and driving new-age investors to get their own slice of the pie. 

In December 2021, digital artist Pak’s NFT creation, The Merge, sold for a staggering US$91.8 million on Nifty Gateway. The price was a record for an artwork sold publicly by a living artist, and the sale made the headlines of most major newspapers, sparking greater interest in NFTs as a concept.

The way in which NFTs work remains a mystery to many, just like cryptocurrency when it first appeared on the tech scene. But, as with cryptocurrency, a roaring digital market has opened up for NFTs, creating a new opportunity for CPAs.

In this article, we will explain what non-fungible tokens are, the difference in fungible vs non-fungible tokens, and how these assets could impact the accounting profession in the future.

Non-fungible Tokens Explained

Non-fungible tokens, or NFTs, are digital assets with blockchain-centric ownership. The token is used to represent the ownership of unique items, such as collectables, digital art, music, and domain names. They can only have one official owner at a time, as they’re (normally) secured by the Ethereum blockchain. This means that no one can modify the record of ownership or copy and paste a new NFT into existence.

NFTs thus create digital scarcity by representing the ownership of a unique asset. This is in contrast to most digital creations, which are almost always infinite in supply. NFTs should, therefore, have an inflated value as long as it’s in demand.

Fungible vs Non-fungible Tokens

Non-fungible is an economic term that you can use to describe items such as a song file or a one-of-a-kind trading card. These assets are not interchangeable for other items because they have unique properties.

In contrast, fungible items can be exchanged because their value defines them instead of their unique properties. For example, bitcoins or dollars are fungible because 1 bitcoin or $1 USD can be exchanged for another 1 bitcoin or $1 USD.

There’s one particular argument that arises when discussing digital assets such as NFTs: anyone who can view the content online can copy the digital files as many times as they want, including the asset that’s included with an NFT.

However, NFTs are designed to give buyers something that can’t be copied: ownership of the work. To put it in terms of physical art collecting, anyone can buy a Dali print online or in a museum gift shop, but only one person can own the original.

The Taxation of NFTs

At the moment, there is no crypto-specific authoritative accounting guidance in place. Therefore, the general rule is that crypto assets are treated as intangible assets. However, the underlying substance of what the NFT represents could affect its accounting treatment.

In terms of taxes, NFT creators are taxed when the NFT is sold, with any income being recognised as ordinary income. If an NFT is bought as an investment and subsequently sold, any gain realised following the conversion of the purchase and sale prices into the exchange rate will be subject to Capital Gains Tax. 

In addition, VAT will likely be due on NFTs in line with VAT on any other goods or services. The taxable amount would be the value of the NFT in the fiat currency (e.g. pound sterling, euro, dollar) at the time of the transaction. Of course, taxation rules for crypto assets may vary from country to country.

Increased Scrutiny Over NFT Accounting

In February 2022, the UK’s HMRC “seized” NFTs for the first time in a tax evasion case worth £1.4 million. 

Nick Sharp, HMRC’s deputy director of economic crime, released the following statement: “Our first seizure of a non-fungible token serves as a warning to anyone who thinks they can use crypto assets to hide money from HMRC. We constantly adapt to new technology to ensure we keep pace with how criminals and evaders look to conceal their assets.”

In light of this case, CPAs must ensure that they are equipped with the specialist knowledge required to handle crypto assets accounting. With more people racing to be a part of the NFT and crypto craze, it’s critical that accounting firms adapt to the growing niche. Not every firm will come into contact with crypto assets — but those who do or who want to provide advice to crypto clients must stay on the ball with taxation updates surrounding this complicated matter.

Why CPAs Need to Get Their Heads Around NFTs

NFTs and crypto are relatively novel, with developments occurring every day. The complexity and evolving nature of the market makes it incredibly difficult to become an expert in the field. Continual learning is required — something that takes up a significant amount of a CPA’s time. But can accountants afford to miss out on this opportunity?

In 2021, NFTs became a $40 billion market. Despite the headlines, not every NFT investor is a millionaire. According to research from Chainalysis, NFTs have introduced a huge number of retail investors to the crypto world, with small transactions of under $10,000 accounting for more than 75% of the market.

Currently, the so-called “financialisation” of NFTs is taking place — for example, businesses using NFTs as collateral for loans. With the tokens becoming mainstream, they could pose a significant opportunity for accounting firms. However, whether NFTs can keep on the same growth trajectory long-term is another question.

Accountants, therefore, need to weigh up the current opportunity of NFTs against the backdrop of uncertainty and volatility that marks crypto assets of all kinds.

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