Non-fungible tokens, often NFTs, have gained widespread popularity as digital proof of ownership. Initially, they were mainly used for digital collectibles like digital art and virtual pets. However, over the past few years, they’ve become more mainstream, partly because of wild price fluctuations and early adopters making big profits.
As this technology has developed, various industries have explored new ways to use it, including gaming, entertainment, and fashion. NFTs are also expected to play a crucial role in the metaverse, a virtual space where people can interact online.
The US NFT regulations up several important issues for policymakers to consider, which include financial regulations, intellectual property rights, protecting consumers, energy usage, privacy concerns, and managing content online. Policymakers in the United States (US) have needed help keeping up with the rapid changes in this technology, but they’ve already taken steps to address some of these concerns.
However, they can do more, such as passing laws to clarify who regulates NFTs, strengthening enforcement abilities in government agencies, simplifying tax rules, and creating an online resource center for policies related to NFTs and other digital assets.
Understanding the Legal Definition of a Security
According to Section 2(a)(1) of the Securities Act, a “security” encompasses various financial instruments, including notes, stocks, profit-sharing agreements, and investment contracts, among others.
The United States Congress has authorized the SEC to oversee products categorized as securities, which include NFTs. When addressing NFT legal matters, the law expects courts to consider the economic substance of a product, not just its form.
Exceptions to Consider
An NFT is generally not considered a security if it represents an existing asset and is marketed as a collectible with a transparent assurance of authenticity on a decentralized ledger. However, if an NFT is promoted as an asset that will generate returns through the efforts of others, it falls under the category of security.
There is an important exception to note. If the NFT’s value increase is solely due to external market factors like inflation, it is not considered a security.
Fractionalized NFTs may be treated as securities, while platforms facilitating the sale and secondary trading of NFTs may need to register with the SEC as a broker-dealer, exchange, or alternative trading system. An alternative trading system is a less strictly regulated marketplace that matches buyers and sellers for transactions.
NFT Regulations and the Howey Test
The SEC v. W.J. Howey Co. case in the U.S. Supreme Court established the Howey Test to determine what qualifies as an investment contract. The Howey Test is a critical factor in assessing NFT-related legal matters.
The Howey Test, now a central consideration in all discussions of NFT legality, defines an investment contract as any arrangement involving:
The key factor when evaluating digital assets is whether buyers reasonably expect financial returns from the efforts of others, whether they anticipate selling for profit in secondary markets, participating in distributions, or engaging in similar actions.
Are NFTs Subject to U.S. Money Laundering Laws and Sanctions?
The Financial Crimes Enforcement Network (FinCEN), a branch of the U.S. Department of the Treasury responsible for combating money laundering, has yet to issue specific guidelines for NFTs. However, they have provided general guidance on how the Bank Secrecy Act (BSA) and its regulations relate to virtual currencies, which could apply to NFTs.
One important question is whether FinCEN sees NFTs as a “value that substitutes for currency.” If NFTs are considered substitutes for traditional currency, then they could fall under the purview of the BSA and FinCEN regulations.
However, since many NFTs primarily represent ownership of unique digital assets rather than acting as a direct substitute for currency, many NFTs on the market may not be subject to FinCEN oversight. That said, depending on specific circumstances, certain activities related to the transfer, sale, and custody of NFTs may still trigger FinCEN regulations.
The Office of Foreign Assets Controls (OFAC) administers most U.S. sanctions programs and has not issued specific guidance on NFTs either. However, OFAC has stated that U.S. sanctions apply to digital transactions and currencies in ways similar to traditional activities. They have also taken enforcement actions involving cryptocurrency transactions and blockchain technology.
The primary risk associated with NFTs and U.S. sanctions lies in the possibility of individuals subject to these sanctions participating, directly or indirectly, in NFT-related activities. NFTs share characteristics with assets that OFAC has identified as presenting elevated risks for potential sanctions violations.
These characteristics include a high degree of anonymity, the use of intermediaries, concealability, and subjective valuation. The decentralized nature of blockchain technology can make it challenging to prevent sanctioned individuals from involvement in NFT transactions.
