Originally published on Forbes.com.
Byron M. Huang’s recent article in the Yale Journal of Law and Technology- Walking the Thirteenth Floor: The Taxation of Virtual Economies has me feeling vindicated.
Taxation of transactions within virtual worlds may have been laughable at the outset of virtual reality, but the idea merits serious attention today. Online video games have become a multi-billion dollar industry within the last decade.
My very first blog post ever nearly six years ago was titled All That Glitters is Not Taxed? Or Is It? and addressed the same subject citing two of the gaming environments – World of Warcraft and Second Life that Mr. Huang discusses in his much longer and scholarly piece. Mr. Huang was a law student when the article was published, which might incline you to take it a little less seriously. However, you might want to consider his first post-law school job – IRS Office of Chief Counsel.
What Turned This Accountant Into a Level 50 Warrior
I suspect that even after all this time there are people, particularly those within a couple of decades of my age (63) who don’t know what a MMORPG is. The acronym stands for Massive Multiplayer On-line Role Play Gaming. If you have never tried it, I would recommend that you invest a couple of hours in World of Warcraft and a couple of hours in Second Life.
I’ve always enjoyed computer games for – well as long as there have been computer games – going back as far as playing Hunt the Wumpus and Star Trek in the Universtiy of Chicago computer center when I was supposed to be entering how individuals in Rhode Island had voted in the 1804 election (secret ballots were decades in the future back then). I was the only guy I knew who had to schlep a microfilm reader into the computer center.
The first time I encountered a MMORPG was looking over my son’s shoulder as he was playing World of Warcraft. William and I had done a lot of computer gaming together. That kid killed his father more times than I want to count in the James Bond first-person shooter we played occasionally. My favorite though was Lords of The Realm which had both a strategic and real-time tactical aspect to it. I made all the decisions about the economy and strategic movements and William took over when battle was joined. WOW was not something we could share though and it struck me that what was going on was him running through a richly detailed cartoonish, three-dimensional kind of medieval world bopping things.
Then William asked me if he could use my credit card to buy gold. I asked him why he didn’t go out and dig gold or whatever it was they did to sell to other people. I mockingly speculated that there were kids in China playing World of Warcraft to sell gold to slackers like him . Silly me. It is a major industry. Google “WOW gold” and you will see what I mean.
Still I decided to get my own account and played enough to get a sense of how absorbing it can be and even got to understand why somebody would want to spend real dollars to buy WOW gold. William, an elite player trusted by his guild to distribute the loot from major raids would gently mock me when he looked over my shoulder.
I also learned what a big industry computer gaming of all sorts was and that there were over 100 companies in Massachusetts. I got one of our business development executives trying to develop leads for me. My partners at the large regional accounting firm based in southern New England, for the most part, did not understand it at all, but there was something that they did understand – Red Sox pitcher Curt Schilling, who founded Green Monster Games LLC, which became the ill-fated 38 Studios. That was the great white whale the BDE and I were hunting.
We never got too close. Better to be lucky than good. An albatross like that around our necks might have scared off the not quite Big 4 firm that acquired us a few years later. I ended up buying stock in every public company involved in MMORPGs. That did not go that well either.
The Object Of The Game
Before getting into the tax controversy, Mr. Huang gives an overview of the virtual economies that gaming sites create and the various types of players. There are three types of economies open-flow, closed-flow and hybrid and five types of players social, vocational, casual, casual-hardcore and hardcore. He uses two of the most popular platforms to illustrate the differences – World of Warcraft and Second Life.
The terms of service that Blizzard lays out for Wold of Warcraft subscribers – more or less “What happens in Azeroth stays in Azeroth” make it a model of closed flow. Players can buy and sell things at an auction house paying with in-game gold and accumulate vast fortunes and rare items, but there is no mechanism for any of it to be translated into real money. You are not supposed to sell your in-game gold for real money or sell your whole account with its Level 80 warrior equipped with epic armor and weapons and a flying mount.
The actions of third parties creating a secondary market in all those things in contravention of the terms of service turned World of Warcraft into a hybrid economy.
