Second Life ledgers

Online communities are creating virtual economies as well as a chance to live a life outside the real world. So will your online persona – and more importantly, its commercial activities – attract the attention of the real-world taxman? Or should second life have its own tax authorities? Richard Young investigates

Ever heard of Anshe Chung? If you are a regular visitor to Second Life (SL), the virtual world where you take on a digital identity in the shape of an ‘avatar’ and interact with other people’s own alter-egos, the chances are you have. She is an entrepreneur and property developer who has become so famous that she’s made appearances on CNN, in Fortune magazine and on the cover of Business Week. But Chung is not a real person. True, her company’s website lists her as ‘our founder [who] decided to test in early 2004 if working in the economy of Second Life could sustain the real life of a person’. And the services she sold are real enough, including erotic entertainment for SL players.

In fact, Chung is the digital alter-ego of Chinese-born, German resident Ailin Graef, who had played other massively multiplayer online role-playing games (MMORPGs) and found she had a talent for virtual commerce. But in SL, the ‘Linden dollars’ (L$) that your avatar earns and spends can be exchanged for hard currency – and Graef has built a 60-person, multi-million dollar crossover business as a result. Anshe Chung Studios pays employees real money, files real accounts and pays real taxes on its real-world earnings – all originating as Linden dollars.

But until the money is converted to real cash, does it have taxable status? What about the fixed asset register? Is that simply the computers the studios use to create virtual property, goods and services bought by avatars? Or should the very existence of these ‘virtual assets’ – all with a demonstrable market value – appear somewhere in the accounts?

The Joint Economic Committee (JEC) of the US Congress is expected to issue a study on virtual commerce later this year, and a final report early in 2008. But even last year, when the investigation was launched, ranking committee Congressman Jim Saxton made it clear that there was no great pressure to create tax events for purely online trade. ‘Based on existing law, if an individual generates cash income in US dollars from transactions in virtual economies, the question may arise whether a tax is due on that real-world income,’ he said. ‘However, if the transaction takes place entirely within a virtual economy, then it seems there is no taxable event. The goal of the forthcoming JEC study is to help lawmakers understand the issues involved and head off any premature attempt to impose a tax on virtual economies.’

That is good news, according to ACCA’s head of taxation, Chas Roy-Chowdhury. ‘The bottom line is that anything other than real money transfer is going to be very hard to police,’ he says. ‘The tax system comes into disrepute if it uses rules that can’t be enforced, so they’ll have to think very hard before trying to issue tax law on virtual economies.’

The issue has not escaped the attention of the UK tax authorities, even though virtual life is less popular in the UK than it is in the US. According to SL’s own figures, US residents are the most active, spending 6.6 million hours in its virtual world this June, followed by the Germans (2.2 million), the French (1.3 million) and the Brits (1.2 million). Outside Europe, Japanese avatars spent under one million hours, although the Far East – where online gaming is huge – has its own virtual worlds.

But even with all that activity, very few people make material gains from their virtual existence, and HM Revenue & Customs (HMRC) has said taxpayers are free to make profits in worlds such as SL providing their activities do not yield sums higher than their annual capital gains allowance of £9,200 – a very neat and uncomplicated holding position. That would cover all but the most professional users – and those real businesses operating online are almost certainly filing real accounts and paying real taxes covering the real money trading (RMT) from virtual earnings.

‘Not that the real money transfer is as straightforward as filling in the amounts on your self assessment form,’ says Roy-Chowdhury. ‘For example, what deductions should you apply for that income? Is your computer deductible? What about your broadband connection? That kind of issue needs to be explored. The other question is whether real money transfer of virtual profits would trigger an income tax or a capital gains tax event. As these worlds develop, the whole thing might well become more complex.’

So the problem for the tax authorities is not what is happening now. It is the potential of virtual economies to grow – and for users to retain their earnings within communities such as SL to avoid tax. ‘Even if these goods and services are theoretically being supplied and consumed in “virtual space”, they’re also being supplied and consumed by real people in real places,’ says Richard Murphy, director of Tax Research LLP and a member of ACCA’s research committee. ‘What’s the difference between buying a DVD and taking it home to watch on your TV screen, and buying a film in Second Life and watching on your computer screen? If that activity is taking place, it ought to be taxed.’

But there are other accounting dangers lurking online. ‘Whatever the eventual rulings on issues like location of business or whether the value can be translated into a real-world currency, these virtual communities are a new mechanism that needs regulation,’ says Murphy. ‘If there are opportunities for money laundering or tax evasion, that also means they’re vulnerable to use by criminal or even terrorist enterprises – so it would be surprising if they weren’t more closely regulated.’

