Income earned in virtual worlds: taxation issues
20 June 2007
First published in E-Commerce Law & Policy, May
2007.
The explosion in virtual worlds has raised some interesting
questions about when taxation should apply. Does tax apply to a
virtual transaction that takes place in a virtual currency, or does
it apply when that income is converted into 'real world' currency?
Graeme
Nuttall examines these issues and the view of taxation
authorities from around the world.
Some frequently-asked questions need answering regarding trading
in virtual worlds. Perhaps the most common of these involves the
misconception that money can be made tax free by trading in virtual
worlds. The UK tax system and other tax systems worldwide are
designed to tax trading whatever its form. Tax systems coped well
with electronic commerce and are probably wide enough in scope to
tax trading in virtual worlds.
The answer to this question surprises many, who are of the view
that tax surely cannot be paid on the equivalent of 'Monopoly
money'. They are correct that there is no tax on the players in a
game of Monopoly. However, in a game of Monopoly, the winner does
not convert their winnings into US Dollars. The Monopoly money gets
put away until the next game is played. The Second Life 'currency',
Linden Dollars, can be exchanged for what any tax authority would
recognise as real currency. The fact that Linden Dollars can be
converted into US Dollars is an important and very real difference
from Monopoly money. This is what has attracted the tax man's
attention.
However, the position is still unclear about whether HM Revenue
and Customs (HMRC) will charge tax on Second Life 'inworld'
profits. This is a developing area of tax law. What HMRC will do is
apply general principles to arrive at the current tax treatment
under existing law, and the UK Government will then decide whether
or not that tax treatment is an appropriate tax treatment, taking
into account a range of policy issues.
HMRC is likely to publish guidance on the tax treatment of
in-world trading. There is a precedent in relation to individuals
trading on eBay. If you (as an individual) buy items with the
intention of selling them on as quickly and as profitably as you
can, then you are a trader. HMRC has issued clear guidance that if
you are running a business online, you will be regarded as
selfemployed for this trade and you must register with HMRC. You
may have to pay income tax and national insurance contributions.
You may also need to register for value added tax.
There is also likely to be some de minimis exemption. The way
HMRC defines trading means that not every sale for a profit by an
individual is taxable. HMRC has provided helpful guidance that you
are not trading if you:
- sell occasional, unwanted personal items through internet
auctions or classified advertisements;
- attend a car boot sale once a year to sell unwanted household
items.
This practical guidance could easily be extended to cover sales
of occasional unwanted virtual items through internet auctions or
inworld.
Under the definition of trading for UK tax purposes, there is a
circular definition in tax legislation that a 'trade' includes
every trade, manufacture, adventure or concern in the nature of
trade. There are numerous reported cases on what is and is not a
trade. A 1955 Royal Commission on the taxation of profits and
income [1] lists six 'badges of trade':
- the subject matter of the realisation;
- length of period of ownership;
- frequency or number of similar transactions;
- supplementary work on assets sold;
- reason for sale; and
- motive.
Court decisions emphasise that these badges do not provide a
comprehensive list and no single item is in any way decisive.
If someone reproduces, through their combined efforts in the
real world and in-world what would clearly be a trading activity in
the real world, it seems likely that this would be accepted as a
trading activity under UK tax law.
For income tax purposes, the profits of a trade arising to a UK
resident are chargeable to tax under the Income Tax (Trading and
Other Income) Act 2005, wherever the trade is carried on. You
cannot argue that trading in cyber-space is not taxable. This issue
has been considered in relation to e-commerce.
In relation to corporation tax, UK resident companies are
charged to tax, under the Income and Corporation Taxes Act 1988, on
profits or gains arising or accruing from any trade whether carried
on in the UK or elsewhere.
It is also a misconception that tax does not apply to items sold
that are not 'real'. There is no need for your customer to receive
something tangible for you to pay tax. What is the difference
between, say, paying to experience an in-world concert and
attending a concert at an auditorium? The customer takes away the
experience. They do not take away anything tangible.
