As the non-fungible token (NFT) craze continues, it is only a matter of time before they start to emerge in SMSFs. But the SMSF reality of owning NFTs may prove more challenging than it appears.
While many SMSF trustees are familiar with investing in cryptocurrency, an NFT is different because it allows investors to purchase and own digital images, artwork, documents, tweets, domain names and anything digitally imaginable.
How do NFTs work?
An NFT lives on the Ethereum blockchain, but is stored differently from Ethereum because of the additional information required to prove digital ownership. While other blockchain platforms have also implemented their version of NFTs, Ethereum NFTs are the most common.
An SMSF will never physically own the digital asset because the token is just a series of 0s and 1s living on the blockchain.
But it does give the fund a digital certificate of ownership that is traceable on the blockchain and comes with the right to sell the asset. It can be anything from a digital image of a pet rock that went for US$46,000 to a video by Beeple, a United States digital artist, sold earlier this year for US$6.6 million.
Why is it called an NFT?
‘Non-fungible’ means a unique, one-of-a-kind token untradeable for another token of the same type. By contrast, a cryptocurrency coin, like Bitcoin, is a fungible token because you can trade it for another Bitcoin.
While an NFT is self-contained, uniquely identifiable and has a value, the NFT owner doesn’t own the copyright. As the asset cannot be adapted or reproduced, it effectively means it is not a collectible or personal-use asset within the meaning of regulation 13.18AA of the Superannuation Industry (Supervision) (SIS) Regulations.
Regardless of the type of digital assets an SMSF holds, they all have one thing in common: they must satisfy the SIS and tax rules.
NFT SMSF record-keeping
SMSF trustees have to keep very comprehensive records when acquiring or disposing of any digital asset. When a fund buys, sells, swaps or exchanges one digital asset for another, there are tax obligations. All these transactions will be subject to capital gains tax and reportable to the ATO.
The ATO is also aware crypto trading in SMSFs has increased and recently released a warning digital assets, including NFTs, are under the microscope by using data matching to ensure the proper tax is paid.
NFT cost base
SMSFs must ensure the cost base is correct. Regardless of how a digital asset comes into an SMSF, including a purchase, receipt of income or gift from a promoter, it is crucial to record the cost base and ensure all documentation is accurate.
Trustees should not be disposing of any records or losing important login information to their account/s because they will have a massive pain point at tax time.
To this end, all passwords and login access details to personal computers, NFT marketplaces and wallets should be safely stored and documented because it will keep fund assets safe.
A requirement under regulation 8.02B of the SIS Regulations is to value all fund assets at market value.
While the value of an NFT at acquisition is the cost, the value afterwards is unclear. Unlike cryptocurrency, there are no NFT price checkers available online to confirm their value.
Determining the market value at 30 June will be next to impossible, especially given the high-risk nature of NFTs due to their price volatility, liquidity issues, lack of authentication, being traded in an unregulated market and multiple scams.
SMSF auditors cannot meet their professional obligations under regulation 8.02B where acceptable, appropriate audit evidence is lacking. It will result in a Part A qualification of the audit report where the value is material and may also be a breach of regulation 8.02B.
Tangible versus intangible NFTs
The SMSF reality of owning an NFT means they are subject to the same SIS requirements as cryptocurrency, but with a twist.
The COVID-19 pandemic has sparked tremendous interest in shared virtual environments, now nicknamed the ‘metaverse’.
The metaverse is where real people can buy and sell virtual land, buildings, avatars and names and build their environments using NFTs and crypto to pursue profit.
Does this sound like online gaming? It is precisely like online gaming, where users can build and explore in a virtual world and create digital assets to generate a return on their investment.
Tangible digital assets, therefore, refer to NFTs such as digital artwork held outside the metaverse. In contrast, intangible digital assets such as virtual land are created, sold or purchased within the metaverse.
There is a significant difference between an SMSF owning tangible and intangible NFTs.
While a tangible NFT can meet the SIS rules, intangible NFTs are unlikely to be a complying SMSF investment.
Given the entire point of the metaverse is to provide a monetised gaming experience for the user, such an investment would not pass the sole purpose test.
The reason is that this type of investment is not for the sole purpose of maximising the benefits of members in their retirement as outlined under section 62 of the SIS Act, but to provide a present-day benefit for members or their relatives.
The trustees could make such an investment if they purchased an intangible NFT and did not develop the environment, create any other asset or do anything else with it inside the metaverse but keep it for capital appreciation purposes.
Proving this at audit would be virtually impossible (pun intended) and it would most likely end up in a breach of section 62 of the SIS Act anyway.
As setion 62 does not require the financial threshold test to be applied, it requires reporting to the ATO in an auditor contravention report.
The SMSF reality of owning NFTs means any digital asset requires compliance with the SIS legislation.
And while the number of different digital assets continues to grow, SMSF trustees need to understand the difference between those that can meet regulatory compliance, such as tangible NFTs, versus those that will fall short like intangible NFTs.
Applying the SIS rules evenly across the board to all digital assets that store value inside a digital environment is the only way to ensure SMSF compliance.
Ready player one?
Shelly Banton is head of education at ASF Audits.