Taxation

Virtual Income: Is it really taxable?

János Szakács BA IB Year 3 5/11/11

Table of Contents

1. Introduction .......................................................................................................................... 2 Virtual worlds and incomes .................................................................................................... 2 2. Theoretical background ...................................................................................................... 4 2.1 Income definitions ........................................................................................................... 4 2.2 Practicality issues of incomes ......................................................................................... 5 3. Taxing Virtual Income ........................................................................................................ 7 3.1 Taxing RMTs ................................................................................................................... 7 3.2 Taxing IWTs .................................................................................................................... 8 3.2.1 Drops .......................................................................................................................... 8 3.2.2 Exchanges ................................................................................................................... 9 3.3 Taxing Virtual Incomes in Sweden.............................................................................. 11 4. Conclusion .......................................................................................................................... 12

1

1. Introduction Virtual worlds were estimated to generate an approximate $1.5 billion revenue in the year 2004 and have probably grown many times the size since then, given the enormous development and fast spread of digital technologies and gadgets. In some countries (notably the USA and Sweden), tax authorities have been thinking for some time now whether or not incomes generated inside such online worlds should be considered incomes strictly speaking as well, and whether they should be taxed or not. This paper will seek to highlight the major features of virtual worlds and to list and comment on some of the arguments brought up by authorities mentioned above. After a general introduction to the concept of virtual incomes, arguments for and against their being taxed will be discussed. Virtual worlds and incomes To be able to analyse the issues of taxing virtual incomes, one must first grasp the meaning of the virtual worlds themselves. A number of definitions have sprung up around throughout the years of Information Technology (IT), most of them trying to explain the true being of virtual worlds from a certain aspect. A more recent and combining definition given by a study on virtual worlds can perhaps better depict to one what the concept really means: ‘A synchronous, persistent network of people, represented as avatars, facilitated by networked computers.’ (Bell, 2008) Thereupon, from an economic analytical point of view, a virtual world exists on one computer (or, at least, on a limited number of computers), but can be accepted by many, with one user’s inputs affecting the results of other users. Furthermore, the world resembles reality in looks and generally implements the natural laws of nature, and, most importantly (since this makes it most similar to reality), it ‘is characterized by scarcity of resources.’ (Castronova, 2001) Last, but not least, a virtual world is persistent in its operations, meaning that it will continue operating regardless of whether anyone is using it at the moment and stores data about places, times and ownership relations. (Castronova, 2001) Thus a virtual world is very much like a real economy: operating with general rules, using scarce resources and working without the need of any individual to operate them, not to mention the existence of private ownership rights and trading (which provides benefits to both parties from a microeconomic point of view). (Miano, 2007)

2

From a taxation point of view, however, an important distinction needs be made between virtual world and virtual world. The first category refers to such script worlds where there is a broad storyline, given characters, places and/or times that offers a framework to users to play in. A basic feature of these online worlds is that most of the content inside the game is owned by the game’s publisher or owner, such as Blizzard Entertainment owns the multiplayer game of World of Warcraft. The other category, on the other hand, includes unscripted worlds, such as the widely known game named Second Life (attracting about 1 million active users, i.e. those who attend the site regularly). These worlds differ from those in the first category in that the owner company of the site does not own most of the content in the virtual world, since most objects are created by users themselves using the given possibilities and materials offered by the game. These worlds have increasingly been used as places for commerce and conduction of other real-life activities.(Chodorow, 2008) This is even more highlighted given the fact that some companies and even politicians are present in the virtual world. (Enright, 2007) Going further along the line of thought of the tax regulator, one needs to examine what type of and how incomes are generated within a virtual world. Two basic categories can be distinguished here, according to Camp: in-world transactions (IWT), which refer to value trading inside the game and real money trading (RMT), which already involves real-world cash movements. (Camp, 2007) In-world transactions have different aspects, based on whether one is talking about script or unscripted worlds. In the first one, IWT refers to trading with objects, which are often necessary to advance in the game itself and (as mentioned earlier) are scarcely available. Therefore one can say that swapping an object required by one player for one need by other is trading and the aggregate of such transactions can be called a market. In the latter type of worlds, by contrast, gamers are able to create any object or offer any service themselves and can therefore use trading for the sole purpose of generating virtual income inside the game. This may give a great opportunity, since by nature, producing an additional unit of such products is close to nil. (Camp, 2007) There are multiple ways to generate revenues in real life, as well. One of the most common methods to do so is to agree on selling avatars, their certain equipment or other goods (often money) to another player’s avatar in-game for real monetary units. Such transactions often take place on internet-based auction sites, where the two parties agree on price and thereafter

