Here come the regulators....everybody duck!

This morning I had a very interesting talk with Dan Miller, Senior Economist at the Joint Economic Committee of the US Congress.  Dan has previously talked about the taxability of virtual wealth, on a panel at State of Play, and to reporters. Now the JEC is trying to stay ahead of the issue by laying out the arguments against real-world regulatory intervention by the IRS and others (like the SEC)—before regulatory bodies take official steps (like issuing regulations or interpretations) that are difficult to reverse.

My hope with this post is to spark comments that would help the JEC identify the most persuasive arguments for and against keeping regulators out of the innards of virtual worlds. I know Dan will see your comments, because he told me that he views Terra Nova as required daily reading—some comfort to those who have read arguments that TN is no longer relevant.)

Here are a few of my own observations:

First, according to Dan, issues of particular concern to governments are the taxability of virtual world wealth and the possibility of money laundering.  I believe both of these are best dealt with at the bright-line interface between virtual and real worlds:  the exchange of inworld currency for dollars, Euros or true digital currency.  The transfer of inworld to real-world currency is like a narrow pinhole connecting real and virtual worlds, and that is where to set up the auditors.  After all, virtual worlds are vast, confusing places, and I don’t think anyone looks forward to reading or writing private letter rulings on the appropriate cost-recovery schedules for investment in  warhammers and beds with built-in animations. 

I see little reason to have regulatory intervention inside VWs to combat terrorism or organized crime….it is hard to see anyone accepting Lindens for an AK-47 or a mafia hit.  I see more sense in saying that income earned in a world like Second Life is taxable….after all, it is possible to have tax liability for goods and services received, as in barter or game shows.  However, if I win a car on a game show, it is indisputably my car.  But land in Second Life really still belongs to Linden Lab, so I don’t think residents ownership is secure enough….until they actually convert their wealth into assets that aren’t subject to arbitrary confiscation or nonperformance by Linden Lab. 

I wonder how far one could push the common notion of virtual worlds as “other lands.”  Under US law, corporations operating businesses outside the US don’t typically pay taxes on overseas profits until they repatriate their earnings.  Analogous reasoning would suggest that US taxpayers aren’t subject to tax on their virtual world profits until they repatriate by converting into currency of value in the real world.  Too much of a stretch?

Finally, how about the question of whether businesses operating within virtual worlds should be subject to real world regulations governing banking, exchanges, commodities and futures contracts….or even antitrust laws (Anshe Chung, watch out!).  In addition to arguments emphasizing that VWs are games (whatever that means), or are somehow so different as to make traditional regulation inappropriate, let me add this one:  Virtual worlds have the promise to allow laboratories for testing the effectiveness of any number of regulatory and policy actions.  Does eliminating a capital gains tax actually increase investment?  Are insider trading rules good for investors?  If regulators will leave these worlds alone, we can find out!

Comments

[Nate Randall]

1.

There is a lot of activity floating around on this subject at the moment. MindArk the makers of Entropia Universe recently returned from meeting with the JEC as well as the IRS, Treasury and even CIA according to a discussion on our site.

"My hope with this post is to spark comments that would help the JEC identify the most persuasive arguments for and against keeping regulators out of the innards of virtual worlds."

I'll start by putting forth my argument that you have two different issues on the table. You have the RTM (Real Money Trade) issue and the RCE (Real Cash Economy) gaming issue. RMT being trade for real money against the rules of the developer and outside of the game system (WoW, LOTRO, Etc.) and RCE being a game designed with a real cash economy ingrained intentianally (ala, Second Life, Entropia, Etc.).

Taking the first path: RMT doesn't need intimate involvement from these agencies because the developers are already against the trade occuring.

Maybe rules need to be put into place to stop the transfer of Virtual Goods for real money outside of recognized RCE systems? Stopping those that facilitate these (illegal) transfers.

In the RCE world eveything is "above the table" as it were. The issue here is in getting recognition for BOTH the deposits and withdrawals. Will this happen though? Will I really be able to claim my SL and EU losses as a business expense? Is that right? It surely isn't right for me to be taxed on a $500 withdrawal if I had deposited $2000.

The dileniation of the RMT issue and RCE worlds must be made though. They are two distinct beasts.

In either case, these agencies do not need to be inside the VW mechanics. They just need the hooks and regulations on the outside to make sure everything is on the up and up.

Nate Randall
RCE Universe

2.

When you have the transaction occurring crossing the real and virtual world, how can you relate the 2 together? You gave me a virtual item, that can be tracked by the game. But in the real world, did you give me cash, dinner, ak-47, all can be pretty much hard to track.

Lets say I sell my account on ebay for $1k, according to the company, the account is only worth their monthly subscription fee.

And if try to tax only in game items, then you should also allow all of the real work tax deductions, i.e. I obtained this sword via a quest, but I had to pay travel and meal expenses.

Also in most of the EULA agreements say the company owns all items, so in a sense we the users just rent them out.

[Mike Sellers]

3.

Robert, your first two paragraphs of observations above are very well-reasoned; I hope those considering policy implications take them seriously.

I think it's important to emphasize that the proper place for regulation -- the only place that doesn't lead to a dozen down-the-rabbit-hole complications -- is where you put it, where virtual wealth becomes actual governmental currency.

That is a bright-line border that exists in other industries as well, most notably casinos: if I go into a casino with $100 and come out with $100, I have no tax or other liabilities, even if I at one point won (and then lost) a million dollars in the process. It's only if I come out with a million dollars that I have real-world issues to think about. There is no reason why virtual world wealth should be any different -- and this does away with all the thorny issues of "who owns your land in SL" etc. as it ceases to matter; it only matters when you bring cash back out.

