Second Life - first tax on virtual profits?

“In this world nothing can be said to be certain, except death and taxes”

Benjamin Franklin (1789)

Everyone remembers the last part of that quote, but I am interested in the first three words. The phenomenal growth of complex virtual worlds such as Second Life has attracted the attention of various governments (notably the US, Sweden and Australia) to the possibilities of taxing profits made in those worlds. Given the record of the current government, can the UK be far behind?

Second Life is a virtual world peopled by avatars created by participants in the real world. It has a burgeoning virtual economy, an unlimited supply of virtual land and virtual businesses supplying goods and services. Its currency, the Linden dollar, has a US dollar exchange rate. Recently, Ailin Graef became Second Life’s first US dollar millionaire (or at least the first to publicly acknowledge her status as such), based on holdings of virtual land, shops, investments and Linden dollars.

It is fair to say that earthbound tax systems do not adapt easily to dealing with the virtual world. Among the various questions that this uneasy interaction begs are the following:

1. Can virtual profits be taxed, or must the taxman wait until the participant converts his or her Linden dollars into hard cash? Sweden has taken the latter view, which accords with common sense, not least because the participant clearly has real money with which to pay the tax. Would the logic of taxing virtual profits be to accept payment in Linden dollars? You see the problem!

2. What is the nature of the profits; are they income or capital gains? Presumably that depends on how they arise. Profits from selling goods or services would be trading income, whilst profit from selling land may give rise to gains (but then again it may be a trade). Selling investments at a profit would almost certainly give rise to capital gains.

3. Where do the profits arise? This is a great question. Tax authorities will no doubt argue that they arise where the participant is resident, which has some logic. Most UK residents are taxable here on worldwide income, but not all. Those who are domiciled outside the UK are only taxed on non-UK income and gains that they bring to the UK. What if a non-domiciled UK resident exchanges his or her Linden dollars for US dollars and keeps them outside the UK?

4. What happens when a participant dies? Does their virtual wealth form part of their estate for inheritance tax purposes? Are the administrators of the estate obliged to convert the virtual wealth into US dollars for the benefit of the heirs?

5. Is VAT payable on sales or exchanges of goods and services in the virtual world?

I have no intention of answering the above questions, but you can be sure that the Treasury is or will soon be addressing them. Watch this space for further developments in this area, which I predict will become a hot topic in the coming months and years.

Mark Simpson

3 July 2007

Comments

[Michael]

Hi Mark!
Great Approach!
I just write my thesis on this topic and I also think about you 5 points.
The only serious article on this with an answer on this question is from Prof Camp --> The cash out rule.
Tax it, when you change L$ in US$
but what if you could buy something real with the L$? Then you could never tax it. Normal in CHina when using the forbidden QQ Currency oder Baidu, also with Wow Gold earning and selling the problem stay the same: there is no change of the currency and no point to tax it...
cheers
Michael