Metaverse taxation: integrating virtual world into current tax policies

With the metaverse booming to 400 million users, the challenge arises: how do we tax this burgeoning virtual world?

Metaverse is a virtual world where millions of people spend their time nowadays. To give you an idea of its popularity, there are currently about 400 million active users worldwide.

Back in 2021, the metaverse was valued at about $58.5 billion. Fast forward a few years, experts are saying it could skyrocket to a mind-blowing $1.5 trillion by 2030. This isn’t just a place for fun and games. It’s shaping up to be a serious contender in the global economy.

Now, with all this growth, a big question is popping up: How will we include this virtual economy in our existing tax systems? It’s like when online shopping became a thing, and everyone was scratching their heads about how to handle taxes.

A Harvard scholar Young Ran (Christine) Kim, who is part of the team at the Benjamin N. Cardozo School of Law, recently shared her insights in a research paper, opening up a conversation about the potential ways to approach taxation in the metaverse. It’s all about figuring out how to update our current tax policies to make sure they cover what’s happening in this rapidly evolving digital world.

Why does the metaverse need to be taxed?

So, why there’s a buzz about taxing the metaverse? 

According to the findings in Kim’s research, it seems we can think of the metaverse as just another business sector. And just like any other sector, it should be part of our existing tax systems.

Let’s dive a bit deeper into the “why” here. This argument for taxing the metaverse isn’t just a spur-of-the-moment idea—it’s grounded in well-established theories and perspectives on regulation. 

Whether it’s companies making profits, investments seeing gains, or people earning rewards in this virtual space, all these activities are quite similar to the recognized ways people make money, as described in Section 61 of the Internal Revenue Code (a big rule book for US taxes).

Going beyond just theories, the paper mentions that there’s also the core principle that governments have the right, or rather the duty, to tax economic activities within their borders.

The research states this should include the bustling virtual spaces of the metaverse, too. Not tapping into the vast potential revenues from this booming sector could mean missing out on a significant chunk of money that could have been used to fill the country’s treasury.

Besides, the paper says that having a proper taxation system in place could prevent the metaverse from becoming a kind of tax haven where people can hide assets or income to avoid paying taxes.

Furthermore, bringing taxation into the metaverse could be a powerful tool for keeping things transparent and well-reported within its financial markets. While we’ve made some progress in bringing cryptocurrencies under tax policies worldwide, it’s high time we take a broader approach, the research suggests.

Taxable elements in the metaverse

Let’s investigate how people might make money in the metaverse and how these could be taxed.

Earnings and profits

First, let’s talk about the usual suspects: earnings and profits. Just like in the real world, people in the metaverse can make money through salary, business profits, and even dividends. But here, the earnings might look a bit different, coming in the form of virtual goodies or cryptocurrencies.

“Such activity falls under the Haig-Simons conception of income as participants can spend and accumulate in-game currency and other digital items that hold real economic value.”

the paper states.

To relate this to current US taxation methods, the Internal Revenue Service (IRS) already classifies cryptocurrencies as property, meaning they are subject to capital gains tax rules when sold or traded. Similarly, these guidelines could be extended to various digital assets in the metaverse, establishing a tangible link between virtual earnings and real-world tax implications.

Now, this whole digital money thing does throw a bit of a wrench in the works. Figuring out the exact value of these assets can be a bit of a rollercoaster ride because of their ever-changing nature. The paper suggests the US tax system may need to develop dynamic approaches akin to mark-to-market taxation. In this strategy, assets are taxed based on their market value at the end of the tax year to assess the value of metaverse transactions and holdings fairly.

Plus, converting these digital assets into cash isn’t always straightforward. But, according to the research, we can still use existing tax rules as a starting point to navigate these waters. 

To get around these challenges, one idea floated in the paper is introducing taxes paid in-kind, meaning paying taxes with goods or services instead of cash. In the metaverse, this could mean using digital assets or services available within that space to pay your taxes. 

Drawing parallels to bartering transactions in the US, which are subject to tax implications, similar principles could be applied to transactions occurring within the metaverse, helping to create a balanced and equitable tax structure that integrates seamlessly with existing frameworks.

Self-made or enhanced assets 

The metaverse is a breeding ground for creativity, with users creating or improving digital assets, be it crafting virtual weapons or personalizing unique digital tokens known as non-fungible tokens (NFTs). NFTs currently carry a 28% tax on all gains from the proceeds. However, the rest of the digital assets are undefined.