The quintessential open flow economy is Second Life in which Linden Labs maintains an exchange to buy and sell Linden dollars. Also unlike World of Warcraft, most of the content in Second Life is created by “residents” who rent “land” from Linden Labs making for a lot more “in game” buying and selling. Of course, Second Life is not really a game in any sense. It is more of a space to play out your imagination and interact with others who are doing the same.
When it comes to types of players, vocational players are those kids in China “farming” gold.
Mr. Huang neatly captures the essence of what is going on with casual gamers – or at least this one.
The experience of leveling up is often most meaningful for casual gamers due to their time constraints and comparatively cursory interaction with the virtual world. With only a few sporadic hours to spare, they enjoy journeying throughout the world, taking time to play through the storyline crafted by the authors of the game. They take longer than average to reach maximum level, and when they do, they often do not have the time to commit to raiding. Thus, casual gamers rarely obtain the rarest items through their own efforts.
His discussion of what is going on with hardcore gamers which is extensive defies quick summary. I have to caution you that my expert on hard core gaming (William Reilly a senior in creative writing at Pratt Institue in Brooklyn) tells me that Mr. Huang may have missed some nuances.
His assumption that it isn’t hard core gamers buying stuff may be false, because the costs of raiding are high and the producers of items that raiders need take advantage of that. There are also more levels of hard core though, and it’s understandable to not get into it. I couldn’t put my finger on who was driving the most demand though, although I remember buying a mount being a popular reason for buying gold.
Tax Issues
The IRS in Notice 2014-21 seems to be implicitly taking a “What happens in Azeroth (or Lindendland) stays in Azeroth” approach
In general, the sale or exchange of convertible virtual currency, or the use of convertible virtual currency to pay for goods or services in a real-world economy transaction, has tax consequences that may result in a tax liability.
Given the terms of service that approach might make sense for WOW, but there is some question whether someone who makes profits in Linden dollars should be able to defer income recognition indefinitely given that Linden dollars are freely convertible.
Mr. Huang goes on at some length as to whether players get basis in their accounts from what they pay in subscription fees. He seems to include that they generally do. I find it a fascinating discussion, but in my mind the dollars are too small to get excited about.
The other issue that is probably more of hypothetical than practical interest is whether a casual player might be able to record a casualty loss due to the destruction of virtual items that he or she has paid for. That was illustrated by a dramatic story.
The single largest armed conflict in EVE Online (“EVE”) began on January 27th, 2014 and lasted for twenty-two hours. The battle involved two in-game alliances, consisting of over 7,500 players, resulting in the deaths of more than 20 million soldiers, and the destruction of 600 Capital-class ships—75 of which were Titans. The Titan is the largest ship in the virtual world, requiring several months of real time and around 100 billion ISK (EVE’s virtual currency) to produce. The battle yielded an aggregate loss of over 11 trillion ISK, translating into approximately $300,000 USD.
Taxing Those Chinese Gold Farmers
The most fascinating discussion was on the taxation of foreign entities that are selling virtual items to US players. This is a developing question with implications beyond gaming. Under most treaties, a foreign company will be taxed if it has a “permanent establishment” in the host country. The question becomes whether a website can constitute a permanent establishment.
On the “alternative nexus” proposal, “an enterprise engaged in certain ‘fully dematerialised digital activities’ could be deemed to have a taxable presence in another country if it maintained a ‘significant digital presence’ in the economy of that country.”In defining a “fully dematerialized digital activity,” the Action Plan lists many potential elements of a facts-and-circumstances test to determine whether an enterprise is engaged in such an activity
He does not discuss SALT (state and local tax) issues at all.
There Is More
I don’t think I have been able to do justice to this article even in what for me is a longish post. I could not resist asking Mr. Huang how hard core a gamer he had been.
I played World of Warcraft in high school. This consisted of one week with a highly ranked US guild before realizing the time commitment was too great and, later in high school, leading a smaller raiding guild that was mostly filled with friends from school.
Something tells me that he might have had trouble getting through law school if WOW had had more of a hold on him.