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.

Wednesday, April 23, 2008

On the Lighter Side...

Since my recent posts have been a bit heavy on serious policy and legal questions, I thought I’d post a link to a recent Foxtrot comic that just happens to be right on target. Enjoy!

Monday, April 21, 2008

Sweden to Tax Virtual Income

A post on Virtual Economy Research Network (VERN) by Vili Lehdonvirta notes that the Swedish Tax Agency (“Skatteverket”) recently issued a statement/ruling entitled “Virtual worlds — value-added tax” (original post). According to VERN, the statement signals the adoption of the idea that “in-game transactions may incur liability for both value-added tax as well as income tax under Swedish law.” According to VERN’s translation:

Transactions between participants in a virtual world, where the deal is about the sale of a “product” or a “service” against reimbursement in an internal currency, should be considered, according to the Swedish Tax Agency’s ruling, [actual] sales of electronic services, if the internal currency can be exchanged to a valid legal means of payment. If the internal currency cannot be exchanged to money, the transactions should not be considered [actual] sales. (emphasis added)

The VERN post correctly notes a critical question regarding this rule: do unsanctioned, secondary markets for virtual world currencies satisfy the Skatteverket’s requirement that “the internal currency can be exchanged to a valid legal means of payment”?

Note also what is absent: There is no requirement that the internal currency actually be converted to real world currency for a tax to be due. A U.S. analogy might be the taxation of unrealized capitol gains.

Just as important, the ruling makes clear that in-world transactions, be they in Second Life or World of Warcraft, are potentially taxable. Game world or alternate reality … there is no difference in the eyes of Swedish tax law. The statement goes on to talk about individuals engaged in professional trade, an activity that many would agree should be subject to taxation. But even then gamers are not exempt from being classified as professionals:

The Agency also finds that a participant who, without carrying on a trade, independently and with certain permanence sells electronic services for more than 30 000 Swedish kronor [about US$5,000], is carrying out an activity that is professional…

The significance of this is that even if a player is only engages in virtual trades for entertainment purposes, if the real-world value of those trades exceeds a certain threshold, Sweden’s value-added tax is due.

One additional point worth noting:

A sale has taken place in Sweden if the seller is a Swedish trader who sells electronic services to … a private person in Sweden or another EC [European Community] country. A sale from a foreign trader to a Swedish trader has also taken place in Sweden. The same applies if a trader from outside the EC sells services to Swedish private persons.

Thus, even U.S. citizens are subject to Swedish taxes in virtual worlds, as long as one of the participants is Swedish. The implication is that if similar tax rules are adopted around the globe, U.S. citizens could end up owing taxes to Sweden, Japan, South Korea, and other nations (depending on which and how many worlds they are part of) – all because they played some games.

The VERN post itself recognizes the difficulty in setting clear tax rules for virtual worlds:

If you categorically rule that transactions inside virtual worlds are outside the scope of tax law, you are creating a tax evasion channel for companies and individuals. … On the other hand, if you rule that all in-game transactions are treated like real trade under the law, you end up with a crazy situation where Swedish World of Warcraft enchanters may have to add value-added tax to the price of their services.

MindArk, the Swedish-based firm behind Entropia, has reacted strongly to this announcement. In an interview on Realtid, MindArk CEO Jan Welter Timkrans said (according to this translation):

Skatteverket states that gamers should send invoices to each other. It’s unreasonable stuff they’re talking about. The users don’t know who they’re interacting with.

Timkrans also notes the difficulty posed by the anonymity of the users as well as international issue. Timkrans favorably observes that the U.S. Congress has taken a more reasoned approach thus far: “They have chosen not to make as rash statements as Skatteverket.”

According to MindArk, the number of Entropia users who generate enough in-world income to be affected by the ruling is small. This led MindArk Director of Special Projects John Bates to expand on one drawback of the Skatteverket's announcement in a comment to Virtual Worlds News:

Hopefully they’ll listen to the feedback from this announcement. I am happy to pay taxes, as I really love the US and I am clear that I get a lot of value from living here. I believe MindArk feels the same way about Sweden. I think the taxman has to be careful not to kill the golden goose, though. I think it’s a good idea to let the gosling grow up and figure out how to get as many golden eggs as possible, instead of one unsatisfying meal of baby goose.

I am sure that MindArk is just the first firm the take notice of the Skatteverket ruling. Other firms, and millions of their users, will likely have similar reactions, particularly if other nations begin to replicate Sweden’s tax expansion.

Note: The above translations of the Skatteverket ruling are courtesy of Vili Lehdonvirta of the Virtual Economy Research Network. The translated quotes of Timkrans are from Entropia Forum. The actual Skatteverket ruling, in Swedish, can be found here.

Friday, April 18, 2008

Money Transactions in WoW and NCsoft

Two giants in the MMO world have taken steps toward sanctioning the flow of U.S. dollars into their games. First, Blizzard Entertainment is currently hosting in World of Warcraft an Arena-based series of global tournaments hosted on special servers. In this Arena Tournament, players pay $20 to participate and in return get “to instantly create level-70 [the maximum level attainable] characters with epic equipment” and unlimited gold. These newly-created characters will be unable to explore or transfer to regular WoW realms that that host the vast majority of players. Thus, these new level 70 avatars are purely a limited creation and presumably expire with the end of the tournament in October. Nonetheless, the tournament is significant as it marks the first time Blizzard has embraced a money-for-advancement exchange. What is interesting is how Blizzard spins this project in their press release:

The tournaments will take place on special realms that allow competitors to instantly create level-70 characters with epic equipment, placing the focus on tactics and execution rather than normal adventuring.

