April 07, 2007
Virtual Tax, Part 2
Posted by Leandra Lederman

Thanks to everyone who posted comments on my first post on virtual tax. As promised, this one discusses Second Life. For those who are unfamiliar with it, Second Life is a different type of world from World of Warcraft (WoW) and other game worlds. Second Life provides a virtual environment and basic avatars but leaves it to participants to provide most of its content. Its Terms of Service allows users to retain intellectual property rights in their content. Second Life earns its revenue from selling "premium" memberships that allow "ownership" of land and from monthly land use fees. Basic membership is free.

Second Life can be used as a type of chat room for avatars and for entertainment activities, such as going to a concert. Second Life also facilitates commerce. It provides the LindeX, an in-world exchange for its currency, Lindens (though it purports merely to license Lindens to users). Second Life users can do things like create a line of cool T-shirts for avatars that they sell copies of for Lindens. Real-world business such as Adidas have joined Second Life, selling virtual items for avatars and promoting their real-world products.

How should transactions within Second Life be taxed? My view is that, from a policy perspective, the right result is to tax commercial activity within virtual worlds but not game play. Thus, if Anna is a Second Life entrepreneur raking in the Lindens and Bert uses Second Life to build and furnish a virtual castle to hang out in with his friends, then, as a general matter, Anna should be taxed on her Second Life activities, but Bert shouldn’t be. The problem is how to reach that result.

One possibility would be to provide a "cash-out" rule, along the lines of what I proposed for WoW. The problem I see with this is the extent to which Second Life is a medium for commerce. WoW focuses on a game with a general storyline and goals and prohibits real market trade. Second Life encourages commerce and not only allows but facilitates the exchange of Lindens for dollars. Were sales for Lindens not taxed, that would encourage excessive allocation of resources to virtual businesses. Deferral of taxation would be a larger problem in Second Life than in WoW because of the larger array of business opportunities and the lower risk of deferring cashing out that the legitimacy of exchanging Lindens for dollars provides. Failing to tax sales of virtual items in Second Life could also facilitate tax evasion by sellers who purport to sell a virtual item but actually sell a real one (for Lindens).

Thus, I think the better result is to tax sales within Second Life (for Lindens). That would result in the imposition of tax on commerce such as Anna’s. (Information reporting by Second Life might be required for effective enforcement of the tax.) It would also, at least in theory, tax sales by play-minded users, but the likely outcome for someone such as Bert would not be any actual federal income tax liability because only profit would bear tax.  That is, because the expenses of an income-producing "hobby" can be deducted from the income from the hobby under IRC section 183, someone like Bert, who spends more on Second Life than he brings in from it, would not actually owe any federal income tax on his Second Life activities.

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Comments (9)

1. Posted by Monte Masters on April 7, 2007 @ 21:15 | Permalink

This is why so many people hate lawyers.


2. Posted by mrsizer on April 8, 2007 @ 10:02 | Permalink

ditto.

It will immediately drive Second Life out of business. Who is going to use an online service of any sort that requires mounds of paperwork in the course of normal use?

How about a compromise: If the [adjectives deleted] government wants to tax exchanges in virtual worlds, it must accept payment in the virtual currency.


3. Posted by Chris on April 9, 2007 @ 8:55 | Permalink

Fact is this is WAY WAY too early to even think about taxing virtual worlds like SL. The bottom line is if any type of in-game tax pops up, or worse if you have to start adding Lindens to your tax return, SL will be dead within a year. Nobody will bother creating anything except for the huge producers who make RL money off it, and everybody else just won't bother.

In another 20 years when things like SL become more common this might be worth looking into.

However IMHO, the only place where taxes should apply to this is when cashing out. The money you cash out minus the money you invested = your profit, tax that just like it is now.


4. Posted by Scott on April 9, 2007 @ 10:00 | Permalink

Do you actually play any of these games you are talking about ways of taxing? For games like World of Warcraft you can have your account DELETED if you are making trades for real world money. Taxing money earned from World of Warcraft would be like trying to implement a sales tax on people selling cocaine. It happens, but if you are caught doing it you lose your product.

Likewise for Second Life. The whole concept of imposing a virtual tax is just ridiculous. Unless there is a real-world exchange then the tax is pointless. Why not try to tax a Swiss bank account? The taxes for these people will be paid when they take their money out of the game (and I believe that current tax law already requires payments of a certain size to be reported to the IRS by Linden, doesn't it? Something to the tune of any transaction of more than $500 value in a single year?). People cashing out thier Lindens would REALLY get it in the short and curlies if an additional tax were implemented, because currently for individuals who are just making some "side money" in the game it is more of a hobby that provides a profit. This would force them to keep track of expenses, etc, and turn their hobby into a business which would drive people out of the game simply because of the headache involved (not to mention unjust... Boston tea party anyone? Taxing my income then taxing what is left of my income AGAIN when I purchase something in a virtual environment? I thought there were laws about double taxation).


5. Posted by Jersh on April 9, 2007 @ 14:00 | Permalink

One can only hope that this will kill these threetarded games and free the legions of obese from their darkened basement dungeons.

Real-life loot drops can be much more lucrative.. You just need to train your "character" to be more beefy in order to rough up the sprites.


6. Posted by Korbtastic on April 9, 2007 @ 15:43 | Permalink

These comments are exactly right. If you're selling your Lindens on eBay for cash, you probably owe tax. If it's totally within the world of Second Life and there's no cash-out point, there hasn't been a realization event so you don't technically have any property. The proper analogy is that you're holding stock which may go up or down in value but has yet to solidify as a cash equivalent.


7. Posted by Kat on April 11, 2007 @ 4:29 | Permalink

In your example of Anna and Bert you say that Anna should be taxed while Bert should not be. Fair enough. Why, then, do you propose a *sales* tax?

The effect of a sales tax is to make merchants raise their prices by the amount of tax levied on them. In this case, while Anna actually pays the tax bill, Bert is the one on whom the burden of taxation falls - totally at odds with your initial example.

Also, isn't imposition of a sales tax effectively a claim that all of the Second Life grid is US territory? Surely it must be, since you have no right to levy a sales tax on transactions outside your own territory. Will you also be seeking to impose US law on this territory? If so, will I, as a British citizen, have to obtain a visa to log in?

I can see why you're suggesting a sales tax rather than an income tax, but there's long historical precedent for dissatisfaction with trade tariffs, particularly between the Americans and the British. Anyone remember "No taxation without representation?".

Tea, anyone?


8. Posted by joe on April 11, 2007 @ 10:26 | Permalink

There was a relatively recent article that focused on the state and local tax implications of virtual marketplaces:

Matthew J. Dowd, State and Local Tax Implications of Virtual Worlds, 41 State Tax Notes 225 (2006).


9. Posted by jon on April 11, 2007 @ 22:45 | Permalink

Whatever happened to taxation being related to some benefit provided by the entity doing the taxing? Gas tax pays for roads because cars use roads and taxing gas is an easy way to charge the users of the benefit.

Seems like these days any time money changes hands for any reason the government feels entitled to a piece of the action! Is it government or a crime syndicate?!

Linden is providing the marketplace, so they should receive any tax charged on transactions. But they've decided to charge for their service in a different manner. Government gets their cut from Linden's profits.

I see no justification for government taxing virtual transactions. Can anyone give me a common sense reason?

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