Understanding Non-Fungible Tokens/ NFT

By Himanshu Joshi, for Legal Corner LLP. Himanshu is a 2021 graduate from NALSAR University of Law, Hyderabad.

(The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) so as to get legal advice specific to your business needs).

 

Non fungible tokens (NFTs) are digital assets ranging from toilet papers and tacos to art and music.  These new assets are generally encoded with the same underlying software as many cryptocurrencies. Besides they are connected to the cryptocurrency because they’re bought and sold online using cryptocurrency. These started to work in 2014 but have gained much popularity now because people have now understood its usage and bought multiple artworks online. Once you’ve got your wallet set up, you can carry out this digital activity after your wallet is funded. After managing your wallet, there’s no shortage of NFT sites to shop. Currently, the largest NFT marketplaces are:

 

1. i) Rarible. It is called a democratic and free marketplace that gives opportunities to the sellers and art creators to use NFT for their marketing. The RARI tokens are issued on this marketing platform

that enables the holders to weigh in on features like fees and community rules.

 

1. ii) Foundation. This is a marketplace where artists receive “upvotes”. It is an invitation from fellow creators to post their art.

 

Glimpse on the present and future of NFTs

 

In November, GuradianLink.io had raised Series A of $12 million led by Kalaari Capital. It recently sold Bachchan’s NFT collection worth $966,000 (Rs 7.18 crore).

 

Regulating NFTs and their Cross-Border Transactions in India

As of today, there exists no explicit regulation or legislation by the Government of India that prohibits or restricts an Indian resident from buying and/or selling NFTs. This is partly due to the fact that the treatment of NFTs in the eyes of the law would depend on how the underlying digital or physical asset is classified. For now, NFTs may be regarded as a “digitally-signed certificate for the underlying asset”. 

 

However, the regulatory status of NFTs might potentially change with the introduction of the long-awaited cryptocurrency bill (“Cryptocurrency Bill”). The draft of the Cryptocurrency Bill of 2019 has been titled “Banning of Cryptocurrency & Regulation of Official Digital Currency Bill” and Section 2(a) of the Cryptocurrency Bill defines “cryptocurrency” as: 

 

“Any information or code or number or token not being part of any Official Digital Currency, generated through cryptographic means or otherwise, providing a digital representation of value which is exchanged with or without consideration, with the promise or representation of having inherent value in any business activity which may involve risk of loss or an expectation of profits or income, or functions as a store of value or a unit of account…” 

 

The above definition of “cryptocurrency” might encompasses NFTs as NFTs could potentially “be considered to be both a representation of value that is exchanged on the basis of having an inherent value in business activity”. On the other hand, Section 3(3) of the Cryptocurrency Bill seemingly lays down a proviso to Section 2(a) as it stipulates that the use of Distributed Ledger Technology would be permissible in instances of “creating a network for delivery of any financial or other services or for creating value, without involving any use of cryptocurrency, in any form whatsoever, for making or receiving payment.” Ultimately, there is still ambiguity as to whether NFTs would fall under the scope of ‘services’ as laid out in Section 3(3). Experts question whether NFTs are cryptocurrencies or virtual currencies, and if they would be affected by any future law restricting or prohibiting crypto-asset transactions? If an all-inclusive definition of cryptocurrencies and/or virtual currencies includes NFTs, it is argued that NFTs should be excluded from this all-inclusive definition as NFTs are non-fungible in contrast to both traditional and crypto currencies which are fungible in nature. Furthermore, crypto-assets like Bitcoin are primarily used as tradable assets and means of exchange whereas NFTs being unique are generally used to “collect” and retain specific digital or physical assets. 

 

Ambiguities in relation to the nature of NFTs might also arise under the Foreign Exchange Management Act, 1999 (“FEMA”). The treatment under the current FEMA regime would largely depend on the classification of the underlying asset, physical or digital, being exchanged via the NFT. In the currently operational Indian NFT marketplaces, it is observed that even though FEMA governs cross-border transactions vis-à-vis India, the country’s central bank, Reserve Bank of India (“RBI”) remains silent on the issues and ambiguities pertaining to digital assets such as NFTs and cryptocurrencies. Experts have stipulated that upon extrapolation of the provisions under the existing FEMA regime, crypto-assets and NFTs may be classified as intangible assets, for instance, like intellectual property.

 

Intellectual Property and NFTs

Legal professionals across India and throughout the world are contemplating the issues pertaining to intellectual property rights (“IPR”) and obligations in relation to NFTs. IPR protection strategies are needed to holistically secure the digital asset, inter alia, the licensing, assignment and transfer of holding rights of IPR of the digital asset. This new shift towards innovative IPR protection strategies is the result of the non-fungible nature or uniqueness of NFT technology. IPR professionals state that these strategies are pre-emptively necessary as they expect potential infringement issues to increase once third-party IPR are at a crossroads with the first creator of the NFT. Furthermore, it might be necessary to establish and develop a framework for the possession rights and first holding terms of NFTs as “the rights granted by an associate NFT marketer depend upon whether the rights were transferred via a license or an assignment, and these will vary with each NFT”.

 

Depending upon the underlying agreement, the mere ownership of the NFT may not grant the ownership of the underlying content/art or the associated IPR which would result in a scenario where the NFT “owner” may not be permitted to “breed, distribute copies, publicly perform, display, or build by-product works of the first work” as the owner of the copyright may exclusively retain such rights. The NFT industry might propose solutions pertaining to these issues, however, stakeholders have not settled on a standardized “best practice” making it difficult for buyers of NFTs to assess which NFTs safely store data in the long term.