The legal rights underpinning an in-world transaction are,
however, relevant in determining whether or not there is or can be
a trade, or the value that can be placed on a transaction.
There are indications that the tax authorities could take the
position that tax is only payable when virtual currencies, such as
Linden Dollars, are converted into real currency. The starting
point in the UK, however, is to remember that barter transactions
are taxable. There is clear HMRC published guidance to this effect
in respect of real world transactions. In other words, you do not
have to receive currency in order to generate a profit from a sale.
If you are paid 'in-kind', you may still have been paid from a tax
point of view. You could be taxed on the 'fair value' of what you
receive even though it is not immediately convertible into
money.
There is, however, merit in the argument that Linden Lab retains
the ability to cancel accounts and to confiscate Linden Dollars, so
HMRC should not apply tax until virtual currencies are exchanged
for 'real' currency. This argument may influence Government policy.
There is a risk under the terms on which Linden Research, Inc.
offers you access to its services that you may lose your Linden
Dollars. However, HMRC could argue this is no different from other
risks faced by traders. A trader might be paid in a foreign
currency which generates a taxable sterling profit in one
accounting period, only to see that foreign currency's sterling
value fall at a later date. At best, HM Revenue and Customs may say
this risk factor affects calculations of 'fair value'.
Another argument that has merit is that income earned in virtual
worlds is through betting and not trading. In the UK the basic
position is that betting and gambling as such do not constitute
trading. Winnings are not taxed as trading income, even if betting
is habitual [2]. There is also an exemption from tax on capital
gains for winnings from betting, although an organised activity to
make profits out of the gambling public will normally amount to
trading.
It is not easy to define a bet or wager. It has been held
essential to a wagering contract: '...that each party may under it
either win or lose, whether he will win or lose being dependent on
the issue of the event and, therefore, remaining uncertain until
that issue is known [3]'
It is difficult to see how anyone can argue that every
transaction on Second Life can be considered a bet or wager unless
you can show, say, significant instability in the Second Life
environment. Nevertheless, a similar taxation policy could be
developed. HM Revenue and Customs could decide that any business
making profits in Second Life is taxable on those profits (whether
or not they are taken out of Second Life), whilst a private
individual could be allowed to make whatever in-world profits they
wanted, tax free. If the private individual ever cashed in their
in-world currency, this may or may not amount to trading, depending
on the circumstances.
The US position
The Joint Economic Committee (JEC) of the Congress of the United
States announced in October 2006 that it would examine the public
policy issues related to virtual economies. A press release, dated
17 October 2006, stated that:
'Based on existing law, if an individual generates cash income
in US Dollars from transactions in virtual economies, the question
may arise whether a tax is due on that real world income. However,
if the transaction takes place entirely within a virtual economy,
then it seems there is no taxable event'.
The aim of the forthcoming JEC study is to 'head off any
premature attempt to impose a tax on virtual economies'. More
recently [4], an IRS spokesman is reported as stating:
'Any time someone wins a tangible prize or award, the value is
reportable as taxable income. An accumulation of 'points' would not
result in tax consequences, but redeeming or selling them for
money, goods, or services would'.
Please note this is a comment on US tax law not UK tax law.
The UK position
An HMRC spokesman, reported by Reuters on 31 October 2006,
commented as follows on the JEC study:
'Our reaction to this at the moment is it's something that's
very interesting and we are considering it. Where we stand at the
moment is it's not something that's having a significant revenue
effect. We don't see a possibility of people being able to exist
solely on money within Second Life. They'd have to withdraw the
money and when that happens they'd be expected to pay a normal tax
bill. Obviously we'll be considering what comes out of the U.S.
review on this, Our general current consideration is that income
from all online games should be declared to the revenue, in exactly
the same way for Second Life as they would be for eBay, say'.
The Australian position
An ATO spokeswoman is reported as stating [5]:
'If you are getting a monetary benefit then it's not treated any
differently - normal rules apply', in what is believed to be a
world first. 'Your income will not be treated any differently than
if you earned it working nine to five in an office'.
