40 INTHEBL ACK october 2009

Hillary Sugimoto wakes up each morning and logs onto her computer. With a few clicks of a mouse, she makes her way to her job as a salesperson for a large Fortune 500 company. Her office is a spacious, three-storey building in the middle of a retail district. Sugimoto greets potential cli-ents as they enter the building then helps them

find the product they are looking for. At the end of her five-hour shift, Sugimoto clocks out and returns home.

Twice a month, Sugimoto receives her salary, which is paid in the employer’s currency and directly deposited into her account. Sugimoto is not, however, taxed on any of her income. Her employer pays no property taxes, nor any corporate taxes. Her customers pay no sales tax or value-added tax on their purchases. For all intents and purposes, it’s as if the transaction had never occurred.

Such is the current state of affairs in the virtual world. However, transactions like Sugimoto’s have recently come to the attention of various tax authorities in the real world, as her virtual currency can sometimes be converted into real dollars, raising some dilemmas about how to tax income generated via virtual commerce.

In 2006, the Australian Taxation Office announced in 2006 its intention to tax income derived from one such virtual world, Second Life. Similarly, in its 2008 National Taxpayer Advocate Report to Congress, the US Internal Revenue Service considered whether to address emerging tax issues arising from virtual worlds in its section entitled “Most Serious Problems.” On the other hand, Japan’s

World revenue authorities struggle With how to tax real-life income from virtual commerce.

by dean page cpa and brandon boyle in tokyo

National Tax Agency has been generally silent on the issue.Of late, online “virtual worlds” (computer-generated, interactive

environments that users access via the internet) have attracted attention, not only because of their popularity, but also because of the economies which have developed within them.

Second LifeOne of the most oft-cited examples of a virtual world is Second Life, a platform created by Linden Labs. In Second Life, users can not only interact with one another socially, but also commercially, by buying and selling virtual goods, services, and real estate for currency that is convertible to real world money. The tax questions that it and other virtual worlds like it present today may be a precursor to larger issues that may emerge tomorrow.

Second Life is a user-created three-dimensional online environment. According to Linden Labs, Second Life’s virtual economy sees over US$35 million in commerce transacted by users monthly. Users, known as “residents”, construct avatars to participate in the virtual world. An avatar is a graphical representation of the user that constitutes his or her presence and personality in the virtual world.

Using an avatar, a Second Life user can meet other users, socialise, conduct business, create virtual goods and property, and own virtual real estate. Users retain the intellectual property rights of their virtual creations. This quality of Second Life, coupled with its emphasis on customisation and interactivity, has enabled the

A virtual tax dilemma

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development of a monetised, user-driven virtual economy.Transactions between Second Life users are made in Linden

dollars, Second Life’s virtual micro-currency. Linden dollars can be transferred entirely within Second Life. In addition to virtual trans-actions, an online currency exchange, the LindeX, facilitates the buying and selling of Linden dollars for real world currency. According to Linden Labs, in 2008 more than US$100 million worth of Linden dollars were exchanged on the LindeX. Exchange rates between Linden and US dollars are not fixed, though only moderate fluctuations occur.

Generating virtual incomeIn the fourth quarter of 2008, Second Life users spent more than US$100 million on virtual goods and services. Businesses have taken note, resulting in a number of Fortune 500 companies establishing a presence within Second Life for marketing and pub-licity purposes. There are three types of revenue-generating transactions which create tax questions in Second Life’s virtual economy:

• user-created goods and services

• virtual real estate that can be bought, sold and rented

• compensated jobs in the virtual world

Second Life users can create, buy, own and sell virtual goods much as an individual would in the real world. Thousands of user-created virtual goods, including apparel, art, landscaping and vehicles, are available for purchase.

Transactions in virtual goods and services are facilitated by an official virtual marketplace and virtual businesses that a resident can visit using their avatar. While a majority of Second Life users generate nominal (if any) income from their virtual activities, over 1100 users earned virtual business profits in excess of US$1000 during July 2009. In total, more than 27.5 million monetised transactions occurred between users over the same period.

Second Life users are able to buy and sell virtual real estate and place virtual homes and businesses on their land. Land owners can also rent land to other users for a fee. Virtual real estate is com-monly used to facilitate virtual transactions: for example, a user could purchase virtual land and set up a virtual gallery that sells virtual photography created from the user’s real world photographs. Similarly, universities such as Stanford and Harvard use their virtual real estate as a recruiting tool.

