Wednesday, April 30, 2008

Apples & Oranges, or Shades of Grey?

In a post on Terra Nova, Richard Bartle articulates what seems to be the consensus on a key point regarding the legal treatment of virtual worlds:

it seems fairly clear now that game-like worlds (such as [World of Warcraft]) are a different kind of animal to non-game worlds (such as [Second Life])

Leandra Lederman, of the Indiana University Law School, echoes this sentiment in her recent article in the NYU Law Review, in which she advocates different taxing rules for different virtual worlds.

The Article concludes that transactions in game worlds, such as WoW, should not be taxed unless the player engages in a real-market trade (a cash-out rule)... that in intentionally commodified virtual worlds, such as Second Life, federal income tax law and policy counsel that in-world sales of virtual items be taxed regardless of whether the participant ever cashes out. (p. 1625)

While this distinction may seem obvious to gamers and virtual world aficionados, I personally do not think the issue quite as clear cut. Take the tax treatment of a virtual world like World of Warcraft (WoW) versus Second Life (SL). According to the consensus, because WoW is a closed system that explicitly prohibits real money trading (RMT), and SL is an open system that explicitly permits RMT, then the two worlds should therefore be treated differently. But it is no secret that despite Blizzard’s RMT ban, robust commercial activity in gold farming and power-leveling persists. Yet if a WoW player manages to sell his character, gold or items for US$, few would dispute that he has real-world (and hence taxable) income. Conversely, consider an SL resident, participating solely for personal entertainment, who sells her home for a profit but keeps the gains in-world. Should she be taxed on that easily-measured gain despite the fact that earning real world money was not her objective? Applying the dichotomy above dictates that we substitute the virtual world’s attitude toward RMT for the individual’s actual attitude. (That outcome seems to not make any sense, like judging guilt or innocence by what neighborhood you live in.) Of course, the intent of the taxpayer is irrelevant to the taxability of her SL income. And the fact that WoW’s EULA prohibits such commercial activity is also irrelevant (Al Capone’s was first big conviction came on tax evasion, not the legality of the income). The point is that it is hard to differentiate between similar actions on dissimilar worlds. Moreover, if one were to make that distinction, you could not base it on intent or legality, as both factors are completely irrelevant when it comes to defining taxation income.

The distinction between WoW and SL may seem obvious, but basing conclusions on the dichotomy of these two worlds is misleading. According to Lederman and others, this is the state of virtual worlds:

If you only consider two extremes, you miss worlds that fall in between. By my last count there were around 200 virtual worlds. If WoW and SL capture the essence of two ends of the spectrum, then what of worlds that don't neatly fit into this black and white dichotomy? Take, for instance, EverQuest 2 and the Entropia Universe. Everquest is a straight-up, regular MMORPG, quite similar in most regards to WoW. However, Sony Online Entertainment has a sanctioned RMT portal hosted by Live Gamer. Through this portal, players on select servers can sell their Everquest characters and gold for US$. So although Everquest is not intended to be a commercial world, in practice players can use it as such. Now consider Entropia, a virtual world similar in most aspects to Second Life: residents can open businesses, make money, and exchange Entropia’s currency, the PED, for U.S. dollars, making it easy to withdraw profits from the world. Yet Entropia also features a deep back-story: an alien planet colonized by humans in the distant future. There are gaming elements as well, that go far beyond just a social network like Second Life, such as searching for valuable items in the environment, collecting resources and developing the skills of your avatar.

The point is that there is no dichotomy, only a spectrum of degrees of commercialization. Conclusions which rest on the assumption of dichotomy are very tenuous because virtual world operators will respond to tax incentives. If tax rules are set based on the dichotomy suggested by Lederman, VWs will simply re-orient their worlds and change their rules so they can be classified as a game world. There’s no escaping the flexibility of technology.

Returning to the tax question, should the IRS issue a separate ruling for each world, declaring in-world income as either taxable or not taxable? Such a course does not seem feasible administratively. Perhaps the better course is to follow the money – the exchange of in-world currency or items for U.S. dollars may be the appropriate trigger for taxability.

Let me be clear: I am not arguing for one treatment or another, and I am certainly not advocating taxing virtual worlds. I am merely asking questions. In addition, I am simply posing my own personal opinion, and would welcome any comments, criticism, questions, etc.

Of course, the tax question is but one aspect of legal treatment of virtual worlds. But the resolution of tax issues could well have an impact on other legal aspects.

Remember too that the likely end-point for many of these questions won't necessarily be a well-informed policy-maker, or even the legislature. Many of the relevant disputes will likely be resolved by judges or unsigned letter rulings from the IRS.

Before I close out this post, let me share with you a comment expressed by a well-respected expert in virtual worlds. Cory Ondrejka, former CTO at Linden Lab, posted the following to his blog:

Attempts to strongly separate “play” and “work” virtual worlds will stunt the growth of both. Communities that play together work together better. And vice versa. While different applications will need to find proper balance between play and work, being able to do both at a distance is a big part of why virtual worlds are so interesting.

Cory’s point, I believe, is that in the future virtual worlds will explicitly attempt to incorporate both gaming elements and commercial uses. If this holds (and it seems to me to be more likely than not), then the whole dichotomous approach breaks down.