3

the ‘underlying’ transaction takes place in the virtual world, where no virtual money is traded afterwards. The president of the auction site IGE estimated that such transactions amounted up to $880 million in 2004 on his website alone. Another common transaction for real world money is to sell one’s whole player’s account, including all the characters it has. (Camp, 2007) Given the enormous amount that is generated in such unscripted worlds (one of such games, EverQuest being estimated to be the 77th largest economy in 2002), the question naturally arises: should such incomes from virtual worlds be taxed or not? (Chodorow, 2008) 2. Theoretical background 2.1 Income definitions Before jumping to any conclusions about virtual worlds and their incomes, one must clearly see what income really is to decide whether or not virtual incomes are ‘incomes’ in the strict sense of the word or simply non-economic benefits of a game. Since most games start out from the United States of America, this paper will examine the concept of income from the US legislation point of view. Apple’s Dictionary defines income as ‘money received, esp. on a regular basis, for work or trough investments’. This, however, seems a bit too narrow a concept and lacking some important factors that make the whole issue much more complicated. The US tax agency, the Internal Revenue Services (IRS), in their Internal Revenue Code’s (IRC) §61 define income more closely but still on such a large scale that it does not give a certain insight about taxing virtual incomes. It rather shows a list, stating that ‘gross income means all income from whatever use derived’. (law.cornell.edu) Their list basically covers everything from wages to pensions. However, this list is only a rough draft of the whole concept of incomes, of course and can only serve as a base for going in deeper into analysing their meaning. There have been studies concerned with the concept of income as such and whether virtual ‘incomes’ can be regarded as incomes at all. Such studies namely include that of Camp, Lederman, Miano and some analysis of these theoretical works, for instance by Chodorow. This paper mostly tries to derive major conclusions based on their works, in order to give a deeper picture about the issue of taxing virtual incomes.

4

According to these analyses, general definitions of income, given by other authorities include ‘receiving anything of economic value, whether in the form of cash, property or services.’ (Camp, 2007) and ‘any undeniable accessions to wealth, clearly realized, and over which the taxpayer [has complete domination]’ (Miano, 2007) Looking at the history of the development of the definition of gross income, one can conclude that US courts over the years have expanded the limits of gross income as such and it seems there is no end to it. Camp, however, clearly states that there is a limit – ‘the practicalities of tax administration’. (Camp, 2007) Miano further goes into analysing the Haig-Simons theory of income and utilisation, making corrections and critiques about the applicability of the model. He finally arrives to the conclusion that, from a hypothetical point of view, income can be understood as one’s consumption plus one’s change in wealth. Based on the aforementioned model, both can be connected to rights to and market values of given properties. Whereas consumption refers to the ‘market values of rights exercised’, wealth can be defined as the change in ‘the amount of monetized wealth’ and in the fair value of ‘non-monetized wealth’. This, therefore, leads to the conclusion that income rather refers to changes in one’s utility than only to one’s monetary gains. (Miano, 2007) Camp, on the other hand, highlights factors behind practicality problems with simply defining and then taxing any income based on theoretical definitions. There are a number of concepts that simply create exemptions from being liable to taxation of incomes. These are mostly of practical nature and can be derived from certain would-be arguments that those subject to taxation could free themselves from the obligation with. 2.2 Practicality issues of incomes First and foremost, utility gains are not always taxable because of social and practical reasons. There are so-called ‘priceless’ events and actions that certainly increase one’s utility but cannot easily be defined as something generating income according to the definition given by IRS §61. Such moments include but are not restricted to certain free-time activities, special moments in one’s life (birthdays, extreme sports, etc.) that are of high utility but cannot be pegged to a given market or be described as having a given fair market value. (Camp, 2007)