Considering these factors, individuals engaging in NFT transactions should be cautious and mindful of potential sanctions-related issues.
Do State Laws Regulate NFTs in Terms of Virtual Currency or Money Transfer?
Given the surface-level similarities between NFTs and certain virtual currencies, it’s natural to wonder whether NFTs fall under state laws regulating virtual currency and money transfer. State regulators responsible for overseeing virtual currency or money transfer have yet to issue specific guidelines regarding NFTs.
However, depending on how a particular state defines money transfer, some may attempt to claim regulatory authority over specific NFTs or certain NFT-related business activities.
Furthermore, a few states, like New York and Louisiana, have enacted laws addressing companies’ operations in virtual currency activities. In these states, a defined list of activities falls under their virtual currency business laws, such as exchanging, transferring, controlling, administering, or issuing virtual currency.
Companies engaging in these activities must obtain licenses or charters and provide financial safeguards for customer protection, like posting surety bonds or funding customer accounts.
Depending on the nature of the NFT, these states may seek to apply their virtual currency laws to NFT markets. Nevertheless, it’s important to note that many NFTs currently available in the market should not be subject to these statutes.
Since 2011, FINCEN has been overseeing money services business (MSB) models that involve digital currencies. The regulatory authority defines digital currency as a medium of exchange that functions similarly to currency but lacks all the attributes of traditional legal tender. Convertible virtual currencies (CVCs) can substitute for real currency.
Whether a non-fungible token (NFT) is categorized as a CVC depends on its practical use as a virtual currency. Most NFTs primarily represent unique assets in digital form, making them more akin to digital collectibles rather than CVCs.
However, it’s important to note that some NFTs can be exchanged for fiat currency, which raises the question of whether they should be considered substitutes for value. It’s worth mentioning that money transmission regulations vary from one state to another.
If NFTs are deemed to engage in money transmission activities, FinCEN may consider them subject to the regulations outlined in the Bank Secrecy Act (BSA).
Tax Policy and Digital Assets
Regarding digital assets, such as NFTs, tax implications can affect individuals and businesses. For tax purposes, all digital assets are treated as property, whether you’re buying, selling, or trading them.
The tax rates associated with NFTs can vary depending on the specific circumstances. Individuals are generally responsible for taxes on any capital gains or losses from digital asset transactions, just like they would be for any other property.
However, there’s a specific set of rules from the Internal Revenue Service (IRS) regarding collectibles. If an NFT grants ownership or rights to another asset that the IRS defines as a collectible, like a gem, it’s treated as a collectible.
Taxpayers are still on the hook for paying capital gains taxes on these collectible NFTs. Additionally, creators who make and sell their NFTs may need to consider this revenue as ordinary income for tax purposes.
Individuals are required to report all their digital asset activity on their tax returns, including transactions involving NFTs. The IRS is actively enforcing these rules, sending thousands of letters to taxpayers as part of their Virtual Currency Compliance campaign in 2019.
More recently, the IRS updated tax forms for 2022, and they now include a question about digital assets at the top of Form 1040, the primary form used for individual income tax returns.
Businesses also have new reporting responsibilities in this realm. The Infrastructure Investment and Jobs Act, signed into law in November 2021, mandates that crypto exchanges provide the IRS with an annual tax form reporting their yearly profits or losses from digital assets.
Furthermore, this legislation extends existing rules on reporting to the U.S. government any transactions involving $10,000 or more in digital assets, aligning them with the rules that already apply to cash transactions.
Are NFTs Considered Commodities?
The CFTC (Commodity Futures Trading Commission) defines commodities as cryptocurrencies, emission allowances, renewable energy credits, and other intangible items. Regulations concerning deceptive and manipulative trading can be applied to NFT transactions when they involve straightforward, fully funded deals, also known as spot transactions.
If an NFT is traded on a margin or leveraged basis, additional requirements may come into play. The CFTC checks whether the NFT has been exclusively traded on a registered derivatives exchange. Furthermore, the CFTC considers the actual delivery of virtual assets as a medium of exchange.