“eSports is one of the most exciting facets of online gaming today,” said Mike Morhaime, CEO and cofounder of Blizzard Entertainment. “We’re pleased to expand World of Warcraft’s tournament options for players who want to focus mainly on the competitive aspect of the game.” (emphasis added)

Here Blizzard tacitly recognizes the validity of players’ preference to bypass the often-interminable grind required to level up to 70 in order to get to the “competitive aspect of the game.” That seems, to me at least, to be a meaningful concession. One of the most common arguments against RMTs is that they detract from the essence of the game, namely investing time in questing and exploring the world. This statement, it seems, appears to weaken the argument against RMTs.

Granted, players are not transferring money into or out of the game. And this move could very well be a one-time event, never to be replicated or expanded in the future. However, it is also possible that executives at Blizzard will sense a market demand for RMT. There are a significant number of players who want to engage in RMT. Perhaps, at some point, Blizzard might even consider setting up special servers where RMT is permitted.

A second and more significant development is that NCsoft has introduced a virtual currency called NCcoin. NCcoin’s micro-transaction system “will allow customers to use real-world money to purchase in-game items and upgrades.” In this system, one U.S. dollar is equal to 100 NCcoin. Currently, NCcoin is only available in Exteel, a third-person shooter released in 2007 in which players control giant customized mechs called Mechanaughts. However, NCsoft promises to have NCcoin “incorporated globally into many of NCsoft’s existing and upcoming games.”

As with Blizzard, the most interesting aspect of this move is how the company spins its decision. However, while Blizzard has taken the strongest stand against RMTs among MMO operators, NCsoft by comparison appears to be more flexible:

NCsoft’s goal is to bring more and more people into the online gaming market, and part of achieving that goal is to continue to diversify how customers can pay and play,” said Chris Chung, NCsoft North America’s president. “This system will offer our customers much greater flexibility and convenience in paying for content. Micro-transactions are a growing part of the online gaming industry and NCcoin will allow us to support micro-transaction based games efficiently, allowing developers and players to quickly enjoy the benefits of those systems. We will soon be rolling out more contents that leverage the flexibility of NCcoin.” (emphasis added)

NCsoft appears to recognize that they are in the business of meeting customers’ demands. There is no disputing that some, perhaps many, MMORPG players would like the option to at least be able to transfer cash into their games currency (even if outflows are still banned). Many, if not most, MMORPG players are either neutral toward or oppose RMT. NCsoft’s statements above appear to suggest that they are looking for ways to satisfy both types of gamers.

An interesting scenario could arise in which NCsoft incorporates NCcoin into Guild Wars, giving MMORPG players a choice between the two biggest adult-oriented MMORPGs: Guild Wars with RMT versus World of Warcraft with no RMT. Consumers, it is said, vote with their feet and such a situation would give those WoW players who favor RMTs an easy place to emigrate to.

Update 4/23/08: NCsoft has announced that the NCcoin system will not be incorporated into current games, such as Guild Wars. As reported on Massively:
NCcoin will not be retrofitted in games that have business models that do not work with a micro-transaction system. We will, however, work to have NCcoin incorporated in as many of our games as possible. What role NCcoin will play in our future console offerings is yet to be determined.

Friday, April 11, 2008

WoW Hits 1 Million Concurrent Users in China

Interesting milestone was announced today by Blizzard. As reported by and The9, World of Warcraft recently exceeded 1 million concurrent users in China. WoW operates somewhat differently in China. There, Blizzard contracts out the provision of the game to The9, and players can pay by time spent in-game not by a flat monthly rate like in the U.S. WoW China is almost like a completely separate and independent MMORPG.

The footnote here is that these players aren't truly interconnected, as they are dispersed across hundreds or thousands of separate shards (servers). It will truly be amazing when a world can claim to have a million concurrent users all linked together, like the way Entropia or EVE work.

Tuesday, April 1, 2008

Congressional Hearing Wrap-Up

Just a quick follow-up on the Congressional hearing today on virtual worlds (see yesterday’s post for additional details). Overall, I thought it was a good hearing. Members of the Committee asked intelligent and pertinent questions, and the witnesses did a fine job in their testimony. Members in attendance seemed to have a good familiarity with Second Life and an understanding of the potential applications and benefits of virtual worlds.

In terms of questions asked of the witnesses, Rep. Jane Harman (D-CA) asked about the use of virtual worlds by terrorists and “virtual jihad.” Rep. Cliff Stearns (R-FL), the ranking Republican Member, asked some tough and pointed questions, including about why Rosedale was stepping down as CEO even as Second Life was enjoying such strong growth. Stearns also pressed Rosedale about child predators, and what specific safeguards Linden Lab has to keep such adults out of Teen Second Life. Rep. Bart Stupak (D-MI) also asked about safeguards for children. Both Stupak and Stearns inquired about the concern that some people could become addicted to virtual worlds and whether Second Life limits time spent in-world.

Here are pdf copies of the prepared testimony of each of the witnesses.

These are the prepared testimonies of the witnesses. There is obviously a Q&A exchange that takes place as well that is not captured in these documents.