NFTs: Are They Financial Products?

The popularity of NFTs was so overwhelming that the word “NFT” was named Collins Word of the Year 2021. NFTs are not entirely novel. The first NFT that was created is called “Quantum”. It was minted on the Namecoin blockchain by Kevin McCoy in 2014.[i]

The surge in popularity of NFTs is arguably due to two catalysts— the COVID-19 pandemic forcing many people to go digital in search of goods and services or to connect with each other on social media platforms; and the first auction sale by Christie of an NFT called the “Everydays: The First 5,000 Days” created by Beeple for a jaw-dropping US$69 million. With renewed interest in NFTs, investments in NFTs entered the mainstream with sales reaching an astonishing US$2.5 billion in the first half of 2021.[ii]

What Is An NFT?

An NFT or “non-fungible token” is a special type of cryptographic token that represents a unique digital asset that cannot be exchanged for another type of digital asset.[iii] An NFT is non-fungible in the sense that it is not replaceable by another identical NFT (because there is no other identical NFT) and it is not mutually interchangeable (because no two NFTs are the same).[iv]

There is a wide range of use cases for NFTs. NFTs can be used to represent art (such as Damien Hirst’s “The Currency”), fashion apparels (such as Dolce & Gabbana’s “Collezione Genesi”), collectibles (such as Karl Lagerfeld’s figurine), virtual worlds (such as Decentraland), gaming (such as Louis Vuitton’s “Louis: The Game”), and financial instruments (such as a unit in a collective investment scheme), or to serve many other functional purposes.

As a matter of law, there is an arguable case that NFTs can attract property rights under English law.[v] This appears to be the position taken by the Singapore High Court in a recent ruling where the court awarded a proprietary injunction to a Singapore claimant to stop the sale by an online persona known as "chefpierre" of a rare Bored Ape Yacht Club NFT belonging to the claimant, which the claimant is seeking to repossess from "chefpierre".[vi] Due to the idiosyncratic nature of digital assets, particularly crypto assets, it may not always be appropriate or easy to rely on existing legal principles to determine the legal status of digital assets.

Are NFTs Regulated?

With decentralised finance (DeFi) continuing to grow and innovate and the different possible ways for the use of NFTs  in DeFi— such as the use of NFTs in the DeFi ecosystem for loan collaterisation (e.g., NFTfi application) and real estate fractionalisation (e.g., Propy NFT), beyond just associating NFTs with art and other collectibles—a question that commonly arises is whether NFTs would be seen as a financial product and hence regulated under Singapore law in relation to the offer or issue of NFTs in Singapore.

Currently, Singapore does not directly regulate NFTs. The chairman of the Monetary Authority of Singapore (MAS), Tharman Shanmugaratnam—in response to parliamentary question on regulation of NFT activities—articulated that MAS does not currently regulate NFTs, a position taken by most leading jurisdictions.[vii] But in line with the technology-neutral approach adopted by financial regulatory frameworks around the world—that is, digital assets would be regulated regardless of their labels if they have features of financial products—MAS takes a similar stance and looks at the features of the digital assets to determine the appropriate regulatory treatment.  

What Is The Regulatory Framework For NFTs?

From time to time, MAS establishes rules for financial institutions implemented through instruments such as legislation, regulations, directions, notices and guidelines. Guidelines, in particular, are formulated to encourage best practices among financial institutions.[viii] In 2017, MAS issued a guideline[ix], “A Guide To Digital Token Offerings” (Digital Token Guide), to provide general guidance on the application of the relevant laws (such as the Securities and Futures Act 2001 of Singapore (SFA)) administered by MAS in relation to offers or issues of digital tokens in Singapore. The regulatory treatment of any NFT offerings would be largely based on the guidance provided in the Digital Token Guide, which adopts a technology-neutral approach.

In the Digital Token Guide, MAS explains the various instances in which a digital token may constitute capital markets products[x] (such as share, debenture or collective investment scheme (CIS)) regulated under the SFA. For instance, an NFT may constitute a “share”, where it represents ownership interest in a corporation or represents liability of the NFT holder in the corporation; a “debenture”, where it evidences the indebtedness of the issuer of the NFT for money borrowed by that issuer from the NFT holder; or a unit in a “CIS”, where it represents a right or interest in a CIS, or an option to acquire a right or interest in a CIS.

Where an NFT is determined to be a type of capital markets product based on an assessment of its structure and characteristics (such as having ownership interest in a company), it may be subject to the regulatory regime governing capital markets products. This may include complying with the offering regime for an offer of capital markets product and the licensing requirements for dealing in capital markets product. If the structure and characteristics of NFTs are not within MAS’ regulatory purview, the issuer of an NFT may nonetheless be subject to other legislation for ML/TF[xi] (such as the obligations to report suspicious transactions with the relevant government agency).