5

Moreover, according there is another factor to take into account: realisation of income. ‘Before an accession to wealth is reportable as gross income, it must be realized.’ (Camp, 2007) Making a distinction of incomes in services and incomes of property, accompanied with the aforementioned concepts of increasing utility, can lead to a broad definition of realisation of incomes. Such as barter (no-cash, service-for-service, good-for-good or combinations of these) transactions can be considered realisations of incomes, human activities in virtual worlds can also be a base for taxation. In such an event, one realises utility increase and therefore a change in one’s wealth, though implicit it may be. The major problem with this concept is the valuation and the reporting of such transactions. (Camp, 2007) As for property, there are two major ways of realising income from it: either by renting it out or selling it for a given amount. In this case, the important issue is that the owner is subject to tax in the first case, since they are the ones having a right to receive payments even if they give them away right away. Concisely, the problem for tax authorities again is with the valuation and reporting of the market value of transactions, especially in case of transactions, where no cash-out payment occurred. These, however, are mainly administrative and legal issues that are to be solved in order to create a uniform tax environment. (Camp, 2007) Further complicating the issues of virtual incomes, one can consider the concept of imputed income. Imputed income according to Camp means ‘a flow of satisfactions from … goods and services arising out of the personal exertions of the taxpayer on his own behalf.’ (Camp, 2009, p 37) Such incomes are not taxed by the IRS and therefore can give a base for arguing against taxing virtual incomes. As for such satisfaction from services, one can mostly say that such imputed incomes or gains come not from receiving wealth but from not decreasing it by finding ways to do certain services by one’s self. Some argue that ‘money saved is money earned’ (Camp, 2007, p 38) – it is, however, from a practical point of view, almost impossible to tax such incomes. First of all, reasons include the impossibility of evaluating every such service that one executes themselves, i.e. to evaluating cooking a meal, cleaning one’s home, painting walls, etc. Furthermore, administrative solutions would also not make it possible to tax such personal gains, simply because of the sheer number of such cases that occur every day. (Camp, 2007)

6

The same problem applies for taxing such gains from self-owned property. Gains from owning a house, repairing it, upgrading it and the like can hardly be measured. How can one say that a self-painted wall or a self-built fireplace increases or diminishes the value of a given property? Thus no tax is imposed on such gains as of today but that is strictly because of administrative difficulties and not because of the non-applicability of such taxes. (Camp, 2007) After giving a number of definitions to income and analysing their practical applicability that can serve as a base to look further into incomes from virtual worlds, the next section will consider arguments for and against the taxation of them. 3. Taxing Virtual Income Different scholars again take different approaches regarding whether or not virtual incomes can (or should) be taxed. If the answer is yes, there is still the issue of what incomes can actually be taxed in virtual worlds and how these should be evaluated. A definition of incomes has already been given in this paper, but it still remains a question (as it has been indicated a number of times) how to implement these concepts to virtual worlds, how to assess them. Should only RMTs be taxed or taxes can be levied upon IWTs, as well? If yes, how to valuate the amount of income? Which currency to use in the valuation? These are the pressing issues that cause the regulator’s dilemma in taxing virtual incomes. Camp in his paper makes a distinction of RMTs and IWTs in analysing the way such incomes can be defined and taxed. 3.1 Taxing RMTs As for RMTs, it seems clear to one that incomes occurring from selling certain in-game properties, sums of virtual currency, characters, accounts or offering certain services done inside the virtual world (like playing as another person’s avatar to help them improve their ‘skills’ or other world-like services) are to be taxed. These incomes occur in the form of realworld money, most usually US$ and therefore certainly increase the monetized wealth of a person. Based on the income definitions given above (both IRS §61 and the theoretical approach of Haig-Simons), such monetized wealth is certainly taxable, either because they are sales incomes or service fees. (Camp, 2007) A number of arguments from the taxpayers’ side arise, of course. The most common of these include the fact that some sites allow for on-site or in-game RMTs for the sales of accounts,

7

characters or properties. Others may mention that, since the End User Licence Agreements of some virtual games do not allow for RMTs, their incomes from such activities are not legal, therefore not legally binding and thus not taxable. US Court decisions recently, however, overruled previous ones denying these arguments, stating that IRS §61 does not regard where the transaction was made, what expenses occurred in making it or whether it was moral or legal or not. (Camp, 2007) 3.2 Taxing IWTs Lederman focuses on taxing IWTs and states at the very beginning that this is no easy issue. Can virtual property be considered real? Should players executing in-game barters or virtualitems-for-virtual-money transactions be liable to tax based on how much US$ their gains represent given the exact exchange rates that exist between virtual and real currencies? Seeking answers to these questions, two events are described and analysed: ‘loot drops’ (gains of properties that were used by certain NPCs or non-player characters) and exchanges (where both parties are avatars controlled by human players and accept the exchange process willingly). (Lederman, 2007) 3.2.1 Drops In case of drops, the tax regulator should consider whether these are properties or not. In case they are not, the issue is resolved, since there are no rights occurring to the player in connection with them, except for licences of usage based on their End User Licensing Agreements (EULA). In case they are, however, deciding if they are taxable or not is a more difficult question. (Lederman, 2007) One argument here is not to tax drops based on the concept of the previously introduced imputed incomes. Since loot drops are ‘found’ or earned inside the game by performing certain self-involved activities, they may represent an exemption from being included in one’s taxes. However, imputed incomes occur in case of self-involving activities, while drops originate from an outsider party, namely the game publisher. (Lederman, 2007) It is therefore arguable that the existence of imputed incomes gives a good base for argument to tax subjects in avoidance of tax burdens. Drops are not to be considered imputed and therefore cannot be exempt on that ground. Another concept mentioned before, namely the realisation of income concept, can also give a good framework to analyse if tax liability incurs in cases of picking up drops in virtual