 

NFTs and Taxation

It is a plausible contention that under India’s taxation system, the tax classification of NFTs would be based on the nature and characteristics of the underlying asset. For example, a NFT of digital art could potentially be classified as an “intangible asset” or “good” in terms of income tax and goods and services tax (“GST”). The cross-border and digital nature of transactions involving NFTs leads to the contention that there may exist additional tax issues along the way. For instance, sales of NFTs by offshore sellers through an offshore NFT marketplace to Indian buyers may be subject to a 2% equalization levy on the gross value of the NFT and the income of the marketplace from Indian customers. Furthermore, sales of NFTs by Indian resident sellers through foreign platforms may get excluded from the equalization levy and additional questions in relation to the platform’s income/commission exclusion in such scenarios are still unanswered.

 

The American Regime

Regulators, as of yet, have not provided explicit official guidance in relation to NFTs, however, there is a contention that it may be possible that NFT might be classified as a “commodity” under the Commodity Exchange Act (“CEA“), which defines the term to include several enumerated items and a catch-all for “all other goods and articles”. The Commodity Futures Trading Commission (“CFTC“) has also confirmed that the expression “commodity” includes cryptocurrencies, in addition to renewable energy credits, emission allowances, and other intangible items. technology. If NFTs are classified as commodities, the CEA may apply in one of two possible ways. Firstly, the CEA’s general prohibitions on deceptive and manipulative trading may apply to NFT transactions, which are affected on a “spot” basis, i.e., fully-funded, unleveraged transactions. However, if NFTs are offered on a margined or leveraged basis, additional requirements may apply which include the requirement to trade the NFT solely on registered derivatives exchange unless the transaction results in the “actual delivery” of the NFT within 28 days. 

 

It is argued by some that numerous NFTs available on the market may not be deemed as “securities” under the American Federal securities laws. NFTs may be considered as securities, “if it was designed to provide an expectation of profit to the buyer based on the efforts of others and were marketed as such”.  One potential example of such an arrangement could be a “fractional” NFT (“f-NFT”), where an investor would share a partial interest in an NFT with others. If an NFT (or f‑NFT) is considered a security, then the common securities law issues would exist including, the registration or exemption of the offerings, sellers, marketplace, the securities law liability for material omissions or misstatements and insider trading; the restrictions on short sales and market stabilization around an initial offering among others. 

 

The Financial Crimes Enforcement Network (“FinCEN“), the regulatory authority tasked with the responsibility of combating money laundering under the Bank Secrecy Act (“BSA“), is yet to issue guidance specific to NFTs and has only published general guidance with reference to virtual currencies (that may or may not apply to NFTs). It needs to be considered whether FinCEN sees NFTs as “value that substitutes for currency.” If this indeed is the view and NFTs are considered substitutes for currency, then the FinCEN may direct that NFTs shall be subject to the BSA and FinCEN regulations. Since many NFTs are more like digital representations of ownership in unique assets than a value that substitutes for currency, however, it seems that many NFTs available on the market should not be subject to FinCEN’s oversight. 

 

Conclusion

 

Keeping in view the regulation of NFTs in the global marketplace, it can be argued that NFTs are here to stay as considering that the current transfer of real estate ownership is labor-intensive and expensive, it is likely that NFTs will be applied to solve these transfers. The concept of “tokenizing” property rights will facilitate the sale and maintenance of NFTs in the long run. In the Indian context, laws and regulatory authorities such as RBI will need to address the issues in relation to permitting fungible and non-fungible digital assets to provide censorship resistance, worldwide participation, and the elimination of trusted third parties within the decentralized ecosystem. Furthermore, it is stated that as the system matures, the underlying blockchain infrastructure applied to NFTs will provide “performant, inexpensive transactions/settlement, immutability of contracts, and execution of smart contracts to handle ownership, authenticity, certification, governance, royalty payments, and a host of other ecosystem functionality”. The decentralized ecosystem transparency would support and provide for price and market efficiency. Furthermore, decentralization will grow via the network effect, as the rise of innovation, performance and resulting participation will elevate a vibrant global ecosystem of applications. However, the negative associations such as the climate controversies with respect to NFTs still remain unanswered. 

 

Lastly, it is suggested that the legal challenges in relation to NFTs are likely to become more pronounced over the coming months or years as the regulators and media increasingly focus and divert their attention into the fintech space. It is important to understand that the NFT or even digital assets regulatory framework is in its fetal stages and is to evolve and mature over time. As the number of Indian buyers and sellers of NFTs increases over the years, the legal regime addressing the myriad issues (discussed above) including anti-money laundering regulations, tax implications, financial regulations, intellectual property issues, etc. shall gradually emerge. India can take learnings from the evolving legal regimes pertaining to NFTs in countries like US, UK, China, etc. while drafting its own set of regulations for the same. For e.g., introduction of licensing obligations for services related to NFTs as done under the current German Banking Act classification of NFTs (like in Russia and UK) in various categories on a case-by-case basis to analyze the related regulatory, legal and tax implications; protection of investors from multiple originals of a work by modifying the copyright laws and supplementing the contracts with suitable clauses specifically drafted for NFTs, etc. can make NFTs more secure and regulated.

We are well experienced in handling legal issues pertinent to tax filings and wealth management. Please email me at chetana@legalcornerllp.com to get a nuanced understanding of your legal issues or if you wish to set up a free consultation.