Non-Fungible Tokens, or “NFTs,” have increasingly begun to attract mainstream attention from creatives, collectors, investors, and a broad range of corporations seeking to explore this new form of digital property. But what are they exactly?
- What is a Non-Fungible Token (“NFT”)?
NFTs are, generally speaking, non-fungible digital representations of the underlying rights that are being sold or licensed. Unlike many other popular iterations of digital assets that are fungible, like bitcoin or Ether, an NFT is an unchanging representation of a designated set of rights. Virtually anything can be represented by an NFT, provided that it is an identifiable asset. For example, real property titles, cars, houses, and art, all can be represented by NFTs. The ease by which rights can be transferred from one party to another, and the security and verifiability of those transfers, is the hallmark of NFTs and the reason there is so much interest in them.
- How do NFTs Work?
At the most basic level, an NFT is a token that is associated with an asset. NFTs are “minted” and stored on shared cryptographic ledgers called blockchains, like the Ethereum blockchain. An NFT can be programmed to reflect the legal contract terms that govern the rights obtained by the buyer of the NFT, known as a smart contract. The pseudonymous address associated with the holder of the NFT and each subsequent address of the party that acquires the NFT, are stored on the cryptographic ledger. Because a blockchain is highly secure, versus the ease by which an entry on a physical ledger can be altered, holders of NFTs can be assured of the rights they hold and the true provenance of the asset associated with the NFT.
- What is sold when selling an NFT?
NFTs, as computer code, contain metadata which describe the corresponding assets to which they are bound. For a creator or holder who owns the intellectual property rights to the underlying asset, they can decide what rights to grant the NFT buyer. For example, a creator may want to allow the buyer the right to use and display the asset, but not copy or commercialize it. Similarly, an issuer of an NFT who possesses only limited rights to use, assign, or license the underlying asset, can correspondingly limit the rights that the buyer of the NFT obtains.
- What is the legal construct of an NFT?
NFTs do not change the legal framework for creating, protecting or transferring rights in assets. An NFT is simply a cryptographic tool for managing and ensuring the security of an asset transfer transaction between a buyer and a seller - the same legal principles that apply to a paper contract, apply to an NFT transaction. Thus, for instance, creators of creative works (e.g. digital art) should carefully consider the scope of any rights they are granting with respect to the creation of derivative works or limitations on the use of the creative work, and well as termination rights in order to ensure the return of the NFT and its associated rights in the event that there is a breach of any terms contained in the NFT.
- What are some of the tax, securities, and other regulatory considerations to be made when selling NFTs?
Given that NFTs can be linked to virtually any type of asset, it is important to remember that the nature of the underlying asset will often determine whether, and how, an NFT is taxed and regulated. At a fundamental level, the sale of an NFT, much like the sale of any other digital asset (e.g. bitcoin), is taxable as income. As well, if the NFT is income generating, for instance, if it generates royalty or license fees, that income will be taxable.
However, the biggest area of uncertainty is whether NFTs can be considered “securities”. At present, the United States Securities and Exchange Commission (the “SEC”) has not directly commented on the status of NFTs as securities. However, the SEC has opined, through filings, speeches by high-ranking members, and a published framework, that certain digital assets may be securities—with each token’s legal status as a security depending on its own facts and circumstances. Facts and circumstances which are likely to pique the interest of securities regulators are those in which buyers are induced to purchase NFTs with the expectation of profits. Instances where there are pre-sales of NFTs which are marketed as being safe or lucrative investment opportunities are particularly at risk of regulatory scrutiny.