8

worlds or not. As mentioned earlier, from a practical point of view, an income is taxable as it is realised. When considered a drop in-game, therefore, there is no income incurred at the point of receipt. No income, no tax, so simply obtaining an object in a virtual world is not an action subject to taxation based on IRS §61. Since drops can be gained through considerable effort from the side of the player, they should be regarded as taken objects and should be thus excluded from the tax base (Lederman, 2007) Chodorow, however, argues that such exemption only applies to taken, i.e. windfall, objects but not to found ones, let alone prizes and awards. He argues that taken objects are taken from nature but no third party is involved in the transaction. Therefore, such objects much better fit into the category of prizes than taken objects from a taxation point of view: a third party is offering an award for performing certain activities and win a contest. The distinction is an important one, because, while taken objects are not included in one’s tax base absent realisation, prizes and awards are. (Chodorow, 2008) 3.2.2 Exchanges In case of exchanging in-world properties, items or currencies, once again the question of realisation is important. Either if a piece of property is exchanged for another piece of the same kind of for currency or any other sort of property, a realisation event occurs if property is exchanged for cash or another piece of property ‘differing materially either in kind or in extent’. (Lederman, 2007, p 1651) Therefore, if someone exchanges a certain property for another one, the net gains (i.e. the difference earned because of differing fair market values) from the transaction are regarded incomes as the exchange itself counts as a realisation event and the higher fair market value of the new property clearly increases wealth of the player and thus counts as income. Regarding virtual worlds, there two main conceptualisations that can be made: in one case, the player is considered the owner of virtual property, in the other one, only a licencing party. The difference here can be the difference between being taxable or not, as well. In case the player is considered to be the owner of the intellectual property (i.e. the item, land, etc. in the virtual world), the issue seems to be resolved quite clearly. If the new property or item possesses a higher fair market value, this net gain is regarded as income and thus becomes part of the tax base. The intangible nature of property does not alter this

9

concept, since intellectual property rights and their generated income are also taxable according to IRS regulation. (Lederman, 2007) The other scenario, in which players are not owners of certain virtual world properties but rather only licensees of it, therefore suggests that any exchange in-game simply reflects exchange of properties that are readily available for both parties to the same extent but is not owned by them. None of them, therefore, will gain any income because of exchanging items in-world, they will simply trade the property of others, without a realisation event and thus net gains. This line of thought applies even in the case of unscripted worlds. The latter, however, may be regarded as somewhat of a different issue, since worlds such as Second Life give players rights to the intellectual property they created. However, according to the most common Terms of Service Agreements (TOS) and EULAs, these items are still regarded as owned by the publisher and operator themselves, since any property in-game only exists as a computer programme code on their servers. In case property is exchanged for virtual currency, however, other rules may apply. Since currencies in-game are not available limitless and their reception may thus be included in one’s tax base. This again depends mostly on what TOS and EULA rules and regulations state. (Lederman, 2007) Counterarguments may be listed in case of virtual property exchanges, as well. The major problem with an ownership-based property approach to exchanges in virtual worlds is that there are different regulations as to property rights and evaluations even inside the US, in different federal states. The issue is even more complicated if one considers that there are a number of different players residing in a number of different countries present in the virtual world. Moreover, since the basic ownership rights to property in Lederman’s discussion come from TOSs and EULAs, there is a high possibility that publishers would change their licencing documents every time the IRS comes up with a new regulation regarding property exchanges in order to favour their players or to protect themselves. As earlier, such administrative issues make it complicated and costly to tax virtual incomes. (Chodorow, 2008) It also needs to be stated, however, that use rights may not differ that much of property rights in case of virtual goods. As Chodorow and Camp explain, use rights actually form a so-called chose-in-action, which refers to the fact that the user has the right to control and exchange the certain asset and thus to gain from the transaction. It is also important to make a distinction in real world and virtual world use rights and exchanges of such properties. Whereas real world

