9 Legal Issues That Stand Behind NFTs

On June 10, 2021, Sotheby’s sold a masked CryptoPunk #7523 called ‘Covid Alien’ (one of the rarest NFTs launched by studio Larva Labs) for a whopping $11.8 million.

9 Legal Issues That Stand Behind NFTs

Another elite auction house, Christie’s, sold an exclusive NFT-based artwork named “Everydays: The First 5000 Days” for $69,346,250, Mike Winkelmann’s authorship, who’s also known as Beeple. Original source is a digital signature in a blockchain. Its author did not use any drops of paint. How is it possible? Well, such a digital piece of artwork is known as a non-fungible token (NFT). Usually, anonymous users purchase such works. This time, it was an NFT art admirer named MetaKovan, a.k.a. Crypto Native.

Those are just two examples of the NFTs marketplace that has been booming for the recent couple of years.

You may have some questions left. What are NFTs? How can a digital signature be worth millions of dollars? What are legal challenges surrounding NFTs? We’ve already answered the first two questions in our previous article. Follow this link to learn more. But there are more things to discuss.

In today’s article, OpenGeeksLab is going to observe the legal aspects that stand behind non-fungible tokens along with underlying NFT technology. Please keep in mind that the information given in this article doesn’t provide any legal advice. Let’s dig deeper into this topic!

Non-Fungible Tokens (NFTs) Market Analysis

Grab some interesting facts and statistics about NFTs by having a look at our market analysis.

No one can deny the popularity of the market for NFT. The process of creating NFTs might be time-consuming, but your results are worth trying. You can check out some figures that prove that.

  • Last year, the NFT market tripled. The total NFT sales volume grew from $159.142 million in 2018 to $250.846 million in 2020. It may vary depending on which NFT transactions are included. It means a 299% growth since 2019. It is closely connected to the crypto market and its rapid and obvious growth. The end of Crypto Winter resulted in a growth in asset value in dollars. NFT projects and new ecosystem users support this increase.
  • They say the NFT market will soon hit $2.5 billion. It should reach this mark by the end of 2021 (if not earlier).
  • Since 2018, the number of active wallets (those that interact with NFT smart contracts) in the NFTs market went up from 110,551 units to 222,179 in 2019. It stands for 97% growth.
  • In 2020, 74,529 purchasers and 31,504 sellers were fixated in the NFT art marketplace. How about its market capitalization for international NFT transactions? It grew from $40.96 million in 2018 to achieve $338 million by 2020. In 2021, the value of non-fungible tokens for arts went up rapidly. However, it dropped for gaming. It makes sense that limited NFTs cost higher.
  • As Morning Consult report states that most NFT purchasers in the US are millennials. 23% of them share that they buy and sell NFTs. Gen Xers are in second place (8%), followed by baby boomers (2%). Another poll discovered that 15% of the male population gathers non-fungible tokens, while only 4% of the female population is involved in the same activity. Ordinary American NFT purchasers are typically male millennials.

These stats push many people to start buying and selling NFTs. You can check more facts to be impressed by the opportunities this market offers.

As you can see, the NFT business is a promising niche worth investing in, but legal regulations must be kept in mind. You should be armed to the teeth before joining this field. We’ll unlock the essentials below.

Legal Issues Associated with NFTs

Nine essential legal issues surrounding NFTs today to keep in mind.

Even though non-fungible assets are acquiring greater popularity with each new release, there are still no certain regulations that dictate legal rules for market NFT and its representatives.

It is not that NFTs are complicated from a legal aspect. No. It’s just that NFT creators and actual owners of NFTs should be aware of some alarming signs and further legal issues. Some examples involve data protection, copyrights, financial liabilities, signing a contract, criminal aspects, and more. In most cases, the US SEC, which stands for Securities and Exchange Commission, classifies NFTs as securities.

Below, you can find commonly questioned legal aspects regarding non-fungible tokens.

1. No Intellectual Property Rights

Only because an NFT is developed displaying an underlying work of art, its author or owner does not hold the underlying intellectual property rights. NFT holders must acquire a license of these underlying rights from those who used to create a piece of art to obtain a right to reproduce the original work itself. Those who own such rights might prefer granting a license along with imposing other constraints on how an NFT can be used and by what means.