As to your third musing paragraph: yes, way too much of a stretch. Again, use of words like "land" in this case really obscures the actual relationships going on here. A virtual world is in every possible way under the control of the laws controlling the company running it and/or the country where the servers are located. Making virtual worlds into more than they are (you're citizens of a new country!) feeds the egos of VW developers, but really only obscures the touch points to real-world issues like money laundering.

[Benjamin Duranske]

4.

The idea of virtual worlds operating as laboratories for social experimentation is, in theory, appealing, but it only makes sense to say, "keep the regulators out" if you don't let people use real money in the transactions at all, or, more accurately, if you don't allow reconversion of any money put into the system back to its government-sponsored form.

If all Linden Lab was doing was issuing a 500L game-token allowance to everyone every week, and not allowing users to purchase game tokens with a credit card (and then sell them later to someone else with a credit card) regulators would stay away, just as they remain unconcerned that I don't pay taxes on my income as mayor of Benopolis, my thriving Sim City, or require me to have a pilot's license to fly a 747 in Microsoft Flight Simulator.

But when Linden Lab advertises "Make real money in a virtual world. That's right, real money" (emphasis in original), they don't leave much in doubt. One can argue that the large print giveth and the small print taketh away, but that doesn't usually sit too well with a jury.

While I, personally, like the idea of freedom from interference (and frankly, wish that the real world had a bit less of it too), virtual worlds where real money is in play are already subject to regulation under current law. Regulators need no new special powers or laws to do this, just as they'd not need a special law to regulate a stock exchange, investment fund, or banking operation someone was running on the web, by mail, or by phone.

[Benjamin Duranske]

5.

Hit button too fast...

That all said, I think that the idea of a bright line between in-world and extracted money is precisely the point where most regulators (tax is the best example) should and will stop looking. But some investigations, notably criminal investigations, should and will occur in world. And some regulation, particularly of financial transactions, should and will occur as well. I just can't see how converting dollars to Lindens (or "Gold Shells" or "Therebucks" or whatever) should render transactions that involve them exempt.

I just keep coming back to this - if I sold people "Benbucks" that I printed on a photocopier and let them spend them on a stock exchange I ran in my garage, or in banking transactions with my friends, and I built a market in Benbucks to allow ready conversion to U.S. dollars -- all in the real world -- I'd expect to be regulated. I don't see why I'd not expect it in a virtual world.

[greglas]

6.

Robert -- Just FYI, there are two forthcoming articles out there on the topic of tax law and virtual worlds -- and two past posts here introduced them.

http://terranova.blogs.com/terra_nova/2007/05/a_virtual_slice.html

http://terranova.blogs.com/terra_nova/2007/03/new_paper_on_th.html

Both papers more or less expect the law to conform to your reasonable expectations and what I understand the JEC proposal to be: the conversion of virtual profits into US dollars should be taxed, but in-game profits or property barter for the purpose of game enjoyment should (generally) not be taxable. But the papers go into a lot more detail.

[Lavant]

7.

The night elf economist is watching you! While MMORPGS seem to warrant some form of exemption from taxation and regulation, the justification that operators are loath to the practice of RMT, fails to take into account the external nature of the market activity, regardless of whether prohibited (WoW) or incorporated (Station Exchange). And once we are outside the virtual economy we enter the realm of traditional tax law which is exactly where RCE and Second Life occurs. Couldn't seem clearer- the questions we are asking here seem to be a direct byproduct of techno-exceptional lag, questioning the underlying assumption that "virtual economies represent an area where technology has outpaced the law." Contextual clarification is key, not more tax law. But that is not to say that there is nothing new going on here. How do we deal with the notion that truly valuable economic activity occurs in Azeroth, Norrath and increasingly other earthland realms? Assessing virtual wealth is key: but how to overcome non-transparent barriers erected under the shroud of protecting the sanctity of play?

Nate said, "Maybe rules need to be put into place to stop the transfer of Virtual Goods for real money outside of recognized RCE systems? Stopping those that facilitate these (illegal) transfers."

While this would be an easy solution in a kindergarten class, I don't think property law is clearly enough defined (stretched and distorted under the claim of intellectual property) to make policy decisions as rash as this one. Given that virtual worlds draw property law into question just as much as tax law (which I said was clear from the start), I think a mutual understanding of the two need to be reached before such bright-line rules are drawn. Alfred Fritsche V has done some impressive work assessing online gamers' authority to sell in-game assets, especially in the presence of adhesive contracts, revealing Lockean, Personhood, and utilitarian interests underlying virtual chattels. In the mean time Bryan's cash out rule system listed above is probably the most efficient. Bring on the pizza! Where did I leave that number for Dynomedia...?

[Amarilla]

8.

Nice work. There are few thoughts , i'd like to relate to Entropia, because it pose a more complex approach to a more complex " de facto " situation : it comes down to traceability , accountability and liability , for both the makers and the players. While in the matter of money laundering ,and financial crimes by large ,and even anti-terrorism, there are in place treaties between the USA and the EU ....in the matter of privacy policies / public expectations there are big issues. Do not ignore that we're talkin about private - owned business operating with customers worldwide . The players' perception at this momment is : " so if i'm in the USA and i kill that virtual animal and i loot 1k Entropia Dollars from it...wich are $ 100 ...i pay taxes , but you don't , because you are in France ....hmmm...not very fair leveled Real Cash Game ".

And the french gal say : " ...ummm...so, according to MindArk, they gonna record/log/trace all my virtual trades / chat in game....and share them to the IRS/ CIA ....according to the Patriot Act i am liable for engaging in financial relationship with a potential terrorist ....wait, i didn't knew that avatar is operated by Bin Laden ! Hmmm....but how can they know that ?! I mean, me and Bin Laden could have a pre-game settlement...so they need to investigate me....geez, this f*kin game became so complicated and dangerous , that i need a lawyer each time i log in !!! "

[Epictetus]

9.

