26 March 2021

NFT – is blockchain disrupting the art market?

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Our magazine article introduces you to the booming application of blockchain-technology to art: Non-Fungible Tokens or NFTs. We also elaborate on secondary markets and the legal implications. You’ll learn about the key aspects to look out for from a legal, tax and compliance perspective.

How it all started and the recent hype

If you are familiar with the intersection of blockchain technology and art, chances are high that you have heard of CryptoPunks and CryptoKitties.

While CryptoPunks was a pioneer in firstly using a Non-Fungible Token (“NFT”) that inspired a new Ethereum standard, the CryptoKitties craze famously led to a sixfold increase of pending transactions slowing down Ethereum’s underlying digital ledger technology (“DLT or blockchain”) in late 2017. These cryptographic art collections have pathed the way for many other projects to come, such as the Hashmasks, a tokenized art collection by a Swiss start-up that went viral in January 2021. The entire collection of 16’384 unique digital portraits was sold within only two weeks, trailing in sales volume only CryptoPunks and NBA Top Shot – an officially licensed collectible that allows fans to purchase and trade tokenized snapshots of NBA games.

However, the art tokenization trend does go further than collaborative digital art collectives. Recently, simple memes have been sold as crypto art and the tech giants seem to be claiming their ground as well. Elon Musk offered for sale a song about NFTs as an NFT, only to back off of it days later, while Microsoft has teamed up with the blockchain platform Enjin to produce a mini-game that distributes NFTs as rewards among the community for performing learning tasks.

Established digital artists are, unsurprisingly, also jumping on the tokenizationtrain. The digital artist going by the aka of Beeple, uploaded every single day for 13-and-a-half years a digital art piece that has now been minted for Christie’s as a tokenized digital art collage. Christie’s offering Beeple’s opus as a digital tokenized work and accepting cryptocurrency as first major auction house, in this case ETH worth of a record amount close to USD 70 Mio., are a definite sign that the NFT art market has arrived in the mainstream.

What is NFT-art all about?

A NFT is a unit of data on a blockchain representing a non-fungible ownership right regarding an item or a respective claim. Thus, contrary to cryptocurrencies, the underlying unit of data of NFTs is unique and not interchangeable. While NFTs can represent any commodity that can be synchronized with a digital token (such as a gold bar or a diamond), creative work provides – due to its immaterial nature – an obvious use case.

The tokenization of an art piece may not prevent that the digital file itself will be infinitely reproduced and spread. However, the NFT representing the digital art is tracked on the underlying blockchain and provides the purchaser of the token with proof of authenticity and ownership. Therefore, NFTs not only commodify, but, maybe even more importantly, authenticate a digital creation. It can hardly be refuted that the method of preventing that the digital file run on the blockchain is faked, forged, or replicated, was vital for the surge of this new market. As Oscar Wilde noted, all art is quite useless - the value of art is purely based on community-consensus and authenticity is valuable because it is scarce.

Which role do secondary markets play?

NFT-technology has the power to provide digital artists, who despite of their IP rights previously had their intellectual creations floating through the internet without any compensation, with a stream of revenue. On the other hand, it makes the art market and its investment potential accessible and attractive to digital natives – as has been shown by the explosive growth of secondary markets.

Some big players in the NFT-art game, like NBA top shot and CryptoPunks, have established their own secondary marketplace, trying to enforce their rules of the resale. Other companies have focused on providing a decentralized marketplace, like AtomicMarket, Rarible and OpenSea. Finally, the artist may use secondary markets to their advantage as well; NFTs connected to Beeple’s artworks, for instance, give him a 10% royalty fee every time his art changes hands.

Large part of the success in the art market disruption of NFT-art is the proven success and liquidity in their secondary market: Taking the example of The Hashmasks, the secondary market trading volume on OpenSea already reached USD 4 mio within the first 24 hours. Now, roughly 6 weeks after the primary market sale of the portraits ended, the total trading volume is close to USD 28 mio, with an average of 100 trades per day.

Legal, Tax and Compliance Considerations

When launching a NFT project, or establishing a secondary market, in Switzerland, various legal and tax consideration need to be taken into account. From our experience in these types of projects, here are some of the key topics to be addressed:

Intellectual Property Considerations

  • While copyright and related rights come first to mind, NFT-art may be protected by numerous other IP rights, like designs or trademarks.
  • An issuer of NFT-art must develop a clear IP strategy and decide what is being sold, which rights are to be granted to holders of the NFT and which rights the issuer, the artist and secondary market platforms may need to keep.

Contractual Considerations

  • Both NFT issuers as well as secondary marketplaces need to put appropriate terms of sale in place. These serve to protecting their business interests and include, inter alia, provisions addressing warranties, IP rights, liability, applicable law and dispute resolution mechanisms.
  • Regularly, additional legal documents are advisable – such as code of conducts or data privacy policies.

Regulatory and Compliance Considerations

  • From a civil law perspective, it is essential to distinguish between absolute ownership rights (which are valid against everyone), relative claims (which are valid only towards specific counterparties) and native tokens without any defined rights.
  • Regarding financial regulation, tokens are categorized into three types, namely payment, utility, and asset tokens, but hybrid forms are possible.
  • NFTs that underly individual pieces of artwork should generally not qualify as securities (asset tokens). However, each NFT project needs be assessed separately to assure that the NFTs are designed in a manner to not be considered securities and that the proceeds of the sale are collected in way that they are accepted by a bank in a later stage.
  • Traders of digital NFT art may become subject to Swiss AML regulations, e.g. if they accept more than CHF 100’000. in cash (or the equivalent in another FIAT-currency or cryptocurrency) as part of trading transactions.
  • Operating secondary marketplaces may trigger another set of legal challenges to be addressed, including consumer protection, KYC and cross border financial market topics.

Tax Considerations

  • The transfer of assets, functionalities or intellectual property rights are generally subject to 7.7% VAT if the place of supply is considered to be in Switzerland. Hence, professional NFT-art traders would most probably perform taxable activities.
  • On the other hand, the transfer of NFT-art might be VAT exempt (without credit) if sold directly by the artist herself in a limited and certified manner.
  • In addition, the supply of electronic services can trigger tax liabilities in the jurisdictions of the recipients. However, clear guidelines do not yet exist in respect to digital art and NFTs.
  • The transfers of claims and securities are generally exempt from VAT (without credit), but subject to stamp duties if sold by or with assistance of a Swiss security dealer.
  • Finally, private capital gains are income tax free in Switzerland, while business income is taxable. However, in any case, NFT holders need to declare their valuable holdings for net wealth tax.

This overview of key legal topics serves as a general guide to the subject matter. Our DLT-Team, consisting of interdisciplinary experts in their respective fields with a focus on blockchain-technology, is excited to learn about and legally assess your project.