If a virtual transaction has real world implications - if it can
be attributed a monetary value - it attracts the attention of the
Tax Office. Sites such as slexchange.com set rates for swapping
Second Life's Linden dollars. 'In addition, there may be GST [i.e.
value added tax] to consider', points out the spokeswoman.
In other words, if you are turning over the equivalent of more
than A$50,000 selling virtual jewellery to Second Life avatars, you
must get an ABN and register for GST. People trading in virtual
worlds should consider very carefully whether they are conducting a
business or a hobby, the Tax Office advises. If conducting a
business, then all money earned is generally assessable income. But
expenses, such as the cost of computer equipment for accessing the
virtual world, can be deducted. Any loss can be offset against
other income.
The Swedish position
A Swedish tax authority spokesman is reported as stating
[6]:
'We're not interested in ordinary gamers. More than 99 per cent
of them play internet games for the sake of playing and most people
keep their virtual money on their game account. However, if they
move it out of the virtual world into the real world, then we're
interested in them'.
The Swedish Taxman says those instances should be taxed as
income because the person involved, although existing and 'working'
primarily in the virtual world, has sold the added value of that
labour in the real world. It is expected that a special tax code
for such people and transactions could be in place by 2009.
Discovering or winning items of value
These questions and answers focus on Second Life because of the
freedom participants have to operate within Second Life and the
existence of Linden Dollars. In relation to more structured
environments where items are discovered or won in the course of a
game, there should be a different tax treatment. Items that are
discovered are probably, in effect, bought from the game's operator
through payment of a regular licence fee. Any items that are won in
the course of a game should be accepted in the UK as non-taxable
winnings from playing a game. The nature of a games world will
probably mean it is unlikely that anyone can trade (within the tax
definition) in that world. Although barter transactions can take
place in the course of a game, in the overall context of that game,
we would expect HMRC to accept that the participants are not
trading. The sale of an occasional unwanted item for real currency
should be covered by the published HMRC guidance that this is not
taxable trading.
Research papers
Leandra Lederman has published a paper Stranger Than Fiction:
Taxing Virtual Worlds [7]. This paper deals with US tax rules, but
nevertheless provides an interesting analysis of the relevant
issues. Professor Lederman recognises that all virtual economies
are not alike and that there is a strong case for not taxing
in-game receipts and trades in game worlds, including sales within
those games for virtual currency. The real world value that can
exist for in-game items as a result of trading by some players
should not transfer game world successes into taxable income.
However, in intentionally comodified virtual worlds, such as Second
Life, then on her analysis, tax issues do arise that need to be
addressed and that may require changes in US tax law to ensure
inworld trades of non-currency items go untaxed (if this is the
agreed policy objective).
Bryan Camp has published The Play's the Thing: A Theory of
Taxing Virtual Worlds [8]. He also considers the issues for US
taxpayers. Professor Camp's central thesis is that while player
activity in virtual words produces measurable economic value to the
player, player activity that occurs solely within the online
virtual world is not gross income under the law. He argues for a
'cash out' rule. Players whose added wealth consists solely in what
are defined as 'units of play' should not be taxed unless and until
they convert those units into cash or property that is something
other than a unit of play. Conversely, when the play ceases,
taxation begins.
For further information, please contact Graeme Nuttall.
Footnotes
1. 1955 HMSO CMD 9474
2. Graham v Green [1925] 9 TC 309
3. Carlill v Carbolic Smoke Ball Company [1892] 2 QB
484
4. http://www.cnnmoney.com, 9 March 2007
and elsewhere.
5. http://www.theage.com.au, 31 October
2006 and elsewhere.
6. http://www.telecomTV.com, 5 February 2007 and elsewhere.
7. March 2007 Research Paper Number 76, Indiana University School
of Law Bloomington Legal Studies Research Series.
8. 15 April 2007 Available at SSRN: http://ssm.com/abstract=980693