I definitely agree that the tax should come at realization, in this case the cash travelling from the virtual world into my brick and mortar bank account.

I'm hoping that these assets will be taxed as capital gains, because it's really hard to make any kind of appreciable profit without first DEPOSITING money.

Virtual worlds don't provide income, not in the tax sense, because a deposit of cash into a virtual world is an investment.

In the future, as telecommuting becomes more commonplace, I hope that these worlds are viewed as just another industry to get in to. Instead of working at home for a brick-and-mortar, I might prefer to work as a teller in a virtual bank, or I might want to manage a virtual factory.

[Amarilla]

10.

15 minutes ago i did this in a VW : " ....hey, i give you this virtual item and you buy me a lunch . Deal ." I do it on a daily basis . Read the TN classics : "....if you can hide a bit of cash, you can hide a cache of bits ". If i cannot do this RMT anymore, then i wont pay any subscription / associated costs anymore : there is nothing else interesting / appealing in SL/Entropia but the RMT. The associated costs / fees/taxes , to SL/ Entropia RCE makes them worthless. RCE means : you don't earn cash, you lose cash and time ; the RCE type of games are not designed and developed for player's fun / entertainment, but for the player to do biz in them ; to make money playing the game; wich ,considering the fees and now taxes , and considering the unethical practices of the devs ...makes them worthless. A gamer's pov, ofcourse.

[Amarilla]

11.

"Virtual worlds don't provide income, not in the tax sense, because a deposit of cash into a virtual world is an investment."

I don't know about the future, but today depositing cash into LL's/ MindArk's bank account is not investment ,but is a payment in order to play a game. Read the EULAs . LL/MA are operating MMORPGs . They are selling a licensed limited access to a game. The monies you deposit into LL's/MA's account , becomes their property. For your monies, you buy the limited right to access that game. That's all. When/if your activity in that game brings you real cash , that's a taxable event. When you have full bi-lateral access , between your in-game goods and your real life wealth, that is a taxable event too : you've accumulated values , capital ,wich you can exchange into real cash , using the Entropia ATM Card, at any momment. In theory, at least.

Long story short : does it brings you money ? It's taxable. Do you keep your monies offshore in a virtual island ? It's debatable.

[Amarilla]

12.

"... A virtual world is in every possible way under the control of the laws controlling the company running it and/or the country where the servers are located."

It is not true , when : i am a USA citizen, the server is located in Singapore, the game-company is in Sweden, i play the game at my laptop flying with a German Jet in the Chinese national air-space , and in game i have a business involving : 1- an avatar operated by a player who have real life ties to money laundering , 2- an avatar operated by a dev , in its off-work time , providing me with inside infos.

[Amarilla]

13.

Second thought ...i would say : there is no good and no need for RCE games. They only creates legal, financial,privacy ,tax and security problems and issues . You regulate them , you kill them. Wanna make a game ? Make a game and sell it as entertainment. Wanna make a online Casino ? A new Amazon ? Pay Pal ? E-commerce? XXX69 ? Make them , label them as what they are , good luck making profit. Do i do RMT in a game ? Ban me, ignore me, tax me the monies i earn.

[randolfe_]

14.

I just keep coming back to this - if I sold people "Benbucks" that I printed on a photocopier and let them spend them on a stock exchange I ran in my garage, or in banking transactions with my friends, and I built a market in Benbucks to allow ready conversion to U.S. dollars -- all in the real world -- I'd expect to be regulated. I don't see why I'd not expect it in a virtual world.

I've heard that argument before...somewhere.

"RCE" worlds are already subject to things like contract law, banking regulations, securities regs, etc. They're just too damned small for the regulators to care to go enforce those rules. Property rights are probably the first shock of reality that comes to virtuality, as a result of a lawsuit I'd imagine.

But what is the argument again as to why private companies get a free pass to start printing their own money again (thereby enabling all the kinds of things we regulate for good reason in the "real world")? I still await any defensible answer to that question, half a year after raising it. It's not microtransactions. It's not economic purity or simplicity. It's not even the need for psychological breakage. Is it to be able to avoid regulations? What about the regulation that says you can't print your own money?

[John Beety]

15.

I agree with drafting regulations as soon as possible, rather than waiting and possibly letting the question be decided by non-experts. I also support the premise of taxation at the point where one "cashes out," along the lines of the casino example above. What are the implications if the government does tax gains in virtual worlds that are not converted to real-world currency?

Taxation of in-world goods would present a number of challenges. How would one estimate the value of an avatar? Most widely-used metrics are linked to the prices posted on real-money trade brokers, private firms that are often secretive about their pricing methods. Using such a metric would leave avatar values open to manipulation unless the government stepped in to regulate such exchanges.

Suppose a company operating a synthetic world comes up with an accurate formula for determining the changes in one's avatar capital. Many individuals would be unable to pay that tax without "cashing out”. A significant number of synthetic-world participants are minors, and while many synthetic worlds have an official minimum age of 13, those who are younger are also present. Taxation of in-world gains would create conversations that start with "Mom, could I have $200 to pay the taxes on my avatar?"

Taxing avatar capital would also drive current and potential players away from synthetic worlds. Participation would plummet as Americans choose other leisure activities (to quote Marshall, "the power to tax is the power to destroy.") Corporations that run synthetic worlds create employ both knowledge and service workers. Blizzard Entertainment, a subsidiary of Vivendi Games and the makers of World of Warcraft, has over 250 employees in its R&D department alone, according to the company profile on its Web site. Sony Online Entertainment, the company behind such games as Everquest, has development studios in California, Washington, Colorado, and Texas. Even Square Enix, the Japanese company behind Final Fantasy XI, maintains a customer service center in California. Taxing avatar capital would both eliminate jobs (an inevitable consequence of a shrinking synthetic-world industry) and reduce the government’s income from taxing corporate profits.