For example, imagine a Russian Mafiosi who wishes to launder money and transfer it to London. Using dozens, maybe hundreds, of SL users in Moscow, they could purchase Linden dollars that their avatars could use to acquire a large property portfolio. The users then sell this property on to another set of users – in London – for a nominal sum of Linden dollars. The London users sell the property at full value to completely unconnected parties, converting the Linden dollars they earn back into sterling. Yes, they would probably lose on the exchange of cash, and there are other risks to the transactions. But that is true of any money laundering scheme.

‘We’re back to questions of location,’ says Murphy. ‘A copyright or a patent is located in the place where it’s created – so you might argue that for goods and services created in a virtual world, the activity actually takes place where the keystrokes to create the virtual activity happen. Assuming that the creators of a virtual world can track and monitor user activity – they almost certainly can – then they are in effect creating an audit trail, and that could provide enough information to allow taxation to occur.’

Until it becomes clear that this kind of mass tax avoidance or criminal activity is happening, it is unlikely that legislators around the world will want to wade in too heavily (with some exceptions – see box below). ‘In general, it’s much better to have a light-touch approach,’ says Roy-Chowdhury, stressing that as far as possible the authorities look to existing models for guidance. ‘The rules around the taxation of barter are a possibility. And there is a parallel with eBay, where most people don’t bother to make any declarations on their trading profits, although HMRC has been clear that they are subject to income tax.’

So, are there opportunities here for accountants looking for a new line of business? The Maryland firm Katz, Abosch, Windesheim, Gershman & Freedman is widely reported to have begun offering accounting services to SL avatars, although a search on the firm’s own website yields no results for ‘Second Life’ (suggesting that maybe their involvement might cause real-world clients to take them less seriously). ‘If there are commercial entities trading exclusively in Linden dollars, then I can see a time when they’ll need to prepare Linden accounts and pay Linden taxes on their activities,’ says Murphy. ‘Someone’s going to be the first to do it.’

And as Chas Roy-Chowdhury points out: ‘You should never say never. Some of the biggest opportunities for the profession have come from nowhere, so we ought to keep our eyes on this area. If virtual commerce really does take off, they’re going to need financial statements and tax returns just like real-world commerce – and with the complex jurisdictional issues likely to arise from the tax position, there may be real openings for entrepreneurial accountants.’

Virtual commerce: how it works

Buying and selling virtual property like Anshe Chung is not the only business you can conduct in virtual worlds. For example, UK-based Rohan Freeman sells dance moves for Second Life avatars through his company Another Dimension. According to SL’s website, every day over US$1m in real currency is spent within their world and roughly US$200,000 in cash is converted to Linden dollars – around L$2.6bn (that’s Linden dollars) are in circulation. There is even a fully-fledged market for the L$, the LindeX, which at the time of writing stood at L$266 per US dollar.

In World of Warcraft, players assume the role of adventurers undertaking quests. Magical items won or collected on these missions are tradable on sites such as eBay, and therefore have a value in real life – as does the gold earned (or, as it is known when it is done on an industrial scale by repetitively undertaking simple tasks for small remuneration, ‘gold farmed’).

Naturally, professional real-world operations transacting their business in recognised currencies attract income tax for the beneficiary – although the usual complications over jurisdiction of online commerce apply. But where the Joint Economic Committee of the US Congress, the IRS, HMRC and all the other tax authorities are puzzled is over pure in-game transactions. If the World of Warcraft gold is never converted, but the player can buy and sell experiences in the game as if they were making similar intangible transactions outside it, should it be accounted for and taxed?

In fact, most owners of virtual worlds retain title over the assets within their realms – ownership of a castle or magical sword theoretically rests not with the player but with the software company running World of Warcraft, even if the right to use that asset is held by the player and the codes for its use may be traded for cash. SL is the exception here – players can freely convert Linden dollars into cash and, critically, SL makes it clear players own all the intellectual property related to their avatars, from clothes and special moves to property. That makes them personal assets. No surprise, then, that the taxman is interested.

Virtual tax around the world

Sweden
In February, it was reported that tax authorities will expect returns for virtual land transactions that yield real money transfer, although ‘we’re not interested in ordinary gamers; more than 99% of them… keep their virtual money on their game account,’ said Dag Hardyson, who leads the internet commerce unit at the tax body.

South Korea
In July, the Government announced it would apply value-added tax on virtual asset sales. ‘Sellers who do between 6 million (£3,245) and 12 million (£6,490) won/half year in business will have VAT auto applied by transaction’s middle-man,’ reported im69.com. ‘Sellers who do more than 12 million won/half year in business will need a business licence and will pay the tax by themselves.’

China
Authorities have issued an edict (but not a law, interestingly) stating that virtual currencies should not be used to buy real commodities, and can only be traded back to real money for amounts not exceeding the original purchase price, eliminating any opportunity for profits.

Links
- www.anshechung.com The acme of ‘real money transfer’ activities
- www.secondlife.com/whatis/economy_stats.php SL’s own economy reference page, including Excel downloads of key data

Richard Young is a freelance writer and editor. He is consulting editor of Real FD magazine.