There has been a large coverage in the media about NFT and Metaverse during the last year which also continues this year. Indeed the "tokenmania" that has taken roots within the gaming and art industries seem to expand now to financial products and consequently trigger national or regional regulation.

What are NFTs?

NFTs (Non-Fungible Tokens) are not only tokenized assets representing immaterial values such as pieces of art collections. NFTs are also "non-fungible". Whereas fungible assets can be replaced by other equal assets and are interchangeable (10 shares, 10 euros, 1kg of rice etc., is replaceable by their respective equivalence), non-fungible assets cannot be replaced by anything and are therefore not interchangeable. They are one-of-a-kind assets, with very exclusive attributes, that cannot be found in any other existing asset.

To the contrary of cryptocurrencies, NFTs were designed to be indivisible by default and cannot be divided into smaller units. Indeed, a token cannot be broken down into new "smaller units" to be attributed to new owners.

NFT aim to provide access to digital works while being a proof of "ownership" of such works or access. Indeed, "exclusive" access or "ownership" most of the time are only common words to design a licensee of a digital collection, not necessarily an ownership of the digital artwork itself.

NFTs may be particularly useful for copyrighted works considering they are not registered with any Intellectual Property organization (unlike trademarks and patents). They may serve as a tool to tag isolated works with great precision, establishing the original authorship, attributing exact timestamps to transactions, publicly determining all subsequent ownership, and thus preventing copy. This may also explain why most items represented by NFTs seem to be copyrightable items, such as paints, drawings and songs.

Yet not every item may be valuable or adequate to be tokenized by NFTs. Assets with more than one owner and subject to co-ownership rules (i.e. buildings) may not be suitable to be represented by NFTs. The NFT creator should have something unique belonging exclusively to him, and something that could be represented by, and transferred through, an NFT.

Still in this regard, it is worth to point out that NFTs are programmable. In other words, when creating an NFT, it is possible to select and incorporate into it different sorts of information. Among that information, it is certainly the identification of the ownership as well as the price. It is also possible to add the conditions applicable to a given NFT when being sold.

Once NFT are created they are recorded in the blockchain. Just as cryptocurrencies or other virtual assets, NFTs are held in digital wallets. A wallet is a program with a similar purpose of that of a bank account: it tracks one person's holdings on a specific DLT.

From the wallets, NFTs may then be traded on different specialized marketplaces. NFTs transactions are possible thanks to smart contracts. Like wallets, smart contracts are also programs contained in the DLTs that are triggered when someone related to the NFT (the purchaser or the seller) interacts with it. It serves the purpose of an authenticity seal. In turn, these interactions are recorded on the DLT and those ensure the transactions authenticity.

DLTs or Blockchains?

NFTs rely on DLTs or more specifically on blockchains. Although DLT and blockchains share the same conceptual origin and are often used to designate a 'blockchain' (because of the success of the latter), those two terms actually refer to different things. Not all DLTs are blockchains, and a Blockchain is not the only existing type of DLT.

A distributed register/ledger technology (or DLT) is a shared/distributed database where logs are recorded in a structured manner, managed by multiple participants, through a network that is spread across different locations (decentralized digital database). A DLT may therefore be defined as "a novel and fast-evolving approach to recording and sharing data across multiple data stores (or ledgers). This technology allows for transactions and data to be recorded, shared, and synchronized across a distributed network of different network participants" ( World Bank, 2017).

On the other hand, a blockchain constitutes a particular type of data structure used in some DLTs. Although a distributed ledger, the data stored and transferred through a blockchain is grouped into 'blocks' locked by immutable cryptographic signatures called 'hash'. Those hash signatures are a fixed series of alphanumeric characters unique to any specific transfer. Therefore, the hash is a transfer fingerprint and any change to that transfer would generate a different hash. Each new block in a blockchain includes a hash of the previous block, and all blocks are linked to each other in a digital chain of blocks (or blockchain).

A blockchain may thus be defined as a "recording mode for data produced in a continuous manner, in the form of blocks linked to each other, according to their validation chronological order, each of the blocks and their sequence being protected against any modification" ( Legifrance).

When applied to NFTs, the blockchain is like an open book in which it is published everyone's properties – similar to a deed published by the notary.

What is the Metaverse?