In conclusion, while taxing real-world gains seems appropriate, taxing avatar capital would have numerous unintended consequences that would reduce the viability, enjoyability, and profitability of synthetic worlds.

[Andy Havens]

16.

Amarilla: Thanks for the quote-love! ;-)

randlofe: "What about the regulation that says you can't print your own money?" Well, I can print Monopoly money, as long as it's only used by players to buy Monopoly properties and pay Monopoly dues.

Now... the argument that since $LD can be exchanged for $USD means that, therefore, it's money is... crunchy. I've agreed with randolfe before that I wish that SL just used micro-dollars and skipped the whole $LD thing. But for reasons of simplicity and clarity; not because I think they're doing anything wrong, per se. Here's my analogy.

You and I play Monopoly and use the game money ($M) for in-game stuff to start. We each buy into the game for a certain amount of dough, with the agreement that, in the end, the proportion of $M we each have of the total is how we'll split the $US. So far, this is all legal, neh?

Now, once we're playing the game, you get really annoyed at my constant whistling and offer me $M 500 to cut it the heck out. I agree and take the game money. Which, during the game, can only be used for buying properties, getting out o' jail, etc. But in the end, we divvy up the $M, and equally distro the $US. Therefore, my concession in the game has a real world financial impact.

This all still seems legal to me, as long as the only things that $M can be exchanged for are in the game. I can't buy (as I've said before) a hamburger with virtual money; all I can buy is virtual burgers. So while virtual money has real world value, it is only as a marker for the value of virtual things.

I'm willing to be convinced on this one, though. It still *feels* a bit like counterfeiting to me, though. Until I can buy a real pizza with my $LD, though...

[Amarilla]

17.

well, at my age i can recognize , appreciate and bow to intelligence, humour , spirituality and the alike . Now back on topic : you cannot buy a pizza with the casino chips either , can you ? As long as the casino chips / $L are subject to online gambling regulations , the same applies to all financial operations in game. As long as the in-game currency is officially linked to dollars , they are just a interface for real world economic activities. From this , derives the need to regulate what's happening in a RCE game. Yes, at the in-game's level. You already regulate it at the " money laundering " and " gambling " level. What does Ginko case tells you , when Sanchez bribed LL staffers' relatives in the real world ? What does it tells you , when in Entropia i've paid a beer to a MA's employee and she told me inside infos ? Is there a need for in-game regulations , when you,as a dev, create at whim a virtual weapon and RMT it for real cash to an addicted player ? We both know the answer : the devs have the power to manipulate and to exploit the in-game mechanics and data . When about the so-called RCE games, there is a need for regulations. Because the devs have the power to store/edit/delete / manipulate data. That data refers and have effects on my privacy, finance, security . We already have laws regarding these things . That excange of monopoly currency does not happends between 5 friends in your livingroom. It happends between thousand / million peoples worldwide . This is a case when the size matters.

[Amarilla]

18.

"You and I play Monopoly and use the game money ($M) for in-game stuff to start. We each buy into the game for a certain amount of dough, with the agreement that, in the end, the proportion of $M we each have of the total is how we'll split the $US. So far, this is all legal, neh? "

You and I play Entropia and use the game money ( PED ) for in-game stuff to start. We each transfer real money into MA's bank account, MA puts PEDs in our avatars' inventory, we buy weapons, ammunitions and start to kill monsters. Your avatar is very skilled , mine is a noob; you use high-end virtual weapon , i use the lowest weapon possible ; we kill the same monsters , same time, at the same in-game location ; or, each of us use exactely the same leveled avatars and items; at the end of the game's session , as a result of game's mechanics wich none of us understand / can relate to player's / avatar's skills, used items or deposits or anything else comprehensive ...your avatar looted 1k PEDS and mines lost 1k PEDS. You can ask MindArk to approve your withdrawal request , so if they agree now you have $ 100 . I've just lost my deposited cash of $ 100 , rolling the dices ; killing monsters ; mining ; crafting ; nobody knows what decides the outcome , except MindArk.

So far, this is all a rigged unregulated online Casino, neh ? There is absolutely NO legal impartial / independent authority checking / regulating / accounting what's happening there in-game. And yet, MindArk is allowed to operate in the USA . I thought unregulated online gambling is illegal. Tell me again, what decides the " loot " in Entropia , and what is the official USA regulatory body who check/supervise MA's software ? What are the odds ?

[randolfe_]

19.

@Andy

Monopoly makes no attempt to provide, enable or encourage that $USD to $M linkage. You could apply your same argument about marbles or tiddlywinks. But there is a fundamental difference. Borrowing from the other brilliant commentors here: you are describing a RMT market and transactions, not RCE. Monopoly is not meant to be played with $USD, the Monopoly loot is not meant to be traded for $USD, and the intra-game interactions are not meant to be facilitated with $USD.

An even better "confusing" analogy would be trade-able cards. Here are game pieces that have discoverable market value, and are used in transactions to and from $USD. But even there the intrinsic value is in the game piece itself, not in any direct value derived from or by the game. It's more like an antique or rare coin than a RMT or RCE transaction.

The L$ market/economy is explicitly and intentionally of a RCE design. The very concept that a L$ represents is fundamentally altered because Linden Research provides the facility, incentive and strong need to buy L$ with $USD. Amarilla has it right in that the L$ is more akin to a poker chip in design than a Daddy Warbucks dollar or a marble.

But we definitely agree with the conclusion that games/worlds that intend to support RCE should not endeavor to pretend they are central bankers executing monetary policy. The real world guys can hardly get it right, why build certain failure into a game? Just peg to the dollar and be done with it. You can even break the dollar up into all kinds of odd-ball credits, tokens, simoleons, whatever with psychologically compelling, hard to divide prime, "breakage" sizes like $1USD = 313$R, or whatever.