Remember a video of a slam-dunk from a famous basketball player LeBron James? He released it as part of a series of limited-edition collectibles of NBA highlight clips. Fans can buy and sell them in the so-called Top Shot NFTs market. In this situation, the copyright or contract ownership belongs to the NBA even if you purchase it. If one ever wants to reproduce this NFT, it will remain subject to licensing terms from the NBA.

What happens if you breach these terms? A marketplace for NFT can reserve all rights to eliminate your user account or delete an NFT “moment” from its application. They are not obligated to let their users know about it in advance. Sir Tim Berners-Lee has created plenty of exciting NFTs, as well as sold web source code NFT for $5.4 million. He can offer NFTs at a high price. He owns copyright, so he has no contract or licensing limitations. Sir Tim can reproduce the code when developing any of his NFTs.

So, in fact, the owner with all rights is a copyright holder who refrains the unique NFTs to spread, change, publish, and showcase the work unless this owner grants exclusive rights to another person. The one who buys an NFT just gets it and the right to use the copyrighted art related to the token for individual usage. If a buyer thinks that the rights were violated or experiences a value loss, they can come up with litigation obligation for the non-fungible token seller under a range of legal theories.

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2. NFT Fractions and Index Funds Can Be Unregistered Securities

As of today, many NFT marketplaces are facing fractionalization of non-fungible tokens in order to let numerous traders take part in an expensive proposal. In such a situation, what NIFTEX characterizes as a non-fungible token fraction is almost the same as what NFTX describes as an index fund.

What do fractionalized non-fungible tokens stand for? Those could be just one specific NFT or a bunch of them that are submitted by the issuance of an ERC-20 coin in a particular quantity. They serve like stocks but are traded as FT on DeFi or DEXs.

Not so long ago, SEC Commissioner Hester Peirce categorized fractionalized non-fungible tokens as unregistered securities. However, it is unclear whether others will support this opinion. Thus, in case a local regulatory body starts acting, an NFT investment can be at risk. Still, the profits that you may obtain are awesome, and it makes sense to dig deeper into the NFT-related topics and give it a try.

3. Anti-Money Laundering (AML) Efforts Can Impact Your Activity

NFTs market players should not think that NFTs are beyond any regulations only because of their innovative, unexplorable nature. NFTs led to the creation of separate laws, and one example is a class-action lawsuit filed recently. Currently, global regulations over art, digital assets, and antiquities, especially regarding anti-money laundering (AML), have extended.

We have mentioned that SEC in the United States classified NFT fractions as securities, and AML regulatory bodies are paying attention as well. That is one example. Taking into account the high costs of non-compliance, market NFT players engaged in purchasing and selling of these tokens, such as art dealers and brokers, would be ready to evaluate what can be at stake while navigating these uncharted waters.

US AML legislation has been expanded to apply in certain cases to dealers of antiquities and works of art. A primary question is if these regulations will expand to NFTs reflecting rights in these specific tokens.

US government enabled some AML provisions in the National Defense Authorization Act (NDAA), available since early 2021. This document offers updates to certain AML regulations, involving the Bank Secrecy Act (BSA), Corporate Transparency Act (CTA), and the Anti-Money Laundering Act (AMLA).

AML Act extended the Bank Secrecy Act to apply to everyone involved in trading pieces of art (consultants, advisors, sellers, buyers, and others). Under the Anti-Money Laundering Act, antiquities experts may possess liabilities to meet a variety of AML requirements.

A digital non-fungible token is not equal to antiquity. Thus, enforcing agents may try to shoehorn in NFTs trades and deem those deals to number to the solicitation of antiquities and within the ambit of the AML Act.

4. Data Hosting and Information Safekeeping

Saving NFTs on blockchain is recommended. It specifies the digital asset’s current location. Digital assets that refer to NFTs are kept in a different location. You can find more detailed info in NFT. An NFT is connected to an asset via a link. In case this asset is somehow erased, an NFT becomes useless. After a link breaks, an NFT would stop being related to the specific digital asset. It won’t be possible to back up the NFT. Any NFT is original. Replacing one is impossible. That is why its buyer risk staying without recourse. It can lead to data storing violations, interruptions, and loss of vital information.