The paper suggests the metaverse could be an arena where a new category of imputed income emerges, stemming from the digital assets users create or enhance. An imputed income is a kind of economic gain that happens when people use their own resources or services for personal gains. Up until now, taxing this type of income has been avoided, mainly because figuring out the value and keeping track of it all can be a nightmare. 

However, the metaverse could change this, making it easier to instantly value and monitor these activities, possibly opening the door to new tax opportunities, especially on virtual properties that have a clear market value. 

Now, this is a pretty big departure from the norm, so it’s something that needs a lot of discussion to work out the most effective way to implement it. This would involve multi-stakeholder dialogues involving policy makers, tax experts, and industry representatives, ensuring a fair and feasible approach to taxation in the metaverse.

Rewards 

Now, onto rewards, a crucial part of keeping users hooked in the metaverse. We’re talking about things like loot drops that players get during games. While they’re a big draw, they also create a bit of a tax headache. 

The research suggests that these virtual rewards, which do have real-world value, should technically be taxed in certain scenarios. The big question, though, is when and how to tax them. 

Because of the digital tracking capabilities of the metaverse, it might be possible to impose taxes on these rewards immediately, helping to keep things fair and avoid tax dodging. Note that the rewards in the US are generally non-taxable, but rewards in the metaverse can be an extension.

Unrealized gains from virtual assets

Lastly, we dive into the tricky topic of unrealized gains in the metaverse. Gains that are only “on paper” are called unrealized gains. Currently, the laws only tax these gains when they’re realized, meaning when they’re converted into cash or used to buy something. However, this approach might not be the best fit for the fast-moving and fluid world of virtual assets.

An alternative approach might be to shift to a system where these assets are taxed based on their market value at the end of each year, giving a more accurate picture of someone’s financial standing. 

The paper strongly hints that the unique nature of the metaverse might allow for this immediate taxation, shaking up the traditional tax landscape and ushering in a new era in the world of taxation.

Where should taxes be collected?

Now, let’s tackle the elephant in the room – figuring out how to tax this sprawling virtual universe called the metaverse when it doesn’t even have a physical address. It gets pretty tangled when trying to pinpoint where exactly these transactions are happening and who should be overseeing them. Let’s dive into some potential strategies discussed in the paper.

The big question is finding the best place to collect taxes in the metaverse. One idea is to use the location of the servers (basically the computers where all the virtual action is hosted) as a stand-in for where the business is happening. 

But this is not foolproof because people can play tricks with server locations to take advantage of lower tax rates, even though there are limits to this because of the need for fast data transfer.

Another suggestion is to look at where the platform owners are based. This seems more stable, but it brings up worries about giving too much tax power to certain places, which might shift the economic balance in those areas. 

Then, there’s the idea of tracking where users are by their internet addresses, but again, users can mask these or use virtual networks to seem like they are somewhere else, seeking better tax rates.

The paper suggests that we need a flexible system that can deal with these complications, including handling digital nomads and people with homes in multiple places fairly and efficiently.

How to make sure the rules are followed

After figuring out where the tax should be collected, the next step is ensuring the rules are followed. Initial talks are hinting at a rule where money made from online gaming above $600 each year should be reported using a specific form, but only when the income is converted into real cash.

But this research paper is suggesting we think bigger and also keep track of money that hasn’t yet been taken out of the metaverse. They’re talking about using a Unified Ledger Transaction Reporting System (ULTRAs) to handle this kind of tax, which is a modern approach to the ever-changing nature of virtual assets.

When it comes to making sure these taxes are collected, two main roads are being considered. One is to put the responsibility on the metaverse platforms themselves, asking them to send the tax directly to the IRS, which could cut down on mistakes and dodging taxes. This would gel nicely with the current taxation at the source system, making things smoother and easier to handle. 

On the flip side, tying it into where users live makes it a bit more complicated but blends seamlessly into the current tax filing process, offering a straightforward way to pass tax information to users.

The road ahead

In a nutshell, building a robust tax structure for the metaverse is no small feat. It calls for a versatile plan that not only pinpoints the right places to collect tax but also strengthens the mechanisms to ensure compliance, mirroring the complex and ever-changing landscape of the metaverse itself. It’s a conversation that’s just beginning, with ongoing efforts to carve out a just and effective system, ensuring a bright future for the digital frontier.