[Ola Fosheim Grøstad]

20.

All the regulators have to do is to distinguish between hobby and professional play, and do so by setting a threshold where taxation kicks in. If you have a billion worth of "virtual assets" spread over 100 worlds you obviously should be taxed (and not only income tax).

[thoreau]

21.

Wired.com is reporting about a SL bank collapse that cost hundreds of thousands of dollars.

http://www.wired.com/gaming/virtualworlds/news/2007/08/virtual_bank

It aint just taxes.

[Robert Bloomfield]

22.

One of my hopes in this post is to identify useful analogies that people can use to persuade regulators to do the right thing. Let me emphasize an important difference between speaking to regulators and arguing cases at law. Lawyers are forced to deal with prior decisions by judges and regulators...but if we get ahead of the issue, we can get the regulators to issue statements on how they believe past law applies, and they are free to be relax their claims on liabilities and jurisdiction.

A famous example was with the Mark McGwire record-breaking home run ball. A lawyer could have easily argued that someone who catches the ball immediately incurs a tax liability for its value (estimated then at about a million dollars), and if that person were then to return the ball, they would be liable for a gift tax. In fact, the IRS initially expressed this view. However, they quickly issued a public statement saying they would not apply this reasoning. If the IRS stuck to their guns, they might well have succeeded in tax court. But they concluded that would be the wrong thing to do, in part because people were able to provide them with compelling analogies--like comparing the baseball fan with someone who declines a prize on a game show. (For a recent discussion, see http://online.wsj.com/article/SB118532191532076935.html)

My "repatriation" analogy has been rightly castigated here, so I won't pursue that one (which was rather tongue-in-cheek in the first place).

So, how is this analogy for not taxing items that one *could* trade for real money if they were willing to violate the game's terms of service (Nate's RMT): that would be like taxing a beautiful woman because she *could* earn money by illegally engaging in prostitution. Not a perfect fit, because at the end of a day, the woman no longer has the opportunity to sell her services for that day, while the person with the virtual good can sell it the next day....but in either case, there is clearly a taxable event if they breach the TOS or local law and receive cash.

Now, an analogy for virtual assets in a real cash economy. You wouldn't tax a player in a game show until they actually walk out with the money. Before that, any number of things could happen (like being banned for "any or no reason") that would leave them with nothing. Same in Second Life or Entropia. Note that the same could be said in real-world businesses, which is why small businesses typically are taxed on cash received, not favorable business events that increase expected future income.

@Ola, regulators often set threshholds under which there is no requirement to comply. So that might be a natural way to go, with analogies to exceptions in tax law allowing small firms to use cash accounting, securities laws allowing small firms to avoid SEC oversight or Sarbanes Oxley....why not the same for investments in virtual worlds, or running inworld banks and exchanges?

[randolfe_]

23.

From the Wired article:

That said, Bloomfield believes residents are already responding by creating a variety of oversight institutions of their own, including companies that insure against fraud and homegrown regulatory institutions like the Second Life Exchange Commission, which is modeling itself on the SEC.

The problem though is that the Second Life "virtual SEC" is entirely self-enforced by participants, not by designated regulators. Complicating that further is the fact that those participants are either anonymous or identity-unverified. The SEC has enforcement power, explicitly granted by the US Congress, as does the FASB have regulatory power granted to it.

Unless Linden Research acts as an honest broker and grants such power to a designated regulatory agency, any "virtual SEC" is more detrimental than helpful. In fact, I go so far as to argue that Linden Research cannot be an honest broker because they have a specific conflict of interest in their own business motives.

A paper-tiger "virtual SEC" only creates a false sense of regulatory safety when, in fact, there are not even any type of accounting principals upon which anyone can measure what the hell banks, corporations, equity exchanges, etc. are even doing. So, what exactly are these pretend regulators regulating other than ex-post fraud and ponzis?

Worse, if I am a participant with a profit motive, I will have a terrible moral hazard when presented with a pretend regulatory regime that I know has little power to enforce regulations upon me short of convincing the despot to kick me out entirely. I stand to earn hyper-returns by gaming the system and using the pretend regulator to delay my inevitable "cash out" exit.

I contend there are at least four paramount requirements:

1. Public registration of all material financial institutions with verified identity publicly posted.

2. Licensing of such institutions.

3. Establishment and enforcement of a set of reasonable generally accepted accounting principals.

4. Designation and empowerment of a regulatory and enforcement agency which is separate from Linden Research, Inc., yet has the power to enforce action upon Linden's customers in-game.

I also contend those four things are too difficult, expensive and unwieldy for any game to hope to implement. Luckily, all these things have already been done ... in the real world. For this reason, if for no other, it is this real world regime that will ultimately govern any virtual world game of any size big enough to demand regulation.

[Mike Sellers]

24.

Robert, re: analogies, what do you make of the casino analogy I used above (and others have used before)? To me it's directly applicable: you put in real dollars to "buy" chips as monetary markers (actually, again directly analogous, you buy a limited access right to use the chips in some ways but not others), and then engage in a variety of monetary and service exchanges with those markers. There is no taxable event until you exchange those markers for actual currency again, which maintains the bright line distinction.

While I'm a bit loathe to draw too close of a parallel between gambling (or "gaming" as that community liked to call it) and online worlds, I think this analogy is pretty direct and comprehensible.

[greglas]

25.

Mike, fwiw, there's a case on taxing casino chips from the Third Circuit that Bryan Camp discusses in his paper and argues is directly relevant to this question.

[Robert Bloomfield]

26.

@ Randolfe,
I oversimplified by calling the SLEC a "regulatory" body, and I agree that there can't actually be regulatory bodies in the way we normally think of them without someone granting them a form of monopoly power to fine, ban or otherwise restrict rights of other residents.

