Originally published in e-Finance & Payments Law & Policy, Volume 1, Issue 7, April 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, a partner with Field Fisher Waterhouse LLP, 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 income1 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 inworld 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 habitual2. 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 known3

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 recently4, 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 stating5:

‘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 stating6: ‘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 Worlds7. 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 Worlds8. 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.


1. 955 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

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.