10

exchanges may be difficult to administer and to evaluate because of a usual lack of market, virtual worlds often offer a definable market for most use rights and it is also easier to follow up transactions. Last, but not least, whereas real-life examples usually include short-term actions and use rights, there is no given definite end to the use right of virtual property given by publishers, which implies a much larger bundle of rights than in real-life cases. This might further alter the tax liability issue of incomes from exchange of such rights. (Chodorow, 2008) All in all, as one can see, there are a number of difficult issues in case of taxing virtual incomes. TOSs and EULAs may alter the whole concept of taxing them. Incentives, as usually, also matter a great deal. What most scholars have concluded is that taxing virtual incomes of any form is mostly difficult because of practical and administrative issues. In my point of view, this is even more difficult in today’s globalised world than those papers analysed here may suggest. Interestingly, despite all the practicality problems mentioned above and throughout the paper, Sweden in 2008 introduced virtual income taxes. These are briefly summarised as follows. 3.3 Taxing Virtual Incomes in Sweden Swedish tax authority Skatteverket has been quite interested in online casino and other gambling activities recently. They have launched several new ‘attacks’ on incomes coming from virtual places, including virtual worlds. According to one of their statements, exchanges of products or services in virtual worlds are to be considered actual real-world electronic sales, in case the internal currency received can be exchanged to real-world currency. In case it cannot, no tax incurs. A certain threshold is given, above which transactions are considered professional sales; therefore a player collecting a certain amount of money over this threshold is liable to taxation. Since anyone making trade with a Swedish counterpart is also liable, even foreigners may be subject to Swedish taxes, raising international personality rights issues. (economicsofvirtualworlds.blogspot.com) Virtual income taxes were also imposed in China, which may project a certain trend to other countries and eventually even the IRS might find a way and methods to tax virtual income gains.

11

4. Conclusion As seen above, deciding about whether to tax virtual income is no easy matter. It seems, on the other hand, that there is no theoretical objection to taxing them – the real problem is with practicability. How could the IRS evaluate all IWTs and what if there is an endless circle of changing IRS Codes and EULAs? If the IRS is to tax RMTs, how can they evaluate the fair market value of obtaining a certain item? Personality rights seem to become important as one evaluates these questions, since publishers then will need to provide tax authorities with the necessary information about players. The issue of residents of other countries also matters because of different property and personality rights, not to mention bilateral agreements on taxation of incomes. Thus, the debate over taxing virtual incomes seems far from over, since national legislations differ a lot in these questions besides the problem of technological and cost solutions that need to be implemented by tax regulators in case they vote for taxing any kind of virtual incomes.

12

Bibliography Bell, M.W. [2008]. Journal of Virtual Worlds Research, Vol. 1. No. 1.: Towards a Definition of “Virtual Worlds” [Online]. Available at: journals.tdl.org/jvwr/article/download/283/237 Accessed: 25 November 2011 Camp, B.T. [2007]. The Play’s the Thing: A Theory of Taxing Virtual Worlds [Online]. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=980693 Accessed: 26 November 2011 Castronova, E. [2001]. Virtual worlds: A first-hand account of market and society on the cyberian frontier [Online]. Available at: http://papers.ssrn.com/abstract=294828 Accessed: 28 November 2011 Chodorow, A.S. [2008]. Ability to pay and the taxation of virtual income [Online]. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1274731 Accessed: 29 November 2011 Enright, A. [2007]. Marketing News p 12: How the second half lives [Online]. Available at: us.i1.yimg.com/us.yimg.com/i/adv2/pdf/brainfood/second_life.pdf Accessed: 26 November 2011 Internal Revenue Code Article 61 Gross Income Defined [Online]. Available at: http://www.law.cornell.edu/uscode/26/61.html Accessed: 25 November 2011 Lederman, L. [2007]. “Stranger than fiction”: Taxing virtual worlds [Online]. Available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=969984 Accessed: 26 November 2011 Miano, T.J. [2007]. Virtual World Taxation: Theories of Income Taxation Applied to the Second Life Virtual Economy [Online]. Available at: http://works.bepress.com/timothy_miano/1/ Accessed: 27 November 2011 Miller, D. [2008]. Economics of Virtual Worlds: Sweden to Tax Virtual Income [Online]. Available at: http://economicsofvirtualworlds.blogspot.com/2008/04/sweden-to-tax-virtualincome.html Accessed: 29 November 2011

13