A better term would be a "certification" body, and the best analogy being Underwriters Laboratories (http://www.ul.com/). You have probably seen the "UL" symbol on electical appliances and extension cords in your home. UL sets standards for product safety, and will certify that your project meets their standards. If it doesn't,stores might not carry it, fire insurers may not cover a building housing the product, and so on. UL has quasi-monopoly power, but only because its practices are relied upon by other parties.

In a similar fashion, an inworld certification body (which is all SLEC actual is) could set standards for licensing, along the lines SLEC has already discussed: disclosure of real-life information, minimum financial disclosures (perhaps including at least rudimentary audits), bonding of key officers, and antifraud insurance.

Shyam Sunder at Yale has argued that the SEC should stop giving the FASB monopoly power to set standards, so that there could be competition among standard setters--firms will select the standards that investors prefer.

He has an interesting paper making this type of argument, drawing the analogy to the unregulated--but certified--market in baseball cards. Here is the link:

http://www.som.yale.edu/faculty/Sunder/JamalSunderCertificationOct31.pdf

[Amarilla]

27.

" Now, an analogy for virtual assets in a real cash economy. You wouldn't tax a player in a game show until they actually walk out with the money. Before that, any number of things could happen (like being banned for "any or no reason") that would leave them with nothing. Same in Second Life or Entropia. Note that the same could be said in real-world businesses, which is why small businesses typically are taxed on cash received, not favorable business events that increase expected future income."

Nope. When you accumulate capital overseas , the same " could happend " : Cayman islands sunk, Hong Kong nuked , Bank of Suisse goes banckrupt or declare war to the USA . Define " small business ". Tell me who is the regulatory body in this matter , and most important : have it full access to LL/MA's database ? I guess not.

[randolfe_]

28.

which is why small businesses typically are taxed on cash received

The problem I see with that line of reasoning is that small businesses past trivial size are forced into accrual accounting for taxes. So they're taxed on accounts receivable, not on cash received.

So what does an accounts receivable represent for a Second Life "business"? Using the foreign-exchange parallel (which itself is flawed, but everyone uses it including Linden) SL businesses would be responsible for taxes on all AR even untranslated AR. They'd just have to reserve for currency translation, no?

I think the problem here is that the business entity is *not* inside Second Life. The net earnings before taxes are accruing to a real entity that exists in a real world taxable jurisdiction. They just aren't translated yet.

Unless we're going to call it a 'gain' and thereby not taxable until realized, in which case we *are* saying Second Life endeavors are just investments. And everyone knows too well where I think that argument-line leads.

[randolfe_]

29.

@Robert

Thanks for the references. I'll read and I know some others who'll be even more interested to read as well. I'm no supporter of the FASB. But I'm not sure that a pure principals based regime or any kind of competing standards system isn't just cutting off the head to trim overgrown nose hairs. I'll read what the good professor has to say first before making a specific judgment about alternatives.

[Amarilla]

30.

"thoreau says:

Wired.com is reporting about a SL bank collapse that cost hundreds of thousands of dollars.

http://www.wired.com/gaming/virtualworlds/news/2007/08/virtual_bank

It aint just taxes."

thoreau , that article is a bogus, a hoax , a fake :

"A lot of people forget, Second Life is governed by U.S. law and the laws of California," Duranske explained. "It just so happens that these laws haven't been enforced."

"Robert Bloomfield, an accounting professor at Cornell University, is of the same mind. Bloomfield says the collapse of Ginko and the recent closing of casinos, among other incidents of alleged fraud, are shocks to participants in the Second Life financial sector.

That said, Bloomfield believes residents are already responding by creating a variety of oversight institutions of their own, including companies that insure against fraud and homegrown regulatory institutions like the Second Life Exchange Commission, which is modeling itself on the SEC.

"It will be very interesting to see which organizations survive (if any), and how they reduce the risk of fraud," he said in an e-mail.

Bloomfield admits he's getting in on the act on a personal level and has forged an ongoing agreement with two Second Life-based stock exchanges, the International Stock Exchange and the SL Capital Exchange (formerly AVIX) that will provide him with comprehensive data on trading histories for all listed firms.

He expects to publish analyses of that data in the near future and says such information could very well be another important step toward transparency.

In the end, Bloomflield says SL's financial and business sector can teach us a lot about the nature of regulation and oversight. Even with the unfortunate case of Ginko, he still believes the intervention of real-world regulation is remote.

"I am really hoping that RL (real life) regulation does not come to SL because right now SL has the chance to sort out what type of oversight and regulation it wants," Bloomfield said. "If the RL authorities or Linden Lab do start meddling with business affairs, it could ruin a golden opportunity for real innovation and creativity, a chance to recreate a world in a new image."

As you can see : Mr.Bloomfield is actually NOT " of the same mind ".

That is not a report, but a lame attempt to misinform / mislead.

What Mr.Duranske and Mr.Bloomfield says, are totally opposite .

@Mr.Bloomfield, why would we want to be " virtually regulated ", " virtually insured " , " virtually protected " ?! We are asking for REAL, not for VIRTUAL regulations, dude. Because Ginko stole from us real monies , with LL's blessing.

[Amarilla]

31.

Doing real gambling in a virtual Casino.
Doing real child-porn in a virtual brothel.
Doing real fraud in a virtual Ginko.
Doing real money laundering in a virtual RCE.
Doing real but unregulated banking and financial operations in virtual RCE.

Mr.Bloomfield offer us a virtual solution to the above real issues :

virtual insurance , to protect our real money.
virtual regulations , to resolve real issues.

Why so ? Because ""If the RL authorities or Linden Lab do start meddling with business affairs, it could ruin a golden opportunity for real innovation and creativity, a chance to recreate a world in a new image."