Metaverse, on the other hand, is a 3D digital environment, or a "virtual reality", or an "augmented reality", close to a gaming space, that comprises avatars, representations, artwork, code and graphics. This environment includes exchanges of virtual assets and access to digital representations. There, NFTs issued on a blockchain come as the best means to ensure a secure and transparent consumption of those digital properties.

Generally speaking, Luxembourg has a wide range of various financial incentives for different businesses, including to finance technical feasibility studies, start-up aids (Fit4Start), aid for young innovative enterprises, aid for SMEs IP protection, etc. A joint public-private partnership - the Digital Tech Fund - was also created, in 2016 to support the Luxembourg technology startup ecosystem in different sectors, such as in the so-called Fintech sector.

Otherwise, Luxembourg was elected the best location for data centers in consideration of its low energy price and reliable electricity supply. The Luxembourg VASP provisions have contributed to legal certainty, and whenever stocks and real estate property will be 'turned' into NFTs, some recent legislative initiatives may be interesting, such as the so-called Blockchain laws of Mars 2019 and January 2021.

NFTs and Metaverse seem to represent excellent opportunities, especially for Arts and Gaming industries. However, they are quite new and have mostly not yet fallen under the radar of national regulators, which does not mean that NFTs and Metaverse are beyond the reach of national regulations and judiciary decisions.

Despite their novelty, there are existing legal provision that must be taken into account when setting up a venture in Luxembourg, in connection with NFTs and Metaverse.

Luxembourg Law Definition of NFTs and Metaverse

As of today, Luxembourg law provides no stand-alone definition for NFTs or Metaverse. However, the Luxembourg Law of 12 November 2004 on the fight against money laundering and terrorist financing (the "AML/CFT Law") currently provides two definitions that may be relevant for NFTs : that of "Virtual Assets" (20ter) and of "Virtual currencies" (20bis). The first one of these two definitions may include NFTs. Indeed, a "Virtual Asset" is defined as "a digital representation of value that can be digitally traded, or transferred, and can be used for payment or investment purposes". Whenever an NFT fulfils these general characteristics, it could potentially be considered a virtual asset, which entails a certain number of obligations (please see our comments to the last point). It may be worth to note that the AML/CFT Law expressly provides that "virtual currencies" are included within the Virtual Asset definition.

The Metaverse is not defined nor regulated per se in Luxembourg law, and it is unclear how it would be treated. It may not ever be fully regulated in a single text but by provisions from different texts, which may apply depending on the qualification of the actions taken within the Metaverse. The Income tax, for example, seems to apply "regardless of whether the income is realized in a real or virtual world" - Luxembourg Direct Tax Administration Circular L.I.R. n° 14/5 – 99/3 – 99bis/3 of 26 July 2018.

Luxembourg regulations on NFTs and Metaverse

One of the first questions that comes to mind when dealing with sale of virtual properties is tax provisions: To the best of our knowledge, no Luxembourg income tax provision expressly states as applicable to NFTs, nor did the Luxembourg tax administration make any statements specifically on NFTs taxation. Nevertheless, the Luxembourg Direct Tax Administration Circular L.I.R. n° 14/5 – 99/3 – 99bis/3 of 26 July 2018 provides that "concerning the income tax, business tax and wealth tax, virtual currencies, such as Bitcoin, shall constitute intangible property". This Circular was adopted before the "Virtual Assets" and "Virtual Currencies" definitions were introduced within the AML/CFT Law, the 20 March 2020. Therefore, the Circular could not possibly refer to "Virtual Currencies" .

Although NFTs may not be considered virtual currencies, it is reasonable to assume that they may as well be considered an intangible property by the Luxembourg administration. Should this be the case, the NFT income may be subject to an income tax whenever this income "falls into one of the categories of income listed in Article 10 L.I.R." (Ndlr. L.I.R. = the Luxembourg income tax law).

Furthermore, any person who, on behalf of or for their clients, provides specific services listed by law that are related to virtual assets (which, as we have seen, may cover NFTs) must comply with a certain number of obligations: apply for a Virtual Asset Service Provider authorization (the "VASP") before the CSSF (the Luxembourg authority supervising the financial sector), pay the CSSF fees for the VASP registration, comply with AML/CFT legal provisions, have at least two persons responsible for the VASP management (article 7-1(3) AML/CFT Law), have these persons approved beforehand by the CSSF, etc. Other licenses and regulations may also be applicable depending on the activity performed in relation with the NFTs (see Point 5 herein).