What Is The Tax Treatment For NFT Transactions?

In March this year, then Finance Minister Lawrence Wong stated in Parliament that prevailing income tax rules will apply to transactions of NFTs. This means that any gains or profits made from NFT transactions will be taxable if such gains are income, but not if they are capital gains. This is generally determined in tax law by the application of what are called the “badges of trade”, which are a list of factors that indicate whether or not the taxpayer is engaged in a trade (of buying and selling NFTs). The Inland Revenue Authority of Singapore (IRAS) is most likely to focus on the following factors. Firstly, how many NFTs were purchased and sold by the taxpayer? Dealing with a large number of NFTs would suggest that the taxpayer may have been trading in NFTs. Secondly, how long did the taxpayer hold onto the NFTs for on average? A short holding period is generally indicative of trading activity. Thirdly, did the taxpayer intend to make a quick profit on the NFTs, or was the taxpayer more interested in collecting the NFTs as works of art, or as long-term investments? Other factors such as a sudden pressing financial need to sell the NFTs may also be relevant, suggesting that the taxpayer may not have intended to trade in NFTs even if he had only held the NFTs for a short period of time. 

One important consideration for taxpayers is that it does matter whether an individual or a company buys the NFTs. The IRAS is more likely to think that there is possible trading activity if the NFTs are purchased by a company than if they were purchased by an individual. Generally, it is much easier for an individual to argue that he acquired NFTs to enjoy as works of art than it is for a company to do so. In any case, buyers of NFTs should try to keep a clear documentary record as to why they are purchasing a particular NFT, to make it easier to show the intention behind the purchase should they be subsequently queried by the IRAS.

If it is determined that a taxpayer is not trading in NFTs, then any gains or profits from the NFT transactions will not be taxable. However, any losses will also similarly not be deductible. Taxpayers have to be particularly careful about this because the rules governing the deductibility of losses in Singapore are quite strict. In many cases, they will not be able to utilise their losses from NFT transactions to offset their income from other sources. While the market is rosy and most NFT investors are making gains, the focus will naturally be on the taxability of such gains, but it is also important to understand the deductibility of losses should things go south.

Closing Thoughts

Both DeFi and NFTs are incredibly young technologies and still have a long way to go. Through the merger of these two blockchain-based concepts, we are seeing the financial services industry being transformed and disrupted in profound ways, DeFi and NFTs being used for a variety of purposes—such as a form of payment or to represent rights in equity or debt securities—and the uptake of digital assets as alternative investment. While the law of Singapore has gone some way to accommodate the rise of new technologies, the law must continue to remain dynamic and flexible to support digital assets as they become mainstream.

Footnotes:

[i] Hennekes, Bud. A Brief History of NFTs. https://www.web3.university/tracks/build-your-first-nft/brief-history-of-nfts. 

[ii] Cointelegraph Research. NFT Sales Aim for a $17.7B Record in 2021. https://cointelegraph.com/news/nft-sales-aim-for-a-17-7b-record-in-2021-report-by-cointelegraph-research.

[iii] Cryptopedia. https://www.gemini.com/cryptopedia/search?query=Non-Fungible%20Token%20(NFT).

[iv] Law Commission Digital Assets Consultation Report. https://www.lawcom.gov.uk/project/digital-assets/.

[v] Osbourne v Persons Unknown and Ozone Networks Inc [2022] EWHC 1021 (Comm).

[vi] The Straits Times. Singapore High Court Blocks Potential Sale and Transfer of Rare NFT.

[vii] Parliament Sitting on 15 February 2022. https://www.mas.gov.sg/news/parliamentary-replies/2022/reply-to-parliamentary-question-on-regulation-of-nft-activities.

[viii] MAS Website. https://www.mas.gov.sg/regulation.

[ix] This guide was last updated on 26 May 2020.

[x] In layman terms, financial products.

[xi] That is, money laundering and terrorism financing.

Hoon Kiong Gerard, Ng
Managing Partner of Legal Ink LLC, Singapore. Broad financial services practice covering general bank and syndicated lending, acquisition financing, structured finance, capital market transactions, art, digital assets, derivatives, and market regulations. Represents banks, corporates, financial intermediaries, fund managers, and fintech companies on a variety of transactional matters.

Yap Teck Chai
Teck Chai is Managing Counsel at Legal Ink LLC and his practice covers a broad spectrum of financial and regulatory transactions. Teck Chai was focusing on banking and finance, corporate, and securities law before expanding his practice to cover payment services and financial regulation. Prior to his current role, he was a senior associate at an international law firm.