I have some bad news for Mr.Bloomfield : the regulators already ruined few golden opportunities : the gambling , the child porn ...next is Ginko-types. When we're dealing with real money , RCE, we need Real Regulations.

[Amarilla]

32.

and those regulations cannot come from LL or from MindArk : LL and MA are part of the game . Conflict of interrests.

[Numtini]

33.

Never has any group wanted more desperately to be taxed than the pundits of Terra Nova.

[Amarilla]

34.

"So, how is this analogy for not taxing items that one *could* trade for real money if they were willing to violate the game's terms of service (Nate's RMT): that would be like taxing a beautiful woman because she *could* earn money by illegally engaging in prostitution. ..... there is clearly a taxable event if they breach the TOS or local law and receive cash. "

Thank you , Mr.Bloomfield . Your argument proves once again that what's happening in SL/Entropia is illegal and needs regulation . You taxed Al Capone , now how about a bit of Law and Police in Al Capone 's business ?

[Erik Bethke]

35.

US Individual’s income is taxable worldwide at the time it is earned NOT when it is repatriated as in a corporation. From that logic your gains in-world as a corporation should be deferrable until repatriated to the United States – not when you merely convert to US Dollars. If your game account was held in the name of a corporation and kept the US Dollars overseas held in the form of a corporate account you would not need to pay taxes yet.

For individuals you should have to pay taxes immediately on every gain of virtual currency OR property. As long as the property has fair market value it should be taxable.

Now so the only questions is whether the EULAs as they stand from the anti-RMT operators are legally defensible. I think they are not. When the greater mass of people believe in these virtual currencies and virtual items as property – as evidenced by their routine use of the possessive pronouns “my land, my house, my mount, my sold, my gold, my bank, my back pack” AND the operators use of the same possessive pronouns – AND most damning is the robust secondary market in these items and currencies. I believe we are not very far from these EULAs needing to be re-written under duress from a court case.

These currencies and worlds are as real as the transactions taking place behind them. It will be an act of pragmatic benevolence for the regulators to take the stance to only tax at the point of realization into a recognized currency.

In fact when you win a million dollars of casino chips you are taxable at that very moment, that is why when you win $10k or more of chips you must fill out an IRS form regardless if you later spend those chips in the same day. Thus it is already established that virtual currencies are not sacred. The government wants its take no matter how you make your fair market value – even if you personally do not care that the property does not have fair market value. Your personal beliefs on what online worlds and games should be about is not important – what is important is the whole of the market’s expectation set.

The government will step in and tax large in-game gains over $10k when it is common enough happenstance that it is efficient for them to collect those taxes – until then gains in these places will simply part of the un-taxed world. In fact a great portion of the US economy is ‘grey’ and un taxed. Only W2s, 1099s and medium to large companies really have a practical requirement to comply. Very few of the individual service industries, garage sales, private party auto sales, and so on are actually reported and thus taxed.

For these reasons I am offering $5,000 (real taxable income generating US dollars that is ^^) to help us write a better set of EULAs that steps ahead and recognizes these property rights as I believe they are already manifest – and go beyond and develop a method of offering due process and other human rights in GoPets:

http://erikbethke.livejournal.com/18138.html

Over a short number of years the operators will for market reasons ahead of legal reasons start to provide replacement value or in other cases fair market value for digital property. When these Kelly Blue Books become more and more established for the consumers benefit then also it will be easier (read cheaper & efficient) for the government to step in and tax. Until then it is simply too expensive for the taxes to take place.

And may we thank the gods of efficiency – for now.

-Erik

[Duke Freedom]

36.

"The problem though is that the Second Life "virtual SEC" is entirely self-enforced by participants, not by designated regulators. Complicating that further is the fact that those participants are either anonymous or identity-unverified."

Complicating it even further then that, is that half of the people involved at the SLEC are probably having a conflict of interests in one way or another (read: owning their own virtual companies, being employees in quoted companies, etc, etc). Reason I would urge Robert to be more sceptic about the SLEC itself as well, even though the underlying idea behind the SLEC might sound nice.

[Amarilla]

37.

RMT :
advantages : you can avoid the IRS and you can save the outrageous fees LL/MindArk are asking ; and afterall, LL/MA never promised to buy your $Ls / PEDs : you can ask and they have the right and the power to refuse , for any reason or for no reason at all. You make a nice script , or you looted a nice item, and you deal p2p to another player. Free market.

disadvantages : they can ban you. Well, Bragg's case it's not over yet,we're waiting to see what power actually an EULA have , so that's debatable.
Also , if you are that dumb to ask the monies to be wired or paypal to you , you'll pay taxes.

RCE :
advantages : you can be a good citizen ; you agree to share your real ID/ bank account/credit card infos to the IRS/CIA/FBI ; you can play with a clean heart , for game's sake ; art for art, game for the joy of play. Also you'll probably reach to heaven. Also, the in-game emergent economy is much easier to rigg / nerf / inflate/manipulate / exploit, wich is good , because the devs needs cash to improve the virtual experience.And to pay their mortgages and cars, from the RMT themselves are engaged in.

disadvantages : i don't see any.

attempt to conclusion : don't RMT , because you simply steal the tax money : they need the monies to feed the starving ones, to build homes for the homeless , for education, for consolidate the bridges,for health care and for defend us against the people of Ugabantu who are after us. Don't RMT, because if you do so, you force the devs to actually design some fun in game .

[Vindi]

38.

Firstly, still we see here as some commentators think about these tokens as RL money or the SLEC as a regulatory body. I think how it is possible to make any good argument when it is missed the real entity on an issue. If we get lost in the names and the tags or labels, we will be not able to address reality. We could see in an every day basis how misleading names and tags lead to wrong decisions in our policy makers. Unless we want to tag it incorrectly in order to achieve our agenda, which is quite usual too. Therefore, my arguments here are based on the basis that these tokens grant a limited access right and they are not money as dollars, yens or euros, which indeed it is clearly stated on dev’s ToS and EULAS.

