German income tax law and 'non-fungible tokens'

"Distributed ledger technology" has a wide range of potential uses. Thanks to Bitcoin, Ethereum and others, the general public is aware of blockchain technology. The multitude of available cryptocurrencies have now even come into the focus of institutional investors as highly volatile investment vehicles. The hype has been and continues to be fuelled by "initial coin offerings", in which company-owned tokens are used to finance companies and projects.

Since the beginning of the year, the crypto world has also been talking about non-fungible tokens ("NFTs"). These are non-changeable unique items in the form of tokens that embody "securitised" rights and grant them to the holder ("tokenisation"). Tokenisation is used for digital artwork, for example, to demonstrate authenticity and authorship and to protect against unauthorised reproduction.

The legal challenges in relation to NFT are manifold. From a tax point of view, trading in NFTs is also subject to some special rules, which we would like to address here.

Income tax treatment of coins/tokens according to traditional taxation regimes

Income tax law generally does not have any express provisions on taxation of income from receiving, exchanging, holding or disposing of coins, tokens or transactions within the blockchain.

Therefore, the "customary" taxation principles are applied on the basis of the current legal situation. These principles had previously been presented by the Hamburg Tax Authority (decree of 11 December 2017 - S 2256-2017/003-52) and the Regional Tax Office of North Rhine Westphalia (20 April 2018, no. 04/2018) for the sale of Bitcoins. They are also applied to other coins/tokens.

Capital gains realised by natural persons or partnerships can either be subject to taxation as:

• income from trade or business (section 12 (1), (2) German Income Tax Act ("GITA") – with the corresponding consequences under trade tax law – if the coins/tokens were held as business assets; or
• income from private sales transactions section 22 (2) GITA in conjunction with section 23 (1) sentence 1 no. 2 GITA.

Current income (e.g. income from liquid pools) in private assets could also be taxable as other income under section 22 no. 3 GITA.

There is legal uncertainty especially when it comes to the important distinction between commercial and private (i.e. asset management) activities. The German Federal Fiscal Court has already developed criteria for distinguishing between commercial securities traders, real estate traders and precious metals traders. If these criteria can be applied to coins/tokens, commercial activity can be assumed, for example, if there is (i) short-term and frequent turnover; and (ii) the use of borrowed capital.

If there is income from private sales transactions, capital gains up to EUR 600 in the assessment period are tax-free (section 23 (3) sentence 5 GITA). If the period between acquisition and sale is more than one year, the full amount of the gains is tax-free. If income is generated in at least one calendar year on assets that are used as a source of income, the period is increased to ten years.

Whether the exchanged coins/tokens are left as FIAT currency on the "exchange" (i.e. a centralised or decentralised exchange for coins/tokens) or transferred to an account with a payment service provider (e.g. PayPal, binance credit card, etc.) or credit institution (e.g. cash-out) should be irrelevant for the question of whether a taxable sales transaction occurred during the holding period. The wallet on the exchange is also likely to be attributed on the taxpayer's sphere of assets.

The income tax burden is based on the individual income tax rate (plus solidarity surcharge and church tax, if applicable). Income from commercial activities is subject to an additional approximate 13% to 18% trade tax, whereas the trade tax exemption amount EUR 24,500 and an income tax credit could be applicable.

In some cases, taxation based on the regulations for capital assets in the amount of capital gains tax (26.375% including solidarity surcharge, plus church tax if applicable) is also being discussed. The tax authorities have not yet commented on this, but in a response to a brief inquiry from MP Frank Schäffler, the German Federal Ministry of Finance has now indicated that it generally classifies cryptocurrency transactions in the regime of sections 22, 23 GITA.

If a corporation sells coins/tokens, the gains are always subject to corporation tax plus solidarity surcharge and trade tax totalling approximately 30%, regardless of the holding period.

Discussion in case law: coins/tokens as "other assets" within private sales transactions

There has been little information from the tax courts yet since to date they have only been required to decide on matters relating to cryptocurrencies by way of interim measures.

The subject matter of the proceedings before Berlin-Brandenburg Tax Court (decision of 20 June 2019 - 13 V 13100/19) was the qualification of the income from the exchange of Ethereum with Bitcoin as other income from private sales transactions. The claimant had explained, with reference to the technical processes, that the income had not been generated by acquisition and sale. In the absence of enforceable rights of economic value, the coins should not be "other assets" within private sales transactions. However, the tax court did not have serious doubts about the taxation carried out and classified Bitcoin as taxable private assets that would be accepted as a means of payment in business use. The tax court did not address whether the technical design of a coin should result in different legal consequences. However, in the reasons for the decision, the tax court refers to Bitcoin, although the matter concerned Ethereum.

In contrast, the Nuremberg Tax Court (decision of 8 April 2020 - 3 V 1239/19) had serious doubts about the taxation by the tax office in another case, which raised the question whether coins/tokens were "other assets". The taxpayer countered that the tokens' classification as an asset, arguing that they were highly volatile. Among other things, the tax court objected to the fact that the tax office had not understood the technical processes and consequently had not determined the relevant facts, although it was responsible for establishing them if it wanted to increase the taxpayer's tax burden (subject to the taxpayer's duties to cooperate). However, the tax court stated that the existing tax regulations were sufficient to assess the taxation of business transactions with a cryptocurrency.

