3 Complexities of Non-Fungible Tokens (NFTs) as Investment Assets

NFT is shorthand for non-fungible token, a digital asset that contains unique data or metadata that can make it more or less valuable. NFTs are similar to baseball cards in that not all baseball cards are worth the same amount even though they appear similar. Their value varies depending on who (what data) is represented on the card, even if the cards are from the same series.

NFTs are interesting as digital assets because they allow uniqueness and rarity to be represented easily. But as humans we need to reconcile the physical world with the digital one, so there are a few complexities that must be considered when looking at them as potential investment assets.

1. What Do You Actually Own When You Hold a Specific NFT?

In mechanical terms, when you hold an NFT you have knowledge of a private key that allows you to move and prove control of a specific token. But once we get past that point things get a little murky.

2. The Way Control of an NFT Relates to the Real World Will Vary Depending on What the NFT Represents.

When an NFT is used as a digital ticket for entry into a concert or similar event, what you have the right to is quite clear. In cases relating to intellectual property (IP), such as when NFTs are used to represent artwork or patents, the rights transferred are more nuanced. The first challenge is establishing that the entity selling those rights has the right to transfer them. The right to IP can be exclusive, non-exclusive, transferable or non-transferable. It may allow commercial use or not. It may include ongoing fees to the creator. It may require alignment with an outside party such as the patent office. Most of these types of concerns may be compared to existing IP regulations, and inferences may be drawn from existing practice.

3. What are Risks of NFTs?

There are certainly risks associated with the digital aspects of the investment class, as well as mechanical, regulatory and financial-related risks.

Regarding digital-specific concerns and risks, you must ask, what happens to your ownership rights if keys are lost, stolen or there is a technical failure? It may not be certain what happens if someone creates another piece of art that generates a collision with the existing hash or if the art is duplicated on another chain. Even when those issues are clarified, the recognition of that right may vary from one jurisdiction to another. The above factors may be influenced by mechanical considerations, such as what type of metadata is used to represent the IP and whether that data is stored on or off the blockchain.

There are also regulatory risks. Digital asset oversight is still in its infancy, and new laws and regulations are constantly being proposed. These new laws and regulations can have a significant impact on digital assets currently held. For instance, in the U.S. some NFT assets could be at risk of being reclassified from collectibles to securities. Case law can also influence the risks associated with holding certain NFTs. Purchases and sales of NFTs are impacted by anti-money laundering/combating the financing of terrorism (AML/CFT) regulations that are likely to continue to evolve. When holding these assets, you must keep your attention on evolving regulation in all relevant jurisdictions.

For entities subject to an audit, valuation for NFTs can be challenging, as value is affected by the aforementioned factors in addition to direct market conditions. NFTs, by definition, are individually different from each other so each requires its own assessment of value for accounting purposes. This assessment will generally require the services of a valuation specialist.

Of course, there are also important tax aspects to consider. With NFTs still considered an evolving asset class, guidance in this area is still emerging, yet important.

» Read "Non-Fungible Tokens: Unique Tax Implications for a Unique Product"

NFTs represent exciting new investment and business opportunities, but as with all new industries there is a lack of well-travelled paths. In addition to research and diligence, keeping an eye on the evolution of both the market and regulatory concerns are critical to success.

Contact Will Coleman at [email protected] or a member of your service team to discuss this topic further.

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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.

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