Secondly, I would not argue about the validity of both regulatory and certification bodies in RL, although I think that their works are rather improvable, just thinking about last couples of weeks. And if their jobs and outcomes are quite questionable when they made policies based on past experiences, I don’t want to think about their outcome if they try to policy on future developments and outcomes. However, what we should not miss or disregard is their experiences as it could be as forgetting history to repeat past mistakes.

Then, we bring here two broad issues; one regarding taxations and the other the use of these tokens as for money laundering and related matters. For the second, I really don’t see how money laundering could be done in an efficient and opaque way, issues that these kind of people look for, as they are bad but not dumb. Indeed, if there is an environment where everything could be easily tracked down, this is the one of VW. So, mounting a scheme of cascading businesses to move the money through will leave a track which is more traceable than in RL.

Regarding taxation, I would state first that I am not fully aware of US law as I live in Europe, so I could make some statements that are not valid there.

In regarding taxes, let me say that they are not a grey area but rather untaxed activities, whether if it is due to efficiency or not, I really do not know but I would rather think that ours owns IRS has thought about it to squeeze the most out of it.

Although we mainly wrote about direct taxes, we should not forget about the other one. The other is indirect taxes or, to put it with another label, consumption tax. When we buy, for instance, a pair of shoes, there is tax which amount for 16% of the good, in my country. If the good is considered as a luxury good, the tax goes up to a 35% (I am not very sure about actual rates and differs also from country to country, even within Europe). So, as you have an increasing income, you are going to buy more goods, which lead you into paying more taxes. Also, if you need to buy some goods or services for your untaxed activity, you will be paying more taxes. However, if you have a legal business, those taxes are deductible as well as those expenses. Therefore, you actually pay taxes on your untaxed “business”.

Regarding direct taxes, we should need to see the overall flow of the income to be taxed and here again it goes my lack of knowledge about US and its States law. Although we have seen here how the repatriation analogy has been dismissed, this analogy, I think, it has not been full brought into the argument because there could be an issue of double taxation which is related to multinational companies too.

On top of that, if we argue about that income earned in a world like Second Life is taxable, how could we consider does expenses related to achieve that income? We need to think on those expenses made in world but also there could be other significant expenses that are made in RL but related to that income too. In addition, when you have a legal business, you have a starting date for your IRS and from there both income and expenses are taken in consideration. So, should we keep our home’s bills just in case that some day in the future we may make money out of our preferred VW?

[randolfe_]

39.

Regarding expenses, the US IRS has very difficult rules surrounding offsetting personal expenses against business (or self-employment) activities. In essence, the IRS maintains that your home expenses have a double-benefit and therefore are often not expense-able against your revenues for tax purposes. Some high profile tax cases exist where individuals, after going to great lengths, ultimately prevailed in court against the IRS. In those cases, however, the home-office situations involved extreme circumstances like having an entirely separate building with separate utility metering, etc., and used exclusively for business activities.

The bottom line is that most Second Life derived real dollar income is taxable, it's just currently untaxed for efficiency reasons as suggested above. Questions of property and capital gains aside, even without definition on those issues any money realized out of Second Life to individuals is strictly taxable _regardless of how much you put in_. That is unless you file corporate returns or you file self-employment returns, in which case you'll pay into either self-employment taxes or pay your corporate burden.

The only grey area relates to "real" corporations earning money in Second Life -- which I suspect isn't much of a problem anyway.

[Vindi]

40.

Sorry for shoes's example ... if it is a personal expense, you would no be allowed over here neither. Wrong as well to use the "home's bill" tag, I should have used some related items. Altought it seems there is a bit more room over here regarding defining deductable expenses, still it has to be either a corporate or self employment.

Agree with efficiency point of view, altought it

[Edward Castronova]

41.

Just a comment - the points I made in my 2003 paper are what I would contribute here. If anyone wants to read ancient history, that's what my opinions were and are about state regulation of virtual worlds.

[Vindi]

42.

(sorry I hit wrong button while I was leaving my desk)
I agree with efficiency point of view, although it is not only on the view of the IRS but also for tax payer point of view, putting aside those activities that are a regulated activity in the sense that it has to have a legal entity to practice it.
What I try to explain here it is that at certain level of economic activity, it is on the interest of the tax payer to move from untaxed to self employment or maybe to corporate, and not only in the meaning of the taxes.
If we impose a tax or other regulation burdens on these economic activities while we don not have the market volume to support it, we will be killing their future development altogether.

[Nobody Fugazi]

43.

Hehe. I got here because someone said that your post might be grounds to clear up that little Ponzi in Second Life. Hehe.

There is a need for some form of regulation when it comes to these things, but it is a question of *where*. Self regulation is well and good, but there are also international laws, credit card processing regulatory issues, potential for money laundering, and many other things.

I'm with Lessig's "have less lawyers" thought on this - and the sensible thing would be that some of these regulations would be on code of the virtual worlds themselves - standards for transactions, fiat/barter<->hard currency exchanges, etc.

The *same* regulations should not be enforced, but the regulations of virtual worlds have to be compatible with international laws, etc. This is something that people are slowly beginning to figure out... and the scale of cost for litigation makes most of these issues bad business to prosecute - as with the internet. Less law, more regulated *code* is what I'm thinking... May toss up a post on this after I simmer on it.

[Nobody Fugazi]

44.

I think I'll stand by what I wrote, with a caveat: Regulatory agencies should have some input - but not drive the process. It is unfortunate that for regulation to come that there may have to be some sword swinging, but hey... if virtual worlds are to survive, they need some teeth in these regards.