German Federal Ministry of Finance shares the view: cryptocurrency is "other assets"

To date, the German Federal Ministry of Finance has not commented explicitly on income tax treatment, but only on VAT treatment and the VAT exemption of the services of trading platforms.

As already mentioned, as a result of a brief inquiry in the German Federal Parliament on "taxation of cryptocurrencies", in April 2021 the German Federal Ministry of Finance confirmed the above legal view held by the tax authorities of the federal states. The Federal government considers virtual currencies to be digitally represented units of value of currencies that are not issued or guaranteed by any central bank or public body and do not have the legal status of currency or money, but whose units of value are accepted by natural or legal persons as a medium of exchange and can be transferred, stored and traded electronically and therefore as "other assets". In a nutshell, the tax classification reads:

Income from cryptocurrencies generated as business assets is subject to the taxation rules for income from profits. Insofar as the income from cryptocurrencies is generated as private assets, it may in particular be subject to taxation as income from services within the meaning of section 22 no. 3GITA or as a private sales transaction pursuant to section 23 (1) no. 2 GITA.

As a result of this legal view, the Federal government sees no need for separate tax regulations. What is interesting about the German Federal Ministry of Finance's answer is that the insertion of "in particular" leaves the door open for other classifications (e.g. as capital assets) in individual cases.

Are general income tax principles applicable to taxation of NFTs?

The starting point for NFTs is the concept of "other assets". It includes all pecuniary advantages that are not real property or rights equivalent to real property, advantages that can be valued independently and are of long-term use. These include (i) securities, the sale of which has lost some of its significance since the 2009 assessment period due to section 20 (2), section 23 GITA; and (ii) movable private assets (e.g. works of art, animals and rights).

At first glance, these criteria should apply to NFTs. On the one hand, tokens fulfil a usage component by granting the holder the "securitised" right (e.g. to a digital work of art). On the other, tokens are transferable and tradable. For example, prominent examples of auctions of digital art show the value-creation potential that can lie behind tokenised art. The independent valuation is evident, therefore, through the prices, some of which are horrendous, and the long-term nature of the benefit may be questionable in its extent, but not on the merits. Ultimately, the holder of the NFT receives a certain "securitised" right and thus an intangible asset, which is a known concept under taxation rules.

There are also examples of everyday items that are even better known. The German Federal Fiscal Court (ruling of 29 October 2019, case no. IX R 10/18, BStBl II 2020, 258) ruled on the taxation of the capital gain from the sale of tickets for the UEFA Champions League final game. The claimant had purchased the tickets on the UEFA website in April 2015 at a price of EUR 330 and originally intended to attend the final game himself. In May 2015, he decided to sell the tickets and realised a profit of approximately EUR 2,900. The tax authorities presented the use component as an admission ticket as well as an appreciation component of the tickets due to the high demand and the possibility of trading on the black market. Consequently, the tickets should be deemed "other assets", the sale of which can fall under the taxation of a private sales transaction. The German Federal Fiscal Court followed the view of the tax authorities. This should also apply to NFTs, which could be used in the future to personalise such tickets.

Unless the NFTs are sold by a corporation or the sale can be attributed to a commercial activity of an individual or partnership, the sale should also be subject to the regime of income from private sales transactions. Based on the previous and rudimentary statements of the tax authorities, it can currently be assumed that they do not distinguish between the forms of the tokens for income tax purposes, and that they are taxed uniformly.

Legal uncertainty remains for income tax

The world of blockchain remains agile and is characterised by hype. The future will show whether individual implementations can be established outside the "analogue" financial world.

From a tax view, the brief inquiry in the German Federal Parliament has contributed to the German Federal Ministry of Finance revealing its view on the taxation of tokens, at least to a minor extent. The Federal Ministry of Finance letter on income tax treatment, which is being coordinated with the regional tax offices of the federal states in order to provide some legal certainty, has been long expected. However, this letter was announced over two years ago. Taxpayers should not expect a favourable surprise. In any case, it remains to be seen whether the previous view of the administration, without taking into account the technical intricacies of the coins/tokens, will stand up to the fiscal court's assessment.

In any case, it is likely that tax authorities will not take a separate position on every possible use of blockchain in the future, but will rely on the traditional taxation system. With the taxation standards for commercial income, income from services and from private sales transactions, the tax authorities have comprehensive taxation options.

Once the tax authorities have recognised the enormous taxation potential (according to an estimate by the Frankfurt School Blockchain Center, approximately 2% of income tax revenue), they will make extensive use of their options. Sales of tokens should always be carried out in consultation with a tax advisor and the transactions should be documented in a comprehensible manner.

CMS would be pleased to assist you with the tax assessment. For more information on how we can help your German-based business, contact your client partner or local CMS experts: Dr. Hendrik Arendt and Dr. Martin Friedberg.