NFT Intellectual Property: Rights Transfer During Sales
Typically, the seller of an NFT determines the rights that come with it. The metadata linked to an NFT provides information about the assets it represents. The asset’s owner initially holds intellectual property rights associated with the underlying asset of an NFT. The owner of these intellectual rights decides what rights to bestow upon the NFT buyer, which could encompass usage, copying, modification, and display rights.
When an issuer of NFT intellectual property acquires content from a creator, they only possess the specific rights granted to them by the creator. Consequently, they can license only those limited rights to the buyer. NFT transactions may involve using proper licensing language and addressing assignment issues.
Recommendations for NFT Regulation and Policy
President Biden’s executive order regarding digital assets has laid a solid groundwork for the United States to lead in developing forward-thinking policies for NFTs. These policies safeguard consumers, address potential risks, and encourage innovation. However, as this technology continues to evolve, there are additional steps the U.S. government can take:
Clear Legislation Needed to Define Regulatory Responsibilities
The SEC and CFTC assert authority over digital assets but adopt differing regulatory approaches, which must be clarified within the digital asset industry. This ambiguity hinders businesses from developing new digital asset products and services. For example, play-to-earn games require clearer guidance to distinguish legitimate ventures from pyramid schemes.
To address these challenges, the US Congress should establish clear criteria for when each agency has regulatory jurisdiction over specific types of digital assets. Furthermore, the US Congress should direct the lead regulatory agency to issue precise compliance guidelines, particularly for crypto exchanges and online digital asset marketplaces.
Such clarity will help consumers and businesses identify where to report potential violations and prevent bad actors from exploiting regulatory uncertainty to evade oversight.
Enhancing Enforcement Capabilities to Combat Digital Asset Fraud
Law enforcement agencies have pursued cases against wrongdoers in the digital asset realm, with the DOJ and SEC forming dedicated enforcement units for digital assets. However, the US regulators still need to develop advanced fraud-detection capabilities based on the analysis of public blockchain transactions.
Notably, an X (formerly Twitter) user flagging potential fraud started the first two cases filed by the DOJ for insider trading involving digital assets, including NFTs and cryptocurrencies. While whistleblowers play a vital role in reporting fraud, regulators traditionally rely on in-house analytics teams to identify illegal activities through trading patterns.
Given the need for this expertise across multiple agencies like the SEC, CFTC, FinCEN, and IRS, these agencies should collaborate to establish a unified Digital Asset Analysis and Detection Center dedicated to developing and maintaining these critical capabilities.
Establishing a Central Online Resource for Digital Asset Policies
The Biden administration’s executive order started a comprehensive government-wide effort to tackle digital asset-related issues. While it’s reasonable for various agencies to be involved in formulating and coordinating policies on digital assets, the average consumer and developer shouldn’t be expected to navigate through many agency websites to find the latest guidance from policymakers.
This information is often scattered across multiple government sites. To simplify this process, the administration should establish a user-friendly website as a central hub for federal government resources related to digital assets, encompassing cryptocurrencies and NFTs. This website would be a valuable resource for both consumers and businesses.
The landscape of digital assets, including cryptocurrencies and NFTs, is rapidly evolving, presenting both opportunities and challenges. The Biden administration’s executive order has set a firm foundation for the United States to shape policies that safeguard consumers, address risks, and foster innovation in this dynamic space.
To navigate this evolving landscape effectively, there is a need for clear legislative guidance to define regulatory responsibilities, ensuring that businesses can operate with confidence and clarity. Additionally, strengthening enforcement capabilities and adopting advanced fraud-detection measures are crucial steps to combat illegal activities within the digital asset sphere.
Furthermore, creating a centralized online resource that merges information on federal government policies related to digital assets is essential. Such a user-friendly hub would provide invaluable support for consumers and businesses, simplifying access to critical information and ensuring policymakers’ guidance is readily available to all stakeholders.
As the world of digital assets continues to expand, the United States can lead with forward-thinking policies that promote responsible innovation while protecting consumers’ interests and the financial system’s integrity. By taking these steps, the U.S. can position itself as a global leader in digital assets, driving innovation and fostering a secure and transparent environment for all participants.