It may be worth to mention that, having regard to the Commission Proposal for Markets in Cryptoassets Regulation (MiCA), NFTs would likely fall into the 'catch-all' category of other crypto-assets and may require a license for a Crypto-Asset Service Provider (the "CASP") – Skadden (Various authors), Regulatory Approaches to Nonfungible Tokens in the EU and UK, 15 June 2021.

Direct and indirect taxes with reference to the issue and sale of NFTs

NFTs may be considered intangible property by the Luxembourg tax administration and the income resulting from NFTs may potentially be subject to an income tax. Should this be the case, the NFT income resulting from transfer operations (alienation, exchange) may be considered, for taxation purposes, either as a "business profit" (Art. 10(1) L.I.R.) or, alternatively, as a "miscellaneous net income" (Art. 10(8) L.I.R.). In this regard, an NFT income may be a "business profit" if it is the result of an "independent profit-making activity carried out on a permanent basis and constituting a participation in general economic life, when the said activity does not constitute agricultural or forestry exploitation or the exercise of a liberal profession" (Art.14 L.I.R.).

As for indirect taxes, in an ECJ Judgment of 22 October 2015 (C-264/14), the European Court of Justice considered that the "exchange of traditional currencies for units of the 'bitcoin' virtual currency and vice versa" are transactions "exempt from VAT within the meaning of provisions from article 135(1)(e) of the VAT Directive". However, it cannot be assumed that the same conclusion would also be applicable to NFT, in that, unlike virtual currencies, they do not serve the purpose of a means of payment (C-264/14, 24 to 26 and 52; cf. also article 135(1)(e) of the so-called VAT Directive of 28 November 2006).

In any case, Luxembourg tax administration have not yet made any statement in this regard.

Specific Luxembourg authorizations / registrations required for operators issuing / intermediating NFTs All professional economic activities are subject to a business permit (autorisation de commerce) granted by the Luxembourg General Directorate for Small and Medium-Sized Enterprises. Those activities are also subject to specific registration and publication obligations before the Luxembourg Trade and Companies Register (RCS) and the Luxembourg Beneficial Owners Register (RBE).

Furthermore, one may need to apply for a VASP authorization before the CSSF (which entails a certain number of obligations), as well as for other licenses depending on the intended activity(ies).

In the near future, it may also need to apply for a CASP authorization before the same authority (it is currently unclear whether the VASP and CASP regimes will coexist or be superseded). As for VAT, one may need to register for VAT with the Luxembourg tax administration (especially if the annual turnover exceeds 35.000.- EUR), usually within 15 days from the start of the activity, with some exceptions.

Finally, one may take in consideration that intermediating NFTs may be understood as intermediating the goods/services that those NFTs represent. In such case, specific authorizations and obligations may be needed, depending on the nature of those goods/services.

Decisions regarding legal and tax aspects of NFT and Metaverse

The European Court of Justice as well the Luxembourg Direct Tax Administration have issued decisions on virtual currencies that we mentioned in our previous points. However, they concern specifically virtual currencies and do not address NFTs or virtual assets in general.

Since the creation of the VASP regime, the CSSF also published a series of documents in its website concerning investments in virtual assets as well as the depository duties in the context of virtual assets (documentation that is mainly directed towards specific entities under the CSSF supervision: funds/undertakings for collective investment, and banks/credit institutions). In one of these documents dated on 29 November 2021, the CSSF briefly refers NFTs, seemingly framing them within "virtual assets" definition, and indicating that the aforementioned entities may or may not invest in them, depending on the risks and on the specifics of their activities. No sentence (court decision) or statement from a Luxembourg authority seems to have been published regarding Metaverse, up to this date.

The Financial Action Task Force (FATF) considered that NFTs "are generally not considered to be VAs" (Virtual Assets) but "it is important to consider the nature of the NFT and its function in practice" since "the FATF Standards may cover them, regardless of the terminology. Some NFTs that on their face do not appear to constitute VAs may fall under the VA definition if they are to be used for payment or investment purposes in practice" ( FATF, Updated Guidance for a Risk-based Approach - Virtual Assets and Virtual Asset Service Providers. October 2021. p.24).

All companies and undertakings wanting to use a specific technology, but having doubts concerning its legal value and implications, are advised to verify those points with a legal professional.

Originally published 22 March 2022

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.