How the NFT revolution poses key risks and legal issues – International Investment

how-the-nft-revolution-poses-key-risks-and-legal-issues-–-international-investment

Non-fungible tokens (NFTs) have been around since 2014, but in the Covid-era, as more cultural experiences migrated online, NFTs began to experience far greater take-up amongst ordinary consumers, say law firm Collyer Bristow partner Robin Henry and associate Jean-Martin Louw.

In simple terms, an NFT is a cryptographic token that represents provable ownership rights in a unique digital asset, such as a piece of art. Those rights can then be traded in 24-hour online marketplaces, which are far more liquid than traditional art markets. 

One of the most exciting aspects of the NFT revolution is that it promises new ways for artists, musicians and other digital content creators to generate value from their works. Creators can, for example, earn future royalties each time their works are resold in the secondary market, with the royalties being paid out automatically and in perpetuity under digital smart contracts linked to the underlying asset.

One point to bear in mind is that, whilst every NFT is unique, the underlying work itself may not be.”

Although NFTs certainly challenge traditional notions of possession and ownership, our current legal framework seems able to facilitate and support the ongoing development of digital ownership rights. So, what are the key legal issues surrounding NFTs? 

Intellectual property 

From a purchaser’s point of view, the legal rights that attach to NFTs can vary and will affect their value accordingly. When you purchase an NFT, you acquire a bundle of computer code in the form of a token, which is linked to the original version (or some other, less scarce version) of the underlying work. Whilst any other party can view or copy that work, the token itself is unique and can never be replicated.

Think of it as an indisputable digital certificate of ownership. 

Typically, however, copyright and other intellectual property rights associated with the underlying digital work will remain with its creator. Disputes around intellectual property rights can arise where a third party “mints” and then sells an NFT that is linked to a piece of art created by somebody else.

Depending on how the NFT is created, this could be a breach of copyright. However, in some cases, because the NFT is a separate digital asset, its creation will not involve copying any part of the underlying work and, in those cases, there will be no copyright infringement.

Proper due diligence should be carried out on the seller before purchasing any high value NFT. 

Ownership rights

After purchasing an NFT, the holder’s legal rights will generally be restricted to owning, selling or lending the token. However, this is dependent upon the terms and conditions of the marketplace where the NFT was purchased, and these should be reviewed carefully before entering into any transaction. 

One point to bear in mind is that, whilst every NFT is unique, the underlying work itself may not be. A recent case involving online marketplace “Nifty Gateway” saw a collector mistakenly bid $650,000 for an NFT linked to a second edition artwork, rather than the original, which the collector believed he was purchasing.

The mix up occurred because, unbeknown to the collector, Nifty Gateway’s terms and conditions provided for a “ranked auction” where the top 100 bidders could each be expected to pay for a particular edition of the same piece, allotted to them in line with their position on the list of final bids. That case is now before the English courts. 

Contractual terms can also be buried within the code of the NFT itself. These are known as smart contracts, which automate transactions by following conditional logic with specific and objective inputs: if “event X” occurs, then “step Y” is executed, and so on.

For example, a creator might imbed a smart contract into an NFT, which automatically pays them a royalty each time the token is resold.

Their varying degrees of complexity and automation can take smart contracts outside the realm of legal familiarity, particularly in the context of contract formation, interpretation and remedies.

Purchasers should take particular care when acquiring high value NFTs to ensure that their rights are not encumbered (and the future value of their investment is not impacted) by such terms.  

Taxation

Taxation law is catching up with the rapid rise in popularity of cryptoassets. However, there remains uncertainty about the tax treatment of profits made on NFT trades. 

A central first question when considering how an asset will be taxed is to identify the location of that asset for tax purposes. This is not straightforward in the context of cryptoassets, which usually exist across a distributed network of computers around the world.

From the court’s perspective, it seems settled that cryptoassets are located where their owner is “domiciled” (i.e. whichever jurisdiction they have the closest connection to). HMRC has taken a slightly different view, saying that it would treat the location of cryptoassets as being the same as the tax residence of their beneficial owner.

In practice, a person’s tax residence can differ from their domicile, which creates uncertainty about how profits on NFT sales could be taxed. 

The popularity of this emerging asset class continues to rise, and with it will come novel legal issues. Although the law might take some time to catch up, our legal framework is, in general, flexible, and able to support the ongoing development of digital ownership rights.

By Collyer Bristow partner Robin Henry and associate Jean-Martin Louw

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