There are three ways to acquire real estate in Second Life. First, a resident can buy land from other users. In July 2009, approximately US$520,000 worth of virtual land transactions occurred between users. Additionally, newly created land can be acquired directly from Linden Labs at auction. Some land parcels are auctioned for just a few dollars, while others are bid up to a few hundred dollars, or more. Finally, users are also able to secure higher-priced “private, expandable regions” directly from Linden Labs.

This quality of Second Life … has enabled the development of a monetised, user-driven virtual economy

42 INTHEBL ACK october 2009

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Jobs in Second Life give users the opportunity to generate real world income via the virtual world. Jobs within Second Life itself include full-time positions such as virtual landlord, private yacht captain, or bartender at a virtual nightclub. Jobs in Second Life generally fall into one of three basic categories: unskilled labour, skilled labour, and freelancers/entrepreneurs.

Taxation of virtual income and real estateThere is no question that cashing out virtual currency into real world currency creates income that may be taxed. The more intriguing issue is whether taxation of transactions that occur entirely within the virtual world is appropriate and feasible. A closer look at the three types of revenue-generating activities present in Second Life highlights some of the common tax issues that arise.

As described previously, users in virtual worlds can create, buy, sell and own a variety of virtual goods. Since some virtual currency is readily convertible to real world currency, a question that arises is whether a value added or sales tax should be assessed on the virtual transaction. In addition to a determination of what types of goods or services would be subject to any such tax, tax authorities will also need to consider feasibility of enforcement.

Another issue that arises is the tax treatment of goods for which no fair market value is readily ascertainable. Some countries, such as the US, decline to assess tax on property unless a fair market value can be determined. Finally, a question remains as to whether the exchange of virtual services (virtual bartering) constitutes a taxable event for income and value added tax purposes. In the real world, the European Union assesses a value added tax on barter transactions, whereas the US taxes the value of the services provided as income. The form of tax, as well as determination of the relevant taxing authority, presents interesting questions for the world’s tax authorities.

Tax authorities are also questioning whether virtual real estate should receive the same characterisation as physical real estate. If virtual real estate is considered equivalent to real property, a user who incurs a profit on the sale of virtual real property may be subject to a tax on any gain. Similarly, as in the real world, a user who sells virtual real property at a loss may be able to use the loss to offset gains from other sources. Furthermore, users that rent or lease virtual real estate might be able to take advantage of common deductions or exclusions under applicable tax law.

The ability to buy and sell virtual real estate also creates novel issues where the value of the virtual property is driven by market

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INTHEBL ACK october 2009 43

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demand. When an individual benefits from the appreciation of real-world property, a capital gains tax will generally be imposed if the asset is property that is not held by the taxpayer in the course of a trade or business. As in the real world, taxation of the virtual gain (or loss) of virtual real estate might be dependent upon the motives of the user in consummating the virtual transaction.

Virtual employmentUsers in virtual worlds can work in a variety of positions, receiving compensation in virtual currency. The existence of compensated virtual jobs in virtual worlds creates a potential for a tax classification of an employer-employee relationship. Alternatively, a user might be considered self-employed or an independent contractor, which could create reporting obligations under several countries’ tax regulations.

If an employer–employee relationship is found to exist, many tax authorities require an employer to withhold, deposit, report, or pay certain income and social taxes owed by their employees. Also, employers may be subject to other legal requirements (such as the regulation of working hours and employment of minors).

Regardless of whether Second Life’s popularity wanes or f lourishes, the virtual world presents an interesting case study in

how tax law will need to adapt to emerging modes of e-commerce. Income, assets, and occupations originating in virtual worlds are generating real world value, and tax authorities are strengthening efforts to bring virtual economies under the purview of real world taxation. User-created goods and services, virtual real estate, and virtual employment raise a host of important issues that tax agencies will need to consider over the coming years. n

Dean Page is a partner with Ernst & Young Shinnihon Tax in Tokyo. He is an adjunct professor at the Temple University Law School and is a CPA (Australia and US) and an attorney (England/Wales & Australia). Brandon Boyle is a member of the Business Tax Services group. The authors acknowledge the contribution of Michael Kent. The views reflected in this article are the views of the authors and do not necessarily reflect the views of the global Ernst & Young

Further reading

The following titles are provided by the CPA Library. They can be accessed via ProQuest, www.cpaaustralia.com.au/proquest. Contact the library on 1 300 73 73 73 or email, cpalibrary@cpaaustralia.com.au

“Changing the rules of the game”, by A Ahmed, Campaign, May 2009; “Exploring intentions to use virtual worlds for business”, by J Shen and L Eder, Journal of Electronic Commerce Research, 2009; “New virtual worlds to cater for brands”, by A McCormick, Revolution, July 2009.