5. What About Royalties?

By applying smart contracts composed into the code of NFTs, distributing money to pay royalties to the creator is possible. A seller can get paid at the moment that they sell their piece of art. Resolding the work is a single requirement. An NFT has to be resold through the same platform. That is the main condition for auto-resale royalty payments to take place.

American law doesn’t distinguish resale rights that have to do with creative pieces. That is why no recourse is offered for unpaid royalties. That said, in many European countries, this problem is also present.

In other words, in case a purchaser gets a token on a marketplace A, moves it to their digital wallet, and decides to sell it on a marketplace B, its original author obtains nothing. Pity.

6. Data Protection Regulations

If we take the EU, as GDPR admits, in relation to every private info point there is a minimum of one legal individual against whom data subjects can enforce their rights (for example, rectifying or eliminating personal information).

In the US, similar law exists: users sometimes can fully delete their private information. That is granted by some data protection laws like California Consumer Privacy Act or the EU General Data Protection Regulation’s provisions.

However, a blockchain may prevent users from using this right because of some obstacles that it may impose. It does not insist that users disclose their identities. That is why exercising their rights is almost impossible for data subjects. Non-fungible tokens that include private data might violate some of the data protection principles.

Thanks to data protection regulations, users can fix mistakes in their personal info. Once again, blockchain tech can make it hard or impossible to do corrections. What does it mean? An individual NFT with private data may contradict data protection laws, as well as personal rights. The lack of regulation of non-fungible token space raises plenty of concerns.

7. Estate and Sequence Planning

Legal frameworks handle digital collectibles on the holder’s death almost the same way everywhere. Still, you’d better check your local regulations first. Estate planning must matter to you in case you wish to make sure that your heirs will obtain ownership of your digital works in case something happens. Smart planning is essential for strategically including non-fungible tokens in a personal Estate Plan.

Provided the number of estates that possess a digital footprint, this issue matters. It has underlined the necessity for detailed estate planning once it relates to the NFT token market.

A big problem is that accessing NFTs is possible only via a personal key and password. That is why many users have no idea what to do upon the owner’s death. In this case, valuable assets risk being lost forever. Mitigating these risks is rather crucial for investors. One good idea is acknowledging personal reps of these assets and access to them. This way, trusted people will be able to access and administer the state in case of one’s death.

What if an NFT is not included as part of an estate plan to move on to beneficiaries? They might be simply eliminated. Saving critical info such as keys and passwords in separate, secure locations is vital. It is part of a robust “digital legacy” plan.

Such plans can be backed up using cloud data storage platforms. Third parties can obtain backup keys via special multi-sig wallets if something happens. In case of the owner’s death, their trustee will be able to withdraw funds and do what the owner initially wanted. It all depends on the owner’s last will. However, investors should keep in mind all possible risks associated with sharing their access, as well as cyber-hacking threats.

8. How to Use Trusts Properly

Keep in mind that you cannot physically hand a digital token over to a beneficiary. You can still pass it through your Will or Trust. Storing your key and password in a digital legacy is recommended so that an owner of an NFT can pass it over to someone later.

Trusts, in most cases, are used as an estate-planning mechanism for preventing the necessity to hand over assets via the last will. It attracts many investors. Trustees, however, have to realize their responsibility when they are asked to hold valuable digital assets. After all, NFTs possess a rather volatile nature. Knowing their powers of diversification is important for trustees. Trusted faces should know liabilities, management, and delegation peculiarities.

That is why you should choose an organization that would suggest a number of vehicles for holding crypto and NFTs. You’ll need proper structuring of ownership rights and sincere discussions with settlers about their risk appetite and the stability of values. Make sure that your attorney has drafted powers and responsibilities right in front of you after having a face-to-face conversation and your approval.

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9. Taxation Aspects

Are NFTs taxed? Most often, they are. In case you are not a side that made money on selling a non-fungible token, you should report the proceeds as income on a tax return. Thus, the same laws that apply to fungible crypto work for non-fungible assets. In case someone invests in them, any revenues that come from sales are taxed as property and subject to the capital profit tax. You may face such activities as:

  • Buying an asset with fungible crypto. This action is a disposal of the crypto and incurs a capital gain/loss. Let’s say, if one purchases a collectible card at Rarible using Ethereum (ETH), they would incur a capital gain, forcing them to pay taxes. In the case of depreciated crypto, a seller would experience a capital loss.
  • Offering an NFT for crypto. In this way, a seller incurs a capital gain/loss. For instance, they purchased a token for $20,000 just to sell it later for $25,000 BTC. It means they receive a gain of $5,000.
  • Trading one piece of art for another. This event triggers some taxes as well. Buying a token for $3,000 of BTC and trading it for another token worth $4,000 would mean a taxable capital gain of $1,000.

In each case, an asset would be subject to legal regulations related to taxation. If you simply come up with a token. it isn’t considered a taxable action. Selling it is different. Such marketplaces as Rarible or OpenSea have their own taxes on trading NFTs. Any profits that you obtain in this case are your personal income and should be taxed just like anything else that you sell. Usually, an income tax rate may vary from 10%-37%. It’s almost identical to those rates that show up when receiving payments in cryptocurrencies or mining. Besides, your profit will be subject to self-employment taxes at a rate of around 15%.

Even though these numbers are confirmed by most services and regulatory bodies, some questions are still left regarding NFTs taxation. As taxes and related regulations are different around the globe, one should refer to their local laws. For instance, in the United Kingdom, HMRC has updated the “Crypto-Assets Manual” that relates specifically to crypto.

Non-fungible tokens belong to a special category of a digital asset. This guide claims that NFTs aren’t “pooled” for Capital Gains Tax (CGT) goals. On one side, it is obvious that Capital Gains Tax deploys to revenues or losses on disposals of NFTs. However, the accurate tax position is not fully clear.

So, is NFT right for tax objectives? Foreigners with assets abroad should consider this primary issue. Their assets risk falling outside the scope of UK taxation. Crypto owners should pay taxes in the location where they are residents, so the same method may work for non-fungible tokens. It applies mostly to assets like digital NFT artwork, but the law is still obscure.

In other words, it does not mean if you are developing an NFT or investing in one. You should memorize some tax implications. The more transactions there are, the more complex tracking and estimating of taxes is. Not all services display taxes that users should pay. It is in your interest to keep records of both NFTs you sell and crypto used to buy them.

So, these legal issues are diverse, and not all of them are interrelated. Today, these disputes occur only in expert circles, but you should be aware of them if you wish to join this marketplace. Some points like liabilities, copyright law classification, and some other issues remain unsolved. You should keep an eye on this field. It is time to sum up everything said before.

Go Conquer the Niche!

Within this article, we’ve been able to provide insight into the market for NFT size and sales breakdown. Additionally, we defined traits that make non-fungible tokens different from other collectibles. Most importantly, our team has listed legal issues and challenges that an NFT buyer or seller should remember. We would focus globally.

The quick expansion of NFTs over the recent months indicates that a legal system hasn’t yet entirely caught up with this phenomenon. It could be a matter of time before legal issues focused on non-fungible tokens and digital art begin to arise.

As NFTs look like the future, legal regulations should be considered by every user who wishes to join an NFT market and carry out business that would fully meet local legal requirements.

Except for reading articles like this one, confer with legal counsel not to miss a thing. Nowadays, multiple services support users involved with cryptocurrencies in monitoring their activities and covering their taxes. Do not forget to report what you have to report in case you are already part of an NFT market. Reply to any requirements of a marketplace for NFT that you use.

Considering safety at each stage and enabling effective governance of the whole network is vital for efficient blockchain implementation.

OpenGeeksLab will be happy to help those who want to learn more. We have vetted blockchain professionals that will assist you with implementing security management tools like access control, the privacy of information, smart contract safety, and more with a blockchain solution that is safe and meets your business goals perfectly. Thus, in case of your pure interest in NFT-related topics, do not waste